New rules regarding treatment of MBS debt on bank balance sheets

A recent ruling by the Comptroller of the Currency, FDIC, and Federal Reserve adopted some new rules for the CRE world and are set to take effect next year. The two major implications of the rule are that more capital must be held in reserve for both banks taking positions in CMBS, and a formula has been enacted to calculate the risk level of a debt security, negating the former method which was based on the rating agencies. For now the formula is only in place for securitizations, corporate debt, and other debt on banks’ trading books but it may spread to include all bank holdings of these securities. 

This formula, which is called the “Simplified Supervisory Formula Approach,” was born because of terms in Dodd-Frank stating that ratings cannot be used to determine credit risk. Under the terms, any bank involved in debt securities must analyze and evaluate data on the underlying loans to determine the credit risk of the holding. One exception to the SSFA rule is the case where a bank already has an approved internal model and will be allowed to continue using that instead of the new formula. The majority of banks do not have this approval though, and will now have until January 1, 2013 to get set up. This could have an adverse effect on CMBS and RMBS pricing performance as well as liquidity in times of turmoil. The real problem is that regulations such as this do nothing to prevent the type of crises that we experienced in 2008 and 2009, while at the same time they vastly increase costs to the bank and at some level this will discourage banks from participating in the mortgage market. 

While it is logical to us as money managers that we want to scrutinize loan-level data when making investment decisions in MBS, regulating as much on a bank is at best unfair from the perspective that they do not have the same requirements in other securities. For instance, if the bank were to buy GE corporate debt (AA- rated), they are not regulated in a manner that forces them to analyze all of its subsidiaries or even GE’s top level financials. In fact, under the legislation there is an investment in the corporate debt of GE Capital (AA-) is treated no different from CIT Group (B+); despite vast differences in their credit quality they each receive a flat 8% “specific risk weighting”. An even better example would be ETFs – the bank could easily invest in a theoretical ETF, whose underlying holdings were solely subprime mortgages or corporate junk bonds, and never have to analyze the ETF’s holdings, whereas buying the bonds directly would require them to adhere to this needlessly onerous regulation.

Eminent Domain is not a solution to the housing problem

During the second quarter a plan to use eminent domain to “condemn” underwater mortgages began making headlines after San Bernardino County California and Cook County Illinois both indicated they were at least evaluating the plan.

The basic idea is that County residents who are underwater, and owe more than their home is worth, but not delinquent or actually under any financial distress, would have their mortgages taken over by the municipality. The municipality would allow them to refinance it at a much lower balance with a new lender. All of this would be arranged by a “helpful” intermediary, which also happens to be the same party that is trying to sell the idea of the plan, which would effectively force the losses on the mortgage lenders, give the homeowners a big free write down on their mortgage and better terms, and give the intermediary a big fee in the process.

The intermediary has been pitching the idea to large pension plans and money managers for over a year now, and has been soundly rejected by most with even a basic understanding of market dynamics.

The most obvious pitfalls of the plan start with the fact that it is not helping struggling homeowners, and in fact is targeted specifically at performing mortgages. It also runs contrary to even the most basic tenets of property, mortgage, and even standard contract law, and would likely result in decades of litigation. Finally, no lender would ever lend in a county that implemented a plan like this in the future without additional assurances that the collateral for their loan was secure.

This would be a devastating "solution" for the citizens as well as the investors in the mortgages, which include all of us as taxpayers, pension holders, and retirement assets in fixed income assets.

Our perspective is that we do not think that this plan will ever actually be executed, but is an example of another poorly thought out legislative “solution” to counter mortgage market problems. These kind of regulatory/legislative risks continue to be a concern.