JPM and CMBS

When one door closes, well, some say that another one opens while others suggest that another one slams in your face. I suppose that it can be either. However, if you want to see a prize example of the former, just look at this weekend’s press.

On the one hand, the FT reported on the US$13bn which JP Morgan has settled with the government in respect of mortgage backed securities which failed to report that they may contain nuts and now, according to today’s edition The Mortgage Finance Agency is about to have a crack at Bank of America for a further US$6bn whilst waving similar charges.

All the while, inside the paper there is a report that the ratings agencies – has anyone forgotten that they were being touted as handmaidens of the devil for having rated many of the MBS products for which Morgan and BofA are being asked to help to fund the O’Bama deficits? – are about to offer up the first credit ratings on bonds backed by “REOs”, real estate owned for rental.

It is well known that I am not an opponent of the asset backed security class although I would also like to remind that they were at the nub of the banking crisis. Not, I hasten to add, because they were inherently bad or even because they were packed with dodgy loans albeit that the subprime mortgage products were the culprits in chief. The crisis was brought about by the fact that when loans or other lendings are securitised and the bonds sold off, nobody knows exactly who owns the risk and how much of that risk they own.

The banking crisis was launched by the fear in the interbank market that banks found themselves being asked to lend to peers whose risk profile they no longer felt able to assess and hence, in an act of over-kill they stopped lending entirely. The Northern Rock was not killed by a poor loan book but by a dysfunctional interbank lending market and, to some extent, so was Lehman Brothers. At the time, the panic was that nobody knew who might be next and, truth be told, no bank could be certain that it might not suddenly find itself in the searchlights. The example of Barclays springs to mind.

Abstract lending

Alas, the systemic issues which drove the crisis did not spring entirely from fears about the quality of the global loan book in general but more from the uncertainty of where those loans were to be found. The abstraction of lending by way of securitisation might have succeeded in dispelling many of the regulators’ fears about risk concentration but it brought with it, as the first derivative of the lending process, a distance between the borrowers and the lenders and was fed by the belief by banks that they can lend entirely on the basis of statistical default probabilities and without the need for KYC, know your customer.

Thus, in the depth of the crisis, the asset backed market looked to be dead and washed up on the beach.

Now, just as we are seeing the last acts of the 2007/2008 crisis being played out, the seeds for the next one are being sown. Securitising rental receipts? I doubt there are too many players out there for whom Olympia and York means much, much less 100 Water Street and 82 Maiden Lane. Nope? How about Canary Wharf? Oly and York was the vehicle of the Canadian Reichmann Brothers, the visionary property developers who brought us the modern, high spec office block. They revolutionised office property in New York and then had the dream of taking the derelict East London docks and turning the area into a business centre. Canary Wharf was originally their totally mad-cap idea and in the fullness of time a very good one it has turned out to be too.

However, sadly they failed. Not because the idea was bad but because the financing was faulty. The two New York flagships were funded through 10yr bonds but backed only by 7yr leases. By the time the leases were up for renewal, other developers had caught up and overtaken the Reichmanns in terms of facilities and luxury and the tenants moved out, leaving the properties with fixed liabilities and falling revenues. It’s what we call an asset/liability mismatch. Banks borrow short and lend long. The Reichmanns found that they had borrowed long and lent short. Boom!

CMBS, commercial mortgage backed securities, are based on that principle but the pool of assets is normally well defined and easy to track. Some CMBS has only a handful of loans in the pool. But renting single family homes is a very different matter and one which surely thrives on the diversity of the asset pool and hence on its opaqueness. Oops; when I see “diversity”, “banker” and “arm’s-length” in the same sentence, I begin to worry.

I’m sure that the chaps and chapettes who have dreamt up the rental income backed structure have done so with the best of intentions and that they are quite proud of the safety nets and circuit breakers they have built into their deals but, once the wagon starts to roll and the competitive race begins to get the next deal into the market, standards will slip in the scramble to secure pools of assets while neither compromising coupons nor fee income. For crying out loud, we’ve been there before and as sure as eggs are eggs we’ll go there again.

So once more I appeal to the regulators to remind themselves why securitisation has become so key to the lending process. It is because the banks’ cost of capital is so high and the regulation so tight that they simply can’t afford to use that precious capital for such mundane processes as high-quality, low-risk lending to customers. Is that really what the aim should have been?

Another door might be opening for the banks but I fear that, going forward, it could once again end up slamming in the regulator’s face.