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EDITORIAL COMMENT: I agree with the editors at the NY Times. Geithner’s loophole is just plain wrong. It is borne out of fear of the unknown. The uncertainty that accompanies letting the derivatives market come under scrutiny and what it would mean if you REALLY found out the condition of the financial markets has created a huge fear that it COULD mean Armageddon. That argument, always weak at best, is based on the lack of precedent or predictive information because what Wall Street did this time was unprecedented.

In plain language, policy makers have not taken the time to analyze the entire system the way their job description says they should do. The truth is that we nailed ourselves in the 1929, we passed Glass-Steagel and avoided it for a awhile, we deregulated and repealed Glass Steagel and nailed ourselves again.

We have a robust collection of banks and investment banking firms other than the the megabanks that have the ability and resources to collectively pick up all the slack from the megabanks and probably do much more in a true free market, instead of the monopolistically controlled market we have now. Europe understands it and is proceeding with regulation and investigations. Why do we pretend not to understand? Because the banks own the place.

What will happen? Using past behavior as the only reliable indicator of future behavior is that the banks will do it all over again, only worse, because they escalate each time.

Mr. Geithner’s Loophole

Until recently, the big threats to the Dodd-Frank financial reform law came from Republican lawmakers, who have vowed to derail it, and from banks and their lobbyists, who are determined to retain the status quo that enriched them so well in the years before, and since, the financial crisis. Now, the Obama Treasury Department has joined their ranks.

In an announcement on Friday afternoon — the time slot favored by officials eager to avoid scrutiny — the Treasury Department said it intends to exempt certain foreign exchange derivatives from key new regulations under the Dodd-Frank law. These derivatives represent a $4 trillion-a-day market, one that is very lucrative for the big banks that trade them.

A loophole in the law — which the bankers and their friends, including the administration, fought for — allows the Treasury secretary to exempt the instruments. The arguments in favor of exemption, beyond a desire to please the banks, were always unconvincing. They still are. The Treasury Department has asserted that the exempted market is not as risky as other derivatives markets, and therefore does not need full regulation.

That claim has been disputed by research, but even if it were true, it would be a weak argument. For instruments to be relatively safer than the derivatives that blew up in the crisis, necessitating huge bailouts, hardly makes them safe. Worse, dealers could probably find ways to manipulate the exempted transactions so as to hedge and speculate in ways that the law is intended to regulate.

The Treasury Department insists its exemption is narrow and regulators will have the power to detect unlawful manipulation. In their spare time, perhaps? The financial crisis made clear what happens when everyone doesn’t have to play by the same rules. And it made clear that the taxpayers are the ones who pay the price.

The department has also said that because the market works well today, new rules could actually increase instability. That is perhaps the worst argument of all. It validates the antiregulatory ethos that led to the crisis and still threatens to block reform.

The Treasury’s plan will be open for comment for 30 days. Count us opposed.

5 Responses

  1. Redwood Trust’s (private money) Clients are:
    • bank portfolio sellers
    • mortgage originators

    Redwood Trust, Inc. (private money) incorporated in the State of Maryland on April 11, 1994 and commenced operations on August 19, 1994. It invests in Mortgage Assets financed by the proceeds of equity offerings and by borrowings.

    The Company produces net interest income on Mortgage Assets qualifying as Qualified REIT Real Estate Assets while maintaining strict cost controls in order to generate net income for distribution to its stockholders.

    Executive Offices:
    591 Redwood Highway, Suite 3100, Mill Valley,
    California 94941 415) 389-7373.


    This is the trust (intermediary funding) Deutsche Bank Trust Americas for example!

    In a manner analogous to the guarantee programs of Fannie Mae and Freddie Mac, Redwood credit enhances pools of mortgage loans to enable
    their securitization.

    By assuming some of the risk of credit loss of these loans, we enable these loans to be funded in the capital markets.

    Sellers of mortgage loans by taking advantage of our credit-enhancement services, can fund their originations by creating and selling mortgage-backed securities with a credit rating of AAA.

    These AAA securities are sold to a wide variety of buyers that are willing to fund mortgage assets, but are not willing to build the operations necessary to manage mortgage credit risk.

    We credit enhance high-quality jumbo residential loans through structuring and acquiring subordinated credit-enhancement interests that are created at the time the loans are securitized.

    Sometimes we buy these credit-enhancement interests in the secondary market for mortgage assets;

    Sometimes we work with seller/securitizers directly to choose loans that will be included in a pool and to structure the terms of the credit-enhancement interest for that pool.

    Generally, we credit-enhance loans from the top 15 high-quality national mortgage organizations firms, plus a few other smaller firms that specialize in very high-quality jumbo residential loan originations.

    We also work with large banks that are sellers of seasoned portfolios of high-quality jumbo loans.

    We either work directly with these customers or we work in conjunction with an investment bank on these transactions.

    Pricing – supply and demand (as well as perception of risk).
    The number of jumbo mortgage loans originated,
    The number of seasoned bank portfolios for sale,
    The percentage of such loans that are securitized.

    Demand is a function of competition.1994-1996 and 1999-2000 Competition subdued we increased our credit-enhancement business at a rapid pace.
    Because of the relative lack of demand, pricing was attractive.

    1997-1998 many financial institutions (including banks, thrifts, insurance companies, Wall Street firms, and hedge funds) entered this business.

    Many inefficient balance sheet for this particular business, lacked mortgage credit management infrastructure, lacked prudence in their asset-liability management practices, or lacked focus. Most have exited this business, improving pricing for specialist firms such as ourselves.

