Last week, I met with a writer who is evaluating some book ideas. During our conversation, she made an intriguing comment about the connection between the S&L crisis and our current credit crisis. Since then, I’ve spent some time reading through the history and it is more than ironic that something widely credited for solving some problems for the Resolution Trust Corporation has evolved into something I credit for creating many of the problems we are now facing.

Please read Securitizations (by clicking here.)

Here are some of my favorite snippets.

The RTC’s Oversight Board did not support the RTC’s issuance of securities backed by a full government guarantee. That lack of support stemmed partly from concerns raised by the Department of the Treasury that (1) the government would retain all of the risk because there was no real asset sale, and (2) issuing a new security with a full faith and credit guarantee by the U.S. government would compete with the securities issued by the Treasury. As a result, the RTC did not use a government guarantee to enhance the credit of RTC securities. Instead, the RTC decided to use cash reserves and other methods to provide credit support. It issued publicly rated mortgage-backed securities for which the senior securities were rated in the two highest rating categories by at least two national credit rating agencies.

In light of the Fannie and Freddie bailout that appears imminent, can you imagine a Treasury that fought for such principles? Oh well…back then I guess they thought high ratings from the credit rating agencies would suffice. Interesting to see how that ratings game was played so long ago. Now that isn’t so workable so it seems we just skip all that and skip the whole “full faith and credit guarantee by the U.S. government” and just nationalize the whole system.

Here is another fun one.

Rating agencies evaluate the transaction structure, the underlying pool of assets, and the expected cash flows, and determine the extent of loss protection that should be provided to investors through various forms of credit enhancement. Securitization transactions typically involve the use of credit enhancement to create securities that have a very high level of credit quality. To achieve the highest ratings from the national credit rating agencies, mortgage-backed securities must satisfy cash flow, delinquency, and loss coverage tests that make default almost impossible. The rating agencies have developed loan loss models to estimate the required level of loss protection for a securitized mortgage loan pool. They use the Great Depression as a benchmark to estimate the level of losses that may occur if a mortgage pool is subjected to stressful economic conditions. Cash flow scenarios are run that subject a pool of mortgages to “stress tests” for which losses and delinquencies are assumed to be two to three times greater than the losses experienced in the Great Depression. The rating agencies monitor the performance of the transaction over time and adjust credit ratings as appropriate.

Is that the way it worked back then? HMMMMM!?!

And my personal fave….

During the structuring process for the first RTC securitization transaction, the issue of whether to include delinquent loans (loans for which payments were more than 30 days late) in the pool arose. The industry standard is to exclude delinquent loans when forming a collateral pool for any new offering of mortgage securities. This practice exists because the rating agencies require much higher credit enhancement levels for delinquent loans and diverging from this practice might make the securities appear less attractive to investors. The concern was that there would be a tremendous pricing concession associated with the inclusion of these loans, in addition to a substantial increase in the reserve fund. The underwriter for 1991-1 conducted a sensitivity analysis to determine the impact of including delinquent loans. The analysis used a “delinquency pricing concession” to estimate the above-market level yield premium that would be demanded by investors to compensate for the inclusion of those loans in the pool. As a result of the analysis, which valued the pricing concession at 0.05 percent, the RTC decided to include loans that were up to 89 days delinquent in the sale pool. This was the first time mortgage-backed securitization transactions had included delinquent loans.

The birth of the subprime tranche concept! It was not an immaculate conception after all!

In conclusion…..

The RTC managed the liquidation of $402.6 billion (book value) in assets. Of this amount, approximately $193 billion (about 48 percent) represented residential, multifamily,and commercial mortgages. More than $42 billion (almost 22 percent of the mortgages and more than 10 percent of all of RTC’s assets) were sold through the RTC’s securitization program. When the RTC was dissolved on December 31, 1995, only $8 billion of the original $402.6 billion in assets remained to be liquidated. The RTC’s liquidation program was therefore deemed successful. Some of that success must be credited to the securitization process. The securitization disposition strategy used by the RTC created new markets with strong participants. These strategies also paved the way for an increasing number and variety of issuers seeking convenient and expedient ways to recapitalize “nontraditional” mortgage loans.

SUCCESS!!!! I like that part about “new markets with strong participants” and of course the “convenient and expedient ways to recapitalize “nontraditional” mortgage loans.”

I am not suggesting that Bill Seidman (somebody I deeply respect) and the RTC did a poor job or that securitizations or RMBS or CMBS are bad things. I was just intrigued by the connections between the two crises and how something seen as such a success evolved into such a disaster.