January 16, 2008 1:04PM

Cleaning up Wall Street’s Housing Mess

By Elizabeth MacDonald

Ok now on to cleaning up the housing mess on Wall Street:

1. More mortgage cops: To be sure, we can’t afford to spend taxpayer money on having a Federal Reserve sheriff sitting in the lap of every mortgage broker. What with Moody’s threatening to downgrade the entire United States of America due to our oceanliner of debt (and if a downgrade happens, you can forget about national health care, we can’t afford the increased borrowing costs to fund it). But the states are just not doing enough to stop reckless brokers. In some states dry cleaners and nail salons are more regulated than mortgage brokers, who are regulated by the states. Extend the Office of Federal Housing Enterprise Oversight to the mortgage brokerage industry as well—OFHEO did a good job cracking down on Fannie Mae and Freddie Mac’s shoddy accounting, in the face of an avalanche of protest from these quasi-government agencies and their political backers.

2. The Street’s reality check has clearly bounced: I’m loving this quote from Dan Fuss, vice chairman of Boston-based Loomis Sayles. He’s taken a pass on all sorts of valuation software used to value mortgage-backed securities, and he refused to include these securities among the $22 billion he manages. He told Bloomberg: “It’s like teenagers: You sort of know what’s going on but not really,” adding, “we spent a fortune on software, $75,000 a month. And what do we end up with? A bunch of zip codes.” What’s going on? Unlike the corporate bond market, which gained price transparency in 2002 when the SEC required dealers to report their trades on a computer system called Trace, the asset-backed debt market has no centralized computer network for disclosing prices. Why? Because investment banks want it that way so they can cook up their own valuations. They objected to Trace when it was introduced for corporate bonds in 1998, and fought hard and got the NASD to back down on any attempt to put prices of asset-backed securities on a shared computer system. Leaving Wall Street alone to their own mark-to-make-believe devices let the banks collect tens of billions of dollars in fees from underwriting and trading asset-backed securities. Enough is enough.The Securities and Exchange Commission must jam a new computer valuation network for asset-backed securities down Wall Street’s throat if it has to. Investors have suffered enough—federal regulators should see it as an embarrassment that we are exporting our subprime pain to places as far afield as the Arctic, Iceland, Norway and Australia. The SEC supposedly has opened about a dozen investigations into how investment houses value their subprime assets. But this after-the-fact refereeing must end—regulators need to grow a spine or investors will continue to suffer.

3. Stop mark to make believe: For too long the market watchdogs let Wall Street get away with using any fantasy model it wanted to price its mortgage-backed securities, with the models now cheekily being called “mark to myth” or “mark to make believe.” It is inexcusable to leave Wall Street to its own devices. Here’s what happened: When Congress opted not to lift the dollar amount of the mortgages that Fannie and Freddie Mac can buy on the secondary market, Wall Street gladly dove in. Wall Street players bought those loans, sliced them up into all sorts of concoctions, and sold them as mortgage-backed securities to investors. In turn, Wall Streeters willy-nilly assigned values to this $2 trillion of asset-backed debt based on their own models, in turn cooking up the earnings it could book off of these assets. It then shoved a lot of this junk off its balance sheet into structured investment vehicles, or SIVs, and then wrote itself big fat bonus checks off these goosed-up earnings. That has led to an estimated $100 billion in losses for banks and brokerages and the ousters of executives at Merrill Lynch, Citigroup, UBS, Bear Stearns and Morgan Stanley. So don’t listen to the calls now to let Fannie and Freddie buy mortgages north of $417,000. Why should American taxpayers provide an implicit guarantee to mortgages of up to $1 million when lenders have made such a hash of it, and when the average sale price of a home is now less than $250,000?

4. More independent credit ratings agencies. Now.: To say that the credit rating agencies were slow off the mark is a thunderous understatement. We saw that happen 10 years ago in the Asian flu and the dotcom crisis in 2000 to 2001. But today’s mess reveals how startling blind they were. Less than 20 publicly traded companies have Triple A credit ratings. But somehow Moody’s, S&P and Fitch handed out triple A ratings like Kleenex to subprime securitizations that are quickly turning toxic. What happened? The credit rating agencies get paid by the investment houses to rate their securitizations and other debt offerings—a huge conflict of interest. Wall Streeters say that such securitizations reap more fees, sometimes double, for the credit rating agencies than plain vanilla bonds.

So the markets need more independent ratings agencies like Egan-Jones. It is now the first credit ratings agency not paid by Wall Street whose instruments it rates to be included by the SEC in a new oversight system. Last June, the SEC introduced a system of registration for credit rating agencies, requiring them to apply for status as Nationally Recognized Statistical Rating Organization (NRSRO). Now, the agencies must disclose their procedures and methodologies for assigning ratings, and the investment houses must use ratings by an NRSRO when they calculate the value of securities on their books (prior to this, brokerages could use any agency they wanted). Seven credit agencies are now NRSROs, including Moody’s Investor Services, Standard & Poor’s and Fitch–the three largest. But they still get paid by the issuers to rate securities. Not good. Sean Egan, managing director of Egan Jones, told the Financial Times that winning its regulatory stamp of approval was significant because it “addresses the primary concern [in the market], which is the alignment of investor interest with rating firm interest.” He added: “It’s lunacy to have investment guidelines geared to ratings from conflicted firms. It exposes fiduciaries to significant lawsuits along with substantial losses.”