    Substantially of the $23 billion of loans added to our credit-enhancement portfolio 1999-2000 were “A” or “prime” quality loans. We do not seek to credit-enhance “B”, “C”, or “D” quality loans (sub-prime loans).

    The amount of capital we hold to credit enhance our credit enhancement portfolio loans (the principal value of the credit-enhancement interests that we acquire) is determined by the credit rating agencies: (Moody’s Investors Service, Standard & Poor’s Ratings Services, and Fitch IBCA).

    These credit agencies examine each pool of mortgage loans in detail.

    Based on the credit agencies review of individual loan characteristics, they determine the credit-enhancement capital levels necessary to award AAA ratings to the bulk of the securities formed from these mortgages. Once we provide this credit-enhancement capital, the credit-enhanced AAA securities can be sold to a wide variety of capital market participants.

    Goal: Post credit result for our mortgage portfolio equal or exceeds credit results of Fannie Mae, Freddie Mac, and the large ‘A” quality jumbo portfolio lenders such as Bank of America and Washington Mutual.

    Redwood Trust capital requirements are less than the 4.0% of loan balances that banks and thrifts are required by their regulators to hold as capital for high-quality residential loans (of any size) if held unsecuritized on their balance sheets. By financing in the capital markets, our capital structure can be more capital efficient than that of the banks and thrifts that are our competitors in the jumbo market.

    The loans that we credit-enhance in this portfolio do not appears as assets on our balance sheet. Rather, our net basis in credit-enhancement interests is shown as a blance sheet asset. 12/31/2000, the principal value of our credit-enhancement interests was $125 Million and our basis in these assets was $81 million.

    Our first defense against credit loss is the quality of our loans. Compared to most corporate and consumer loans, the mortgage loans that we credit-enhance have a much lower frequency (they tend not to default) and a much lower loss severity (the amount of the loan that we lose when they do default is low).

    Our exposure to the credit risks of the mortgages that we credit-enhanceis further limited in a number of respects:

    (1) Representations and warranties: As the credit-enhancer of a mortgage securitization, we benefit from representations and warranties received from the sellers of the loans. In limited circumstances, the sellers are obligated to re-purchase delinquent loans from our credit-enhanced pools, thus reducing our potential

    (2) Mortgage insurance: A portion of our credit-enhanced portfolio consists of loans with initial loan-to-value (LTV) ratios in excess of 80%. For the vast majority of these higher LTV loans, we benefit from primary mortgage insurance provided on our behalf by the mortgage insurance companies or from pledged asset accounts.

    Thus, for what would otherwise be our most risky loans, we have passed much of the risk on to third parties and our effective loan-to-value ratios are much lower than 80%.

    (3) Risk tranching: A typical mortgage securitization has three credit-enhancement interests — a “first loss” security and securities that are second and third in line to absorb credit losses.

    Of Redwood’s net investment in credit-enhancement assets, $12 million, or
    15%, was directly exposed to the risk of mortgage
    default at December 31, 2000. The remainder of our net investment, $69 million, was in the second or third loss position and benefited from credit-enhancements provided by others (through ownership of credit-enhancement interests junior to our positions) totaling $87 million. Credit enhancement varies by specific asset.

    (4) Limited maximum loss: our potential credit exposure to the mortgages that we credit-enhance is limited to our investment in the credit-enhancement securities that we acquire.

    (5) Credit reserve established at acquisition: We acquire credit-enhancement interests at a discount to their principal value. We set aside some of this discount as a credit reserve to provide for future credit losses. In most economic environments, we believe that this reserve should be large enough to absorb future losses. Thus, typically, most of our credit reserves are established
    at acquisition and are, in effect, paid for by the
    seller of the credit-enhancement interest.

    (6) Acquisition discount: For many of our credit-enhancement interests, the discount that we receive at purchase
    exceeds anticipated future losses and thus exceeds our designated credit reserve. Since we own these assets at a discount to our credit reserve adjusted value, the income statement effect of any credit losses in excess
    of our reserve would be mitigated.

    We believe that the outlook for our jumbo mortgage credit enhancement portfolio line in 2001 is excellent, as the supply of credit-enhancement
    opportunities is expected to increase as mortgage originations and mortgage securitizations increase. We expect pricing to remain
    favorable, as we expect demand from competitors will remain subdued.

    We expect to achieve continued growth with attractive pricing in this product line.

  2. They are trying to hide the private money investors who bleed the nation dry.

    For example: Do you know who Redwood Trust is?

  3. This is really getting beyond pathetic. So this is really the response from the US Treasury on Friday – the SAME DAY that the European Union announces investigations into the largest banking firms for collusion in the credit derivatives market? (See Guardian article, “EU inquiry into claims of banks’ collusion in credit derivatives market” at ) Give me a break!!!!! Europe moves toward transparency while the US moves to protect opacity!?! WTF?!?!?!?!?!?

    Neil, you are cutting Geitner far too much slack. You say, “Geithner’s loophole is just plain wrong. It is borne out of fear of the unknown.” I say that the response is not “out of fear of the unknown,” but instead is “out of fear that what they know will become known to the rest of the world.” And that “fear” is the “fear of getting caught” and it smells a lot like urine.

  4. […] Source: Livinglies’s Weblog […]

  5. I read your blog often because the economic and policy issues you discuss also appear on my blog. I was reading yours today, when it occurred to me that I haven’t praised your work, so to speak, to your face. I think it is important for bloggers to get feedback so they can improve their work. Generally praise is less useful for improvement than criticism. But you are going to get short changed because I only have praise for your blog. Best wishes! Keep up the good fight.

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