The IMF Financial Stability Review: Chapter 2

Perhaps the most important part of Chapter 2 is a (mitigated) vote of confidence from the IMF in structure finance at the beginning:

Structured finance can be beneficial by allowing risks to be diversified

Before we get into the detail of the IMF report, that comment is worth noting. Now for the 'but's, or rather for my comments on selected 'but's.

• First a remark from the IMF about ratings: In particular, when reliable price quotations were unavailable, the price of structured credit products often was inferred from prices and credit spreads of similarly rated comparable products for which quotations were available. For example, the price of AAA ABX subindices could be used to estimate the values of AAA-rated tranches of mortgage-backed securities, the price of BBB subindices could be used to value BBB-rated MBS tranches. [...] In this way, credit ratings came to play a key mapping role in the valuation of customized or illiquid structured credit products, a mapping that many investors now find unreliable. This is important and has not received that much comment thus far. Many firms are currently marking a lot of ABS, some of it rather different from typical US subprime, as a spread to the ABX. They are doing this because they can't think of anything better to do. But of course this only works if AAA ABX is comparable with AAA something else. So not only were ratings important for some purchasing decisions, they continue to be important for marking inventory. Which is scary.
  
• Credit rating agencies insist that ratings measure only default risk, and not the likelihood or intensity of downgrades or mark-to-market losses, many investors were seemingly unaware of these warnings and disclaimers. True, but really can we have a small does of caveat emptor please?
  
• Next a very sensible observation on fair value: Accounting frameworks require professional judgment in determining the mechanisms for fair value, including the use of unobservable inputs in cases of the absence of an active market for an instrument.
  Such judgment allows the possibility of different outcomes for similar situations, which in times of market uncertainty may compound the risk of illiquidity. As instruments turn illiquid moreover, they move from level 1 or level 2 of the FAS 157 hierarchy to level 3. The IMF notes that some people have drawn the wrong conclusion from this:investors seem to have a perception contrary to what the standard setters intended because a firm risks a negative market reaction with a reclassification of assets from level two to three, as events during the turmoil indicated.
  
• Reasonably enough, the IMF is concerned about SPV assets coming back on balance sheet at the worst possible moment, with no hint prior to that of the exposure. They opine:investors would benefit from more comprehensive regulatory requirements for disclosures about the scope and scale of exposures to OBSEs. [...] Increased disclosure achieved through consolidation or some form of parallel disclosures of an entity’s unconsolidated and consolidated positions also means these entities have a direct impact on the institution’s regulatory capital requirements, funding sources, and liquidity. (OBSE is IMF speak for SPV.) If this suggestion is taken seriously it will mean a huge change to IFRS. My sense is that the regulators will go further and faster than the accountants on this (not least because the accountants are saying “completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”). Certainly caps on the regulatory benefit for securitisation are under active consideration.
  
• Will banks voluntarily take more of the OBSE’s assets onto the balance sheet to provide greater assurance to investors as to the vehicle’s quality? Only if that is the only way to get the securitisation market restarted and/or if regulators make them. Or should banks be required to retain a stake in the performance of these assets, thus having the incentive to conduct better due diligence? Yes.
  
• In general, variations in the regulatory treatment of securitization among different types of financial institutions may provide an opportunity for regulatory arbitrage across financial sectors. Some securitization exposures are evaluated for regulatory purposes differently for insurance companies than for banks. Finally in between congratulating themselves on the level playing field between banks someone in the supervisory community has noticed that the playing field between banks and non-banks is far from level. Basel 2 is flawed in many ways but it looks pretty good compared with insurance capital requirements for the monolines.
  
• Finally it is worth noting that the banks did not play the SIV and conduit game cynically: many of them seemed to have believed that risk really had been transferred. Or as the IMF puts it the perimeter of risk for financial institutions—that is, the risk assessment of all of an institution’s activities, including its related entities—did not adequately take into account the size and opacity of institutions’ exposures to SIVs, commercial paper conduits, and their related funding support. Given the size of the SIV and conduit activity, this failure of risk assessment is a big deal for the banking system.