While Washington pundits play parlor games pondering changes to the regulatory architecture, the real work of resolving failed assets is beginning. The fact that the work is beginning is not so much testimony to price stability nor a turning point, but merely to the fact that investors facing losses finally realize that the losses are real and unavoidable.
Be ready for many experiments. This week Goldman announced a hybrid bad-bank/auction strategy for resolving Cheyne’s SIV portfolio. Basically, the strategy allows investors who think prices remain artificially low the chance to maintain their investments if they can afford the long-term illiquidity. Investors who value liquidity or merely feel that values will not improve will have the opportunity to exit at some notion of present market values, created through an auction. Whether this will work or not remains to be seen, but it is a creative effort.
Meanwhile, the FDIC continues to staff up their resolutions division, preparing for sizeable bank failures. The FDIC will have to be equally creative in resolving failed bank assets. While the FDIC showed creativity in working with the RTC to resolve bank assets in the early 1990s, that program experienced delays and difficulties due to budgetary pressures from Congress. Furthermore, the FDIC does not yet have a template for dealing with mortgage or other consumer loan servicing rights, and such rights have yet to have been smoothly transferred in resolutions to date without the FDIC doing the servicing, themselves.
Problems with servicing transfers have been known for some time. In 2002, Moody’s noted that servicing quality can be maintained if the underwriter/servicer is able to obtain debtor-in-possession financing and sell liquid receivables. But cash transfer requirements imposed in the event of servicer downgrade effectively reduce the bankrupt servicer’s ability to attract debtor-in-possession financing so crucial to its restructuring. At the same time, increased leverage in the industry—that is, greater reliance on securitization—reduces the amount of liquid assets the underwriter/servicer has available for sale (and collateral). Hence, today’s more highly leveraged underwriter/servicers have lower probability of emerging from bankruptcy than those of even a few years ago.
But servicing can also be difficult to transfer effectively because it so crucially relies on private information. Most underwriter/servicers charge between 25 (for mortgages) and 200 (for credit cards and other consumer credit) basis points on the deal for servicing. That charge appears to be economical as long as the servicer has the private information required for effective collections, loss mitigation, and disposition management.
In the late 1990s, however, it began to appear that rates at the lower end of the scale did not cover the costs a third-party incurs in maintaining servicing quality of a portfolio of an underwriter/servicer that had declared bankruptcy (bankruptcy itself being a tangible manifestation of shortcomings in its underwriting and/or servicing operations). As Moody’s writes, “These developments raised concerns about the viability of servicing arrangements and the feasibility of a smooth transition to backup servicing.” In the Spiegel-First Consumers credit card bank debacle, the servicing cost was in the 350 basis point range while the receivables were still high-quality, and soared to the 700 basis point range once the bank became impaired. Similar large increases to servicing rates occurred with the Delta, United Companies Financial, and Conseco mortgage company failures when the loan servicing had to be sold on the secondary market at rock-bottom prices.
Even without those difficulties, resolutions are slow. Fundamentally, it will take a long time for investments in the sector, even those bought at rock bottom prices, to pay off. My own research shows that resolutions take, on average, about six years at a linear rate – a fact that has remained constant since before the Great Depression. The time is somewhat shorter for restructurings and mere defaults (without restructurings).
The interesting part of that research is that it is not time, however, that dictates the length of the process, but the amount of loss the investor is willing to take before exiting the investment. Clearly prices will not come back to their peak levels. But investors may also believe prices are artificially low. Hence, investors may want prices to recover somewhat before divesting. Expected recoveries are driven by the magnitude of the decline and the expected volatility of the investment value. Whether the resolution is that of an SIV, a mortgage servicer, or a bank, the story is the same.
Ultimately, we have a long way to go and we’ll need a lot more creativity to get us there.