Thursday, 6 September 2007

Is alignment of interests a panacea?

Probably not, but it surely helps. Martin Wolf in the FT says:

Good reasons can still be advanced for shifting exposure from the balance sheets of thinly capitalised banks to those of better capitalised outside investors. The theory was that risk would thus be shifted on to those best able to bear it. The practice seems to have been that it was shifted on to those least able to understand it.

The supply of such fools has, if only temporarily, dried up. In the short run, securitised debt is likely to contract, as existing debt is paid down or written off. In the longer term, intermediaries will have to find a way to make their products more transparent to the buyers. Unfortunately, the ratings agencies, which once served this purpose, have lost their credibility.

The reason many of these assets have ended up with fools is that if the equity was a good tranche, it was retained, and if it sucked, it was sold. For many deals the mezz was sold - that should tell you all you need to know about how good that tranche is going to turn out to be. One quick fix would be for regulators simply to cap the benefit of securitisation at 50% for any tranche. That would give banks no benefit from selling more than half of each tranche, and hence encourage them to look after the interest of all the securitisation buyers as a side effect of looking after themselves. It would not stop cross subsidy between tranches, of course, but it would be a reasonable start.

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