This week in the IRA Advisory Service we talk about the revenue prospects for Citigroup (NYSE:C), describe why the bank resolution process is likely to pick up steam, and ask whether the discussion over fixing the securitization market may become a vehicle for the banking industry to counter-attack against the FASB rule change requiring the repatriation of off-balance sheet ("OBS") vehicles.

It is noteworthy that JPMorgan Chase (NYSE:JPM) and Morgan Stanley (NYSE:MS) have publicly forsworn further use of FDIC guarantees to support their debt issuance. This is part of an intense lobbying and PR effort in, around and under Washington, to convince lawmakers to leave well enough alone on Wall Street.

JPM, MS and Goldman Sachs (NYSE:GS) all wish to escape the clutches of the "positive liberty" crowd around President Barack Obama, this even though they have paid their subscriptions in full through 2012. Indeed, we hear a special assessment may be levied before the November 2010 election as part of Wall Street's price of liberation.

Being positive means being confident, of course, and confidence takes money. Confidence is one of the two key planks of the economic recovery program carefully designed and implemented by National Economic Council chief Larry Summers. Summers has increased his confidence lately by adding the Federal Reserve to the growing list of subsidiary agencies to the NEC. Just think of the classic Bill Cosby routine "Chicken Heart" and you understand the growth characteristics of Larry Summers' confidence.

For those of you who missed the June 5, 2009 report on Bloomberg, "Fed Intends to Hire Lobbyist in Campaign to Buttress Its Image," the Board of Governors hired a Summers minion and former Enron lobbyist named Linda Roberston as the new political tout for the central bank. Why federal agencies are even allowed to lobby the Congress is beyond us, but you can certainly understand Summers' desire to keep the Fed on a short leash. After all, the central bank is the one source of short-term cash available to the White House as the mid-term election approaches in 2010.

An independent Fed chairman or even the whole FOMC might be a threat to the continuation of the Summers confidence game at the White House, thus the use of the "designated hitter" in the installation of Ms. Robertson at the Fed. But the key thing to understand is that Summers is now explicitly calling the shots at the Banco Central de los Estados Unidos. Robertson's title is "senior adviser" to the Board of Governors, but we hear that her true role is political liaison and chief poodle sitter for Chairman Ben Bernanke.

Is this yet more evidence that the Federal Reserve Board under Bernanke has lost its way as an independent agency of the federal government? Many members of the US Senate seem to believe so. Despite the proposal from the Obama Administration to give the Fed more power as a regulator, we see increasing signs that the Congress will reject that path and perhaps even reduce the power of the mismanaged, politically compromised central bank. There are few votes in the US Senate, at least, to support any expansion of the Fed's powers, a point we intend to address next week in our comments before the Senate Banking Committee about reforming the markets for OTC derivatives.

To us, the next question now for the Summers confidence game is how to force the FDIC's board to continue indefinitely the debt guarantee program for zombies like Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), GMAC and Bank of America (NYSE:BAC), as well as a list of smaller banks. It is all very fine for JPM, MS and GS to stop issuing FDIC guaranteed debt, a move that will quickly show markets which banks are viable and which are not in an operational sense. But what about the banks that are not repaying TARP capital or leaving the FDIC debt guarantee program?

The FDIC wants the bank debt guarantee program to end in October, but none of the zombie banks can survive without federal debt guarantees, a confirmation of their GSE status. And don't even ask about tangible common equity levels after the $1 trillion or so in OBS vehicles all come marching home. That is why we are watching the interplay between the FASB rule change and the securitization discussion in Washington to see just where the final "net" exposure ends up for the large banks in political terms.

Another Summers confidence game data point is the article in the New York Times this past Sunday, "As U.S. Overhauls the Banking System, 2 Top Regulators Feud." To us this was a clearly pitched "news" story that illustrates another aspect of the ongoing Summers power expansion in Washington.

