Securities regulations and exemptions
Let's start with the definition of a security. There are many out there but the most inclusive is one that says every transaction other than one for goods or services that is represented by a piece of paper is a security. Another definition is everything that you can't taste touch or feel that is represented by a piece of paper or an electronic entry. When one purchases stock for example there is a piece of paper or a electronic entry that says you own the security.
The securities laws generally require that every security sold be registered with regulatory bodies like the SEC and state regulators, unless there is a exemption for that specific type of security. A mortgage is an example of an exempt security. It is a security backed by an interest in the real estate being purchased and the mortgage holder can examine the value of that tangible piece of property to determine the value of the mortgage.
However if you "securitize" the mortgage and put it into a pool of several mortgages the resulting security is likely to no longer be exempt. So this new security would have to go through the registration process if it were to be sold to the public.
It would not have to go through the registration process if it were sold in an exempt transaction. An example of an exempt transaction is one where one financial institution such as a bank or investment banker sells to a similar institution. The basis for this exemption is that sophisticated institutions have the knowledge and clout to get the kind of information from an issuer that would be revealed in the registration process.
Thus you can have a market in mortgage backed securities that largely escapes the normal regulatory framework and leaves the regulators looking at the books and records of the institutions largely relying on what the market prices are for the securities they hold.
Where the system broke down in the current crisis is a cascading failure of assumptions. It started with assumptions about the value of mortgages that did not take into account the potential devastating effect of a downturn in the real estate market. Then there was the assumption that pooling these risks would make the investment of the larger pool less vulnerable to the down turn. Other invalid assumptions included a belief that by securitizing mortgage debt in would increase the liquidity of the market for real estate loans. But when the down turn came, it had the exact opposite effect.
Added to these false assumptions was a belief that by hedging and insuring against losses in the portfolios in the pool of mortgage debt and then slicing and dicing the debt to the point where no one could calculate the value of the underlying securities one could avoid risks. The bottom line is that risks, which would have been manageable for a traditional mortgage holder, became unmanageable with the so called spreading of the risks to the point where tax payers wound up having to assume the risks.
The butterfly wing flapping that started this monster storm began with Democrats pressuring banks to loan to people who could not afford to qualify for traditional loans.
The NY Times looks at how regulation will be changed by the Obama team to deal with the current problem. It is a pretty safe bet that dealing with root cause of the problem will not be addressed by Democrats. They may try doing away with some of the exemptions for derivative securities. It is quite clear that there was a massive failure to quantify the risks inherent in these securities and the devices used to deal with those risks were wholly inadequate.
I think they should start with the question of whether we really need derivatives and not with whether we just need to regulate them. When you consider the rationale for them to begin with was to add liquidity to the marketplace and the fact that they have caused the opposite of liquidity, the fundamental question needs to be answered first.
Karl Rove has an excellent history of how Democrats thwarted regulation of Fannie and Freddie which led to the mortgage debacle.
The securities laws generally require that every security sold be registered with regulatory bodies like the SEC and state regulators, unless there is a exemption for that specific type of security. A mortgage is an example of an exempt security. It is a security backed by an interest in the real estate being purchased and the mortgage holder can examine the value of that tangible piece of property to determine the value of the mortgage.
However if you "securitize" the mortgage and put it into a pool of several mortgages the resulting security is likely to no longer be exempt. So this new security would have to go through the registration process if it were to be sold to the public.
It would not have to go through the registration process if it were sold in an exempt transaction. An example of an exempt transaction is one where one financial institution such as a bank or investment banker sells to a similar institution. The basis for this exemption is that sophisticated institutions have the knowledge and clout to get the kind of information from an issuer that would be revealed in the registration process.
Thus you can have a market in mortgage backed securities that largely escapes the normal regulatory framework and leaves the regulators looking at the books and records of the institutions largely relying on what the market prices are for the securities they hold.
Where the system broke down in the current crisis is a cascading failure of assumptions. It started with assumptions about the value of mortgages that did not take into account the potential devastating effect of a downturn in the real estate market. Then there was the assumption that pooling these risks would make the investment of the larger pool less vulnerable to the down turn. Other invalid assumptions included a belief that by securitizing mortgage debt in would increase the liquidity of the market for real estate loans. But when the down turn came, it had the exact opposite effect.
Added to these false assumptions was a belief that by hedging and insuring against losses in the portfolios in the pool of mortgage debt and then slicing and dicing the debt to the point where no one could calculate the value of the underlying securities one could avoid risks. The bottom line is that risks, which would have been manageable for a traditional mortgage holder, became unmanageable with the so called spreading of the risks to the point where tax payers wound up having to assume the risks.
The butterfly wing flapping that started this monster storm began with Democrats pressuring banks to loan to people who could not afford to qualify for traditional loans.
The NY Times looks at how regulation will be changed by the Obama team to deal with the current problem. It is a pretty safe bet that dealing with root cause of the problem will not be addressed by Democrats. They may try doing away with some of the exemptions for derivative securities. It is quite clear that there was a massive failure to quantify the risks inherent in these securities and the devices used to deal with those risks were wholly inadequate.
I think they should start with the question of whether we really need derivatives and not with whether we just need to regulate them. When you consider the rationale for them to begin with was to add liquidity to the marketplace and the fact that they have caused the opposite of liquidity, the fundamental question needs to be answered first.
Karl Rove has an excellent history of how Democrats thwarted regulation of Fannie and Freddie which led to the mortgage debacle.
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