In the actual mortgage crisis, banks first refused to do any sort of workouts for borrowers because they feared violating the QSPE structure, but then later found a rationalization that twisted the existing accounting to justify rewriting whole swaths of loans without even contacting the borrowers. Do you think securitization can recover in the eyes of investors?
That’s a very important question. The answer is first to have real transparency. I know that’s a buzzword, but remember, if we have these entities on balance sheet, we won’t have very good disclosure about them either. You’ll have a footnote somewhere in Citigroup’s financial statement that will aggregate them all together. We’ve got to have really good disclosure.
So in addition to having banks disclose their contingent obligations in off-balance-sheet vehicles, you also propose that off-balance-sheet vehicles themselves should remain registered SEC entities.
Yes. They usually are registered in the initial offerings and usually deregister within a year, claiming that they no longer have 300 investors. That’s a mistake, because then there’s no way for shareholders of the company, the shareholders of the bank, or the investors to really figure out what’s happening once there’s a deterioration of the assets. Realistically, there are two groups of investors who care: one is the investors in the off-balance-sheet entity and the other is the investors in the sponsor, whether it be a corporation or a bank. So we ought to say that unless the total number of investors who are interested drops below 300, then we shouldn’t allow deregistration.
It would seem that credit-rating agencies, also badly tarnished by the crisis, remain a necessity for the capital markets.
Let’s be clear: credit-rating agencies are a necessity for two classes of investors: investors who are legally required to only hold A, AA, or AAA securities, and the many pension funds and other [investing entities] where the directors, the trustees, have [established that requirement]. These tend to be small and middle-sized investors. The anomaly that makes the problem [of credit-rating agencies] very difficult to solve is that the large bond investors, like MFS or the IBM pension fund, actually don’t think that highly of the credit ratings. They look down on all of them and say, “We’re not going to pay for that because we don’t think it’s worth much.”
In theory it’s clear what the answer should be: investors should pay for the credit-rating agencies because they’re the ones who are supposed to be benefiting from it. Unfortunately, the big players in the bond business don’t want to pay. And I don’t think we could tolerate a solution where we had all the small and middle-sized investors paying for something that would inevitably be a public good. It would get out, and the big investors would have the slight advantage of knowing the rating, but they wouldn’t pay for it. So having investors pay for ratings is a theoretically interesting solution that has no practical chance of being adopted.