Conference on Securitization
Securitization, the packaging and repackaging of bundles of securities or financial
contracts, is pervasive in today’s marketplace. Mortgages, for example, are packaged into pools against which collateralized mortgage obligations are issued. Similarly, other types of debt claims such as car loans and credit card receivables are packaged into debt securities.
Securitization is also common in equity markets as stocks are bought and packaged into pools and resold as investment companies or hedge funds. While securitization creates liquidity and diversification, the process of securitization also raises a number of important issues. Do the ultimate owners of assets know the quality of the underlying assets? Is there sufficient transparency? What is the role of credit rating agencies and credit insurers in assessing the risk of the underlying assets? What mechanism exists for maintaining the link between the price of the final securitized assets and the underlying claims? The recent asset-backed credit crisis and the associated write-downs by major financial firms have heightened concern about some of these issues.
The 21st conference of the Financial Markets Research Center held at Vanderbilt on April
17 – 18, 2008 examined some of the issues raised by securitization as well as other developments in financial markets. Jim Bradford, Dean of the Owen School, welcomed conference participants. Then Hans Stoll, director of the Center, introduced the chair of the first session, Neil Ramsey, Chairman of Ramsey Quantitative Systems Inc. and an Owen School graduate. The first speaker, Rich Lindsey, President of Callcott Group LLC, gave a comprehensive overview of the credit crunch that began in the summer of 2007 and its broad-based effect on all corners of the financial system. After tracing the changes in interest rates, bank loans, and the mortgage market, Lindsey concluded that changes in the financial system including the development of structured finance and securitization of financial claims provided important benefits but also had their faults. In particular, imperfections in these developments led to failures in delegated monitoring and worsening of information asymmetries. The next speaker, Roy Henriksson, Chief Investment Officer of Advanced Portfolio Management, discussed the similarities and differences between the stock market crash of 1987 and the credit crunch of 2007. One important similarity was that no event since 1987 has so threatened the integrity of the financial system as the 2007 credit crisis which continues to linger in its effects today. The conference continued after a coffee break with a session on Asset Securitization chaired by Bob Davis, Executive V.P. of the American Bankers Association with responsibility
for housing finance and risk management.
The first speaker, Adam Ashcraft, Senior Economist at the Federal Reserve Bank of NY, described the “seven deadly frictions” associated with the origination and securitization of subprime mortgages. The frictions arise from asymmetric information and principal-agent conflicts affecting the various participants in the securitization process. These include the homeowner who takes out a mortgage loan, the originator of the loan, the arranger to whom the loan is sold, the investor who buys claims on the packaged loans, the
investment manager who oversees the investor’s portfolio, the credit rating agency that evaluates the credit risk of claims on the package of mortgage loans, and the mortgage servicer who collects loan payments from the mortgagor. He proposed a variety of methods to reduce the frictions. The next speaker, Richard Herring, Professor of International Banking at the Wharton School, described the securitization process and the growth in securities backed by subprime mortgages in a talk entitled “The Darker Side of Securitization: How Subprime Lending Led to a Systemic Crisis.” He discussed the policy issues raised by the role of ratings agencies, the difficulty of valuing positions (i.e. what is fair value), the adequacy of disclosure, the requirements of Basel I and II, and the size of the subprime crisis and the problems its potential systemic effects pose for regulators. Oliver Jakob, Managing Director at Jeffries & Co and formerly a risk manager at Bear Sterns, spoke on the topic, “Risk Management: What Went Wrong?” Jakob put up an interesting slide showing the EPS of two financial concerns – one going sharply negative in 2007, and the other declining in 2007 but staying positive. The company that went bankrupt was the one with declining but positive earnings. This led to the question, “Does market risk matter or can panics upset apparently viable firms?” He concluded his remarks by noting the importance of giving risk management a prominent role within the firm including reporting directly to top management.
SEC Commissioner Paul Atkins gave the post-luncheon keynote talk on “Improving Financial Markets.” He noted the SEC responsibility in the area of capital requirements for broker-dealer firms and in the area of credit rating agencies (Nationally Recognized Statistical Rating Organizations – NRSROs). He summarized the recent recommendations of the Treasury for a new regulatory structure which would divide regulation into functional categories – financial stability, prudential financial regulation, and business conduct. He emphasized the need for efficient and competitive financial markets that are not hampered by unnecessary regulation. The talk was followed by a lively question and answer session. Rick Kilcollin, partner in Sanborn Kilcollin and former president of the Chicago Mercantile Exchange, chaired the session on credit risk transfer and assessment.
