The Crisis So Far: A Market Restructured

By Davenport, Todd | American Banker, April 23, 2008 | Go to article overview
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The Crisis So Far: A Market Restructured

Davenport, Todd, American Banker

Fifth in a series

Whether the government or investors force it, change is coming to the country's credit markets.

A key element of that change will be reuniting asset originators with some responsibility for their products. Their dissociation emphasized volume rather than quality, put fees in front of interest and principal repayment, and further commoditized lending.

The economics of the originate-and-distribute model were - and are - seductive.

"The complexity of modern finance - involving originators, securitizers, and investors - is based on compelling mathematics that shows how you can slice and dice the risk up into little pieces and allow everyone a piece according to their own risk preference," said Richard Brown, the chief economist of the Federal Deposit Insurance Corp. "On paper, it's a beautiful system, but now we recognize that there were some faulty incentives in the system. Not everyone had skin in the game in terms of the final outcome."

Getting the incentives right will take some time. In the meantime, the prolonged constriction of the capital markets presents an opportunity for traditional lenders with balance-sheet capacity and the courage to use it.

"Banks are still able to underwrite, evaluate, and fund some of the credits that the markets are nervous about," Mr. Brown said. "Earlier this decade the pricing of bank loans was very thin, because of the competition from market-based lenders. I think we'll see improved pricing for the banks, and the risk-return ratio will be more favorable for some of these credits."

Longer term, however, the securitization spigot will open.

"Will we go back to the days of all assets on the balance sheet? I don't think so, but we're not going back to the days where everything could be sliced and securitized," said Toos Daruvala, who heads McKinsey & Co.'s banking and securities practice for North America. "Somewhere in the broad gray zone, we are going to find some balance, and institutions should be thinking about that now."

Structured investment vehicles are likely done. The future of collateralized debt obligations is a little more uncertain; the taint is so strong that the name is surely dead, but the basic concept may still have a place in the capital markets.

Though burned investors are tempted to think otherwise, the failure of the CDOs may be more about incompetence than immorality. Packagers generally priced the products with models that failed utterly. Investors will require the banks - and the rating agencies - to come up with better models before they commit their money again to those types of structures, whatever their name.

The structures are likely to include stronger collateralization of the senior tranches, and disclosure that allows investors to monitor a structure's assets theoretically would restore confidence. The initial crisis, though precipitated by delinquencies and traditional credit problems, spread because investors could not draw borders around their exposure.

Investors "found disclosure is absolutely insufficient to allow them to measure the risk, and even if they did have the disclosure, the techniques that have been used so far have been proven to be dramatically wrong, even on simple structures," said Donald van Deventer, the chief executive of the consulting firm Kamakura & Co. Investors have "zero confidence in calculations on more complicated collateral like asset-backed securities underlying CDOs."

The limitations of the pricing models - generally known as copula-based models - are well established, but there is no clear alternative at this point. That presents another opportunity for banks.

"Major commercial banks could improve best practices in risk management and modeling on pricing in a way that provides more leadership, perhaps providing a proper platform for CDO pricing," said Darrell Duffie, a finance professor at Stanford University's Graduate School of Business.

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