The NYT article talks about the competition among regulators over how to resolve large banks, but the reality is that FDIC Chairman Sheila Bair is the only regulator in Washington that is still following the law when it comes to dealing with zombie banks and protecting the taxpayer. Click here to see our rant on the NYT article in TheBigPicture.

As we've noted before, the Summers approach to the economic crisis is "continuity and confidence," meaning buy time, borrow more money and subsidize the largest zombie banks, especially zombie banks in the Midwest around Chicago. That is why having trusted, reliable minions like Tim Geithner at Treasury and John Dugan at the OCC is so important to the success of the Summers political project. Unfortunately, by the time President Obama realizes that Summers' approach is not addressing the problem, more time will have been lost and the market fundamentals will be even weaker.

A key issue exerting downward pressure on real estate valuations, for example, is the dysfunction in the private market for securitization of all manner of real estate financing. Until the market for issuing privateizations is fixed, both the revenues and the funding opportunities for the entire US banking system will be sharply curtailed, and credit availability overall will remain at a fraction of pre-crisis levels -- with dreadful consequences for the real economy.

Just imagine what happens to US residential and commercial real estate valuations this Fall as foreclosure sales increase dramatically in relations to voluntary sales in an environment where there is no credit available in the jumbo and CRE market. Remember that CRE is a large investor market, but less than one fifth the size of RES as a bank asset class. The same squeeze on private financing that is killing RES property values above the conforming limits is also killing CRE valuations. The solution is private refinancing and restructuring, but a functioning securitization market is necessary for both. Apparently Larry Summers does not yet appreciate that this issue cannot wait.

The new proposal from the Obama Administration to regulate the securitization market includes requiring banks to explicitly recognize a 5% capital charge vs. the assets of a securitization, this to show they have "skin in the game " to paraphrase the Administration plan. The obvious question occurred to us and many other legal and risk practitioners focused on the securitization issue, namely why does a 5% capital charge matter to a sponsor when the sponsor already owns 100% of the risk? The Administration proposal does not even acknowledge this basic economic and legal problem - a reality that neither Larry Summers nor his various minions dare to address publicly.

But because fixing securitization is so important to the recovery of the US economy, we return to this topic with two important features that are both sourced from last week's PRMIA panel in Washington on reforming the credit default swap market. Today we run a commentary by Joe Mason of Louisiana State University, who provided some important insights into the changing behavior of loan services in the deteriorating credit environment. Joe noted last week, for example, that many sponsors of securitizations had effectively stopped substitution of collateral by the end of 2006, ending the pretense that these deals were performing anything like advertised. Both the fact of the changing in policy by the sponsors of securitizations and the change are significant.

On Monday we will feature an interview with Ann Rutledge of RR Consulting, who will talk about the root cause behind the collapse of the securitization markets, the rating agencies and what Washington needs to do to restore investor confidence in the valuation of securitizations. Besides the issue of "good sale," valuation is another key component of the problem that the Obama proposal for the securitization market does not even recognize.

Note that Mason discusses the role of reps and warranties in the securitization process, a key issue we also address with Ann Rutledge next week. As you read his comment, ask yourself: Are reps & warranties a substitute for doing the diligence?

Securitization Market Reform: Enough with the "Skin in the Game" Already
Joseph R. Mason

I bought a "certified pre-owned" car last month. I bought certified pre-owned because the price is lower and they often have a longer comprehensive warranty than new cars. When I went to put the convertible top up on Saturday, the top jammed and the car had to go back to the dealer. The repair bill will easily exceed $1,000. I'm okay with that (albeit annoyed because the weather has been nice). The dealer will repair the top under warranty, at no cost to me.

The important question to ask - one relevant to the securitization policies advanced by the Treasury yesterday - is, "who has the 'skin in the game' here?" The Treasury stance presupposes that the dealership has too little skin in the game since the car malfunctioned. They say that the sale "…led to a general erosion of … standards…" and lower quality cars being sold.

