Tuesday, December 16, 2008

Revival of Mortgage Securitization Depends on Greater Transparency Says Fed Governor Kroszner

A recovery in the market for mortgage-backed securities will require greater transparency and less complexity, as well as comprehensive and standardized loan-level data that will allow more independent credit analysis, in the view of Federal Reserve Board Governor Randall Kroszner. In remarks at a Fed seminar on the mortgage markets, he sketched a scenario under which investors may gradually regain confidence in mortgage securitization.

However, the Fed official does not expect a revival for some of the most complex structures that were created in recent years to finance a portion of sub prime mortgages, specifically collateralized debt obligations that were themselves backed by other structured credit products, including the lower-rated tranches of mortgage-backed securities. These two-layer securitizations were far more complex and much more exposed to systematic losses than were the mortgage-backed securities themselves. Indeed, investors in, and more importantly, financial institutions that retained, the super senior tranches of CDO-squared securities took substantial losses. Given the magnitude of those losses and the recognition that rigorous credit analyses are extremely information intensive, he expects investors to remain skeptical of two-layer securitized financial products for the foreseeable future.

But he does envision the recovery of securitization with much less complex structures of cash flows from mortgage payments in the pool to the various tranches of mortgage-backed securities. In addition, securitization contracts will need to be made more homogeneous so as to allow greater comparability of risk profiles across deals and promote more robust liquidity. Also, securitizations should involve fewer and larger tranches of mortgage-backed securities which, in addition to further promoting liquidity, could also reduce the exposure of some securities to certain tail risks and model uncertainty

This change would make the situation closer to what occurs in the corporate bond market, he noted, in which standardized disclosures about relatively homogeneous and straightforward securities of publicly traded companies allow many analysts and potential purchasers to come up with their own evaluations, in addition to those of the credit rating agencies. Moreover, such changes might also lead to the creation of structures whose credit analyses are less sensitive to certain tail risks and types of model uncertainty and more likely to be liquid even in times of market stress. Thus, this new infrastructure might allow investors gradually to regain confidence in their ability to assess the risk-return tradeoffs inherent in mortgage-backed securities, allowing them to reconsider how those securities may best fit into their overall portfolios.

A new infrastructure for mortgage-backed securities built upon these foundations might also reasonably be expected to lower the costs of information production and processing in the marketplace. The reduction of these costs will facilitate broader independent credit analyses, greater due diligence by potential purchasers, and, hence, greater ability to provide a double check on credit rating agencies' evaluation of the riskiness of the securities. In other words, market participants would be more likely to acquire the expertise to evaluate securities issues that were more homogeneous and less complex.

The Fed official also noted that the American Securitization Forum is in the midst of a large-scale project called RESTART, or Residential Securitization Transparency and Reporting. This project seeks to develop a standardized format for mortgage data that would be available to all investors and other market participants, with the goal of substantially improving disclosure and transparency related to mortgage-backed securities. RESTART has wide support in the industry, he said, and the project is receiving input from a wide range of market participants, including investors, mortgage originators, and credit rating agencies.

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