NY Fed President Calls for Broad Reform of Securitization Process

NY Fed President Timothy Geithner has called for the comprehensive reform of the entire securitization process in light of the ongoing crisis in the financial markets. Improper valuations of complex securitized instruments and inadequate risk management significantly contributed to the problem, in his view. The damage to investor confidence in credit ratings of securitized products, in the tools used to value those securities, and in the capacity of investors to evaluate risk, will prolong the process of adjustment in markets. His remarks were delivered at the recent Council of Foreign Relations corporate seminar.

As part of the reforms, the NY Fed chief said that banks, and institutions that are built around banks, must be subject to a stronger form of consolidated supervision than the current framework provides. At the same time, there must be a move to a simpler framework, with a more uniform set of rules applied evenly across entities involved in similar functions, and a more effective balance of regulation and market discipline.

He noted that US financial regulations have evolved into a very complex and uneven framework, with substantial opportunities for arbitrage, large gaps in coverage, significant inefficiencies, and large differences in the degree of oversight of institutions that engage in very similar activities. Some illustrations of this are the current incentives to shift risk to where accounting and capital treatment are more favorable and the amount of risk built up in entities that operate in the grey areas of implied support from much larger affiliated institutions. The official thus raises the specter of regulatory arbitrage, a serious problem that must be resolved.

The Presidents Working Group on Financial Markets and the Financial Stability Forum are laboring to produce a comprehensive framework of reforms. The senior Fed official said that many of these recommendations will focus on changes to the ratings process for asset-backed securities, regulatory and accounting treatment of these instruments and special purpose financing vehicles, enhanced disclosure, and other dimensions of the securitization process.
The NY Fed official said it is imperative to encourage improvements in the quality of valuation methods and disclosure by the major regulated financial institutions and the necessary adjustment in valuations and reserves to reflect the deterioration in expected losses. Better disclosure can reduce some uncertainty about the incidence and magnitude of potential losses, he posited.

Analyzing the crisis, Mr. Geithner said that, as complex derivatives and structured securities products proliferated, the models used by issuers to structure these products, and by credit rating agencies to assess the risk and assign ratings to them, turned out to be much more sensitive to macroeconomic assumptions than was apparent to investors. In addition, the proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity, he noted, which left credit and funding markets more vulnerable when liquidity receded. For their part, banks and other financial institutions lent substantial amounts of money on the assumption that they would be able to easily distribute that risk into liquid markets through securitized products.

In his view, the crisis exposed a range of weaknesses in risk management practices within global financial institutions. Banks and investment banks with stronger risk management practices and cultures did substantially better. The most common failures were in how firms dealt with uncertainty about the scale of losses they would face in a less benign financial environment; the scale of the cushion they built up against that uncertainty; how well they managed the internal tension between risk and reward; and how quickly they moved to mitigate risk as conditions deteriorated.

The typical arsenal of risk management tools relies on history and experience, he said, and thus has only limited value in assessing the scale of potential future losses. Uncertainty about the future, and the greater complexity of leveraged structured products, created a ``dense fog’’ around estimates of potential loss, he noted, making institutions and markets more vulnerable to an adverse surprise when conditions changed.

In turn, the substantial impairment of securitization markets reduced banks’ access to liquidity and their capacity to move assets off balance sheets. As the market value of many securities declined, and investors reduced their willingness to finance more risky assets, liquidity conditions eroded further. In response, even the strongest financial institutions have become much more cautious, building up large cushions of liquidity and reducing financing for their leveraged counterparties.