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One Common Sense Solution For Financial Reform

SSince the subprime crisis began, many people have offered ideas on the best way to reform the financial system. Since the crisis has many different causes various proposals have been raised to try and prevent this crisis from occurring in the future. Some of these ideas have included a consumer protection agency, strict loan standards, and the regulation of credit default swaps.

To be honest, I have stopped following the various proposals for some time now. Like the health care bill currently being debated in Washington the details are being changed constantly to try to secure enough votes for passage. However, I remember reading a proposal several months ago that I thought would be an excellent idea. The proposal is titled the Credit Risk Retention Act of 2009. I will quote from the proposal.

Credit Risk Retention Act of 2009 - Amends the Truth in Lending Act to require the federal banking agencies to prescribe specified regulations jointly to require any creditor that makes a residential mortgage loan that is not a qualified mortgage (as defined by such agencies) to retain an economic interest in a material portion of the credit risk for any such loan that the creditor transfers, sells, or conveys to a third party. Requires the standards governing such regulations to: (1) apply only to residential mortgage loans that are not qualified mortgages; (2) prohibit creditors from directly or indirectly hedging or otherwise transferring the credit risk they are required to retain under the regulations with respect to any residential mortgage loan; and (3) requiring creditors to retain at least 5% percent of the credit risk on any non-qualified mortgage that is transferred, sold, or conveyed.

The act requires that any lender that issues a loan cannot sell off the loan entirely to another institution, instead they would have to keep at least 5% on their books.

Why do I think this is a good idea? One cause of the subprime crisis was the process of securitization. Securitization increased significantly from the mid 1990s until 2007. Trillions of dollars of loans were securitized during this time period. Let’s take an example of securitization of a subprime loan.

A mortgage lender in California would issue a loan to someone who had absolutely no chance of being able to afford their mortgage. Their employees were paid commissions based on how many loans they issued regardless of the quality. The lender did not care because they sold these loans to an investment bank on Wall Street. The investment bank did not care about the quality either because they would securitize the loan and quickly sell it off to some investors in Europe and Asia. The investors overseas were happy because they were getting an investment grade bond with a high rating from the credit agencies that paid a high yield. The investment bank and loan originator were happy making a quick profit without taking any risk, and the investor overseas was happy getting a AAA rated bond with a high yield.

However, once subprime borrowers started to default the whole scheme collapsed. The loan originator was not able to sell off all the loans because the investment bank stopped buying them; the loan originator eventually was stuck with billions of dollars of subprime lenders who defaulted. This forced the loan originator into bankruptcy. The investment bank could no longer sell off their securities to investors and they too were stuck with the bad loans. The investors who bought the loans initially quickly realized that these were not really AAA bonds.

What the Credit Risk retention Act will do is nip this whole process in the bud. The loan originator will not be so quick to issue any mortgage to anyone who applies, because they will have to retain part of that loan. If the borrower defaults, they will be taking part of the loss. Therefore they will put pressure on their employees not to issue any loan possible. They will be much more prudent in their loan practices, because they will bear part of the risk. Of course the amount cannot be insignificant because that will not deter the loaner enough. However the amount that must be retained cannot be required to be too large to shut down the whole securitization process. A fair and logical amount would be 5% like congress proposed or maybe even 10%.

Of course the critics will argue that this law will hamper the whole securitization process. Critics argue this law will make securitization more expensive. However, the same people arguing this are the same people who opposed financial reform for years. Even after this law is passed, an institution will still be able to sell 90-95% of a loan; all they will need to do to be in compliance is retain 5-10% of it.

This law alone will not solve all the problems that caused the crisis. An obvious problem which this law does not solve, is there were and will be many foolish institutions that actually believed the subprime lenders would not default, because housing prices would continue to rise. However, the Credit Retention Act would go a long way to addressing the issue of financial institutions making a quick profit and “selling the risk” to someone else. This law would not solve all the problems that cause the current recession. There are many other complex factors that also need to be solved. However, this law is a simple law that would go a long way to providing a common sense solution for one of the main causes of the recession.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

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