Investor Confidence Could Lead to New Asset Awareness

MBA (4/24/2008 ) Murray, Michael
Investors remain the key catalyst in turning around the credit-crunched capital markets and—after the smoke clears—a more sophisticated investor could eventually emerge in a new, similar securitization model.

Deloitte Consulting LLP, New York, expects the beginning of the end for the credit crunch only when "thousands of investors" begin to find distressed assets valuable, begin acquiring these assets and answer questions on how to invest and the value of their returns.

“Investors are the fundamental source of capital that will begin to clear the market and move us out of a credit crunch situation to, hopefully, a credit recovery situation. They’re the source of stability,” said Adam Schneider, principal of Deloitte Consulting LLP.

Deloitte Consulting expects future investors in the mortgage markets to become more sophisticated about mortgage products and begin to understand more about underlying collateral rather than depending on ratings of securities.

“They will be particularly focused on piercing the various collateralized structures as a core investment capability,” Schneider said, noting that the current investment community is still very liquid.

Investors, after this crisis, will worry less about the description of the security but more about the asset or collateral underlying the security and any relevant guarantees as they seek returns. The creation of new mechanisms and cross-checks will improve pricing, not only for mortgages but for other products if they “lock up,” Schneider said.

The securitization model also will need to change, including stronger underwriting with more clear, focused and transparent products and new guarantors to emerge and price loans at a point with positive returns.

The ratings agencies will continue to enhance processes to become better at changes in underlying collateral and greater risk monitoring. “We think that the attraction of investor capital...is a key part to redeveloping and moving the market into a positive direction right now,” Schneider said.

Deloitte Consulting forecasts a more sound market environment after the mortgage industry rebounds, without "exotic" securitizations but with more traditional products in the near future.

“We expect something that is similar to processes today but more sound [processes], more controlled, better risk, better lending [and] better disclosure,” Schneider said. “We expect strong lenders to survive. We suspect there will be much more in-house production. We suspect there will be much more balance sheet lending. The securitization process will clearly evolve, essentially adding more compliance, more check-out and more transparency.”

Involvement from “thousands of investors” in the credit crunch created a significant difference to the “infinite balance sheet” during the savings and loan crisis, which evolved into the Resolution Trust Corp. [RTC].

Schneider said weak underwriting, low teaser rate products, packaging that increased risk in some instances, mortgage insurers and guarantors subject to “great speculation in the marketplace” and ratings agencies that “did not get the information quite so perfect” all played a part in losing investor confidence.

“The markets will recover over time—perhaps not as fast as the equivalent of the RTC formed to swoop up [commercial mortgages] but, again, with thousands of investors, it is not obvious how to form such an entity or how it will go forward, so we do expect it to take some time,” he said.

The recovery process will include financial institutions rebuilding their balance sheets and creating sound financial practices. “We have seen mortgage products get more interesting in terms of pricing, risks being taken out of the system and prices for various types of credit insurance improving,” Schneider said.

“The financial institutions, per se, have to strengthen up and toughen up,” he said.

Deloitte forecasts government intervention on a global basis to support the market because “they do not want this to balloon much further,” and the government would support portfolios and balance sheets “too large to fail” but not necessarily stockholders, Schneider said.

He viewed the Federal Reserve’s assistance with J.P. Morgan Chase’s purchase agreement of Bear, Stearns & Co. Inc. in March as an inflection point in the liquidity crisis because it showed a portfolio that survived as existing transactions, collateralizations and cash balances were “successfully moved” and the impact on the rest of the market was contained.

“From a confidence point of view, I thought that it was an extraordinary step,” Schneider said. “But with support is going to come additional regulation, and—probably—fairly [or] dramatically different [regulation].”