Securitization, structured products, and derivative contracts are ways by which different types of risk are transferred from one investor to another. The process of transferring credit risk and the potential flaws in that process were discussed by Michael Gibson, Associate Director of the Division of Research and Statistics at the Federal Reserve Board and a member of the Bank for International Settlement’s joint forum team to analyze risk transfer. He noted that failures in the management of the risk transfer process included managing the risk of super-senior tranches, managing offbalance sheet exposures, dealing with complexity and valuation of certain instruments, and accounting properly for counterparty risk. Tom Ho, President of Thomas Ho and Co, spoke on the importance of integrating the assessment and management of credit risk and market risk. He noted these risks are not simply additive, and he presented a model for managing the risks jointly. Comments by Mike Edleson, Morgan Stanley’s Managing Director responsible for equity risk management, concluded this session. Edleson discussed the difficulty of anticipating what could go wrong and the importance of keeping the risk management staff attuned to the unknown. The last session of the day, chaired by Scott Morris, CEO of the Boston Options Exchange, dealt with a number of dimensions of the credit crunch. Andreas Preuss, CEO of the Eurex, noted that Eurex performed well in the face of the disruptions caused by the subprime crisis. The increased volume of trading was effectively handled, and market quality, as reflected in the bid-ask spread, was maintained. Preuss expressed the view that a significant demand exists for exchange-traded credit derivatives, but that the major banks are opposed. Bjorn Flesaker, senior quant at Bloomberg and formerly at MBIA, the leading monoline credit insurer, discussed the economics of the monoline bond insurance business. Jim Overdahl, Chief Economist at the SEC, noted some of the areas in which SEC regulation is related to the credit crunch; for example, accounting policy, issuer disclosure, and the SEC’s membership in the President’s Working Group and in IOSCO. He spent most of his discussion on the SEC’s authority over credit rating agencies given to the Commission by the Credit Rating Agency Reform Act of 2006. Proposed rules for the rating agencies, which reflect a response to the credit crisis, are to be issued in June 2008.
The conference next broke for cocktails and dinner. While there is a tradition of no afterdinner speeches, the participants did take a moment to celebrate the upcoming 90th birthday (July 6) of Dewey Daane, Senior Advisor to the Center. Hans Stoll noted Daane’s penchant for telling stories about his many small adventures of which there seem to be an ever growing number and thanked him for his contributions to the Center.
Friday morning’s first session was chaired by Jim Cochrane, formerly Senior Vice President of the NYSE and currently an independent consultant. John Damgard, President of the Futures Industry Association, spoke on the current regulatory issues facing the derivatives industry, including the recent Justice Department paper calling for separation of futures clearing from futures trading. Damgard agreed that a captive clearing house makes it difficult and costly for new futures exchanges to compete since positions established in the new exchange would not be fungible in the established exchange. The next speaker, John Labuszewski, Managing Director at the CME Group, described the tremendous growth of index trading at the CME and discussed how index futures can be used to “transport alpha.” A portfolio manager, for example, can match his benchmark with the appropriate index futures contract and generate alpha by effectively investing the funds not needed to margin the index futures position. Brian Reid, Chief Economist of the Investment Company Institute, discussed the effect of the credit crisis for money funds. Money funds may only invest in asset-backed securities rated in the two highest credit categories. Downgrades and defaults may cause significant problems for money funds and potentially cause them to “break the buck.” The final speaker in this session, Jeff Smith,
Director of Research at the Nasdaq Stock Market, discussed recent developments such as Reg NMS, the merger with the OMX, and the acquisition of the Philadelphia and Boston stock exchanges. He emphasized the competitive nature of equities and options markets.
Bob Whaley, Professor of Finance and Co-director of the Center, chaired the last session
of the day on the topic, “Hedge Funds.” Nick Bollen, Associate Professor of Finance at Owen, presented his latest research (joint with Veronika Pool) on hedge funds, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution.” Bollen and Pool conclude that some hedge funds avoid reporting losses because losses tend to lead to fund withdrawals. Barry Schachter, Director of Quantitative Resources at Moore Capital, in a philosophical commentary, argued that the empirical regularities identified by Bollen and Pool do not prove that returns are misreported to the exclusion of other possible explanations.
In the ensuing audience discussion a number of interesting examples were offered that are consistent with the patterns documented in the paper.
SEC commissioner Paul Atkins speaking on improving financial markets.
Neil Ramsey introducing the first speaker.
Bjorn Flesaker and Scott Morris contemplating the speaker.
Chuck and Pat Scott keeping things organized.
Dewey Daane Invitational Tennis Tournament
On a beautiful day, a record turnout battled for the contents of the Daane Cup. The event
was marred when Bjorn Flesaker snapped his Achilles tendon. Not since Dewey Daane was hit in the nose by an erratic partner several years ago has an injury of any type occurred, much less one as serious as Bjorn’s. We wish Bjorn a speedy recovery. The winner of the somewhat deflated group was Craig Lewis with Christoph Schenzler runner-up.
Tennis players before the battle.