But the economics of representations and warranties are complex. Indeed, the warranty incentivized me to care less about the quality of the purchase. So was that really too little skin in the game for the dealership? I propose that the dealership may have too much skin in the game, since they now have to bear the cost of thousands of dollars of repairs. Now let's beat the analogy to death, assuming that the dealership not only covers the cost of unexpected repairs, but also regular repairs and expenses like gas, oil, tires, windshield wipers, brakes, and clutches. Do I have any skin in the game now? The dealership seems to have it all.

In fact, that is an apt analogy to today's securitization markets. Banks don't sell the loans in a securitization, they sell the cash flows from the loans. In particular, banks sell the predictable cash flows and retain the unpredictable cash flows (because nobody wants to buy those). Banks keep the expected losses (the gas, oil, tires, windshield wipers, brakes, and clutches) and even some of the unexpected losses (the convertible top mechanism) and sell only the enjoyable driving time.

So now the Treasury proposes that "Federal banking agencies will require that loan originators retain 5% of the credit risk of securitized exposures." Assuming that "credit risk" refers to expected losses, loan originators already hold 100% (the gas, oil, tires, windshield wipers, brakes, and clutches) so the policy suggestion makes no difference. Assuming that "credit risk" refers to unexpected losses, loan originators again already hold a considerable amount (the convertible top mechanism - well above 5%), so the policy suggestion again makes no difference.

The Treasury also proposes that "Sponsors of securitizations will be required to stand behind the securitized products sold to investors - in the form of strong, standardized representations and warranties regarding origination and underwriting practices of the underlying loans." Wait a minute. Increasingly liberal interpretations of the bounds of those representations and warranties over time by both FASB and the bank regulators, as well as the desire by banks to cover all sorts of losses, are the problem. When that optional support was dropped and deals were left to perform on their own in 4Q2006, representations and warranties dropped from more than $1.2 billion that quarter to half that in 1Q2007, bottoming at $15 million in 4Q2008. It is not surprising, therefore, that deal values plummeted and the crisis began. So, do loan originators really have too little skin in the game? I think not.

The rest of the Treasury proposal rings just as hollow as the skin in the game proposals, representing a lack of understanding of securitization markets and their development - as well as what is needed for reform and recovery.

Treasury proposes that credit rating agencies disclose conflicts of interest, "disclose what risks their ratings are designed to assess," "report on the credit rating performance measures for structured credit products," and "publicly disclose additional information about the methodology used to rate structured finance products," which - by and large - they already do. Ratings agencies will be further required to, "differentiate the ratings they assign to structured credit products (e.g. asset-backed securities) from those they assign to unstructured debt (e.g. corporate bonds)," as well as "disclose non-public rating agency data and methodologies to the SEC," neither of which prevents ratings agencies from repeating the same behaviors that contributed to the crisis. The sad fact is that lacking any significant performance history, ratings agencies rated unratable products for regulatory approval and escaped liability for doing so under first amendment protection. Nothing in the Treasury proposal changes that.

Treasury proposes that loan-level data be disclosed to investors at inception and over the life of the securitization. That data is already mandated under SEC Regulation AB and is the source of trustee data sold by many vendors. Treasury also proposes contract standardization. Most of the contracts are already boilerplate, save the economic terms of the deal: the tranche cutoffs and credit enhancement characteristics whose standardization can add liquidity to the marketplace and safety to commercial bank securitization.

On the positive side, Treasury also proposes reporting trade data on TRACE: we could already get marks on AAA-rated bonds off of Bloomberg and the rest of the lower-rated bonds still don't trade. Still, this would be a welcome development. Treasury also proposes changes to gain-on-sale accounting treatment of securitization revenues. While I think most everyone in the industry would appreciate improvements to gain-on-sale accounting treatment that has contributed to at least five major securitization crises since the early 1990s, I remain to be convinced that FASB has the stomach for such reform - as I remain unconvinced that regulators appreciate the importance and mechanics of securitization markets, generally.

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