We remarked last week that the FDIC had put forward a proposal for fixing the securitization market. To be a bit more precise, it was the FDIC’s plan, put forward for public comment, of the rules it wanted to have in place for banks to get “safe harbor”, meaning off balance sheet treatment, for their securitizations.

As anyone who had even slight contact with the business press no doubt knows, a whole raft of credit bubble era securitizations, particularly real estate and credit cards, have suffered losses far in excess of what banks and investors anticipated. The result, with real estate securitizations, is that almost all of the market ex government guaranteed paper is in a deep freeze. Worse, servicers, who were never set up to do loan mods (and by happenstance also make more by not doing mods) are operating to the disadvantage of investors and communities (as we have mentioned on previous posts, vulture investor Wilbur Ross, the antithesis of a bleeding heart, has demonstrated that deep principal reductions work and for viable borrowers produce better results for the investors than foreclosures). For credit card conduits, rather than let them flounder (banks desperately need to keep that pipeline open) banks have intervened to shore them up, raising serious questions about their off balance sheet treatment.

So right now, we have a securitization markets, ex the parts on government drip feed, or actively supported by the banks, that are in a wee bit of disarray. And the FDIC plan reveals an ugly little conundrum: what it takes to private real estate securitization safe for investors (in particular, twelve month seasoning of deals and a 5% retention, but there were other well though-out provisions as well) make it much less attractive to banks.

Now that might sound perfectly fine to most readers, but there was a reason loans started shifting off balance sheet in the 1980s: securitization was cheaper. If a bank held a loan, it had to put some equity up against it, and pay FDIC insurance on the portion funded by deposits. So banks had skinnier balance sheets all across the banking system and shifted loans to investors.

Now it may be that we have two unattractive choices: making the securitization market “less unsafe” (which seems to be the direction of the OCC ideas, which are getting vastly more MSM attention than the FDIC draft) or make it safe, which has the effect of making it much much smaller, and thus requiring banks to get bigger (in terms of their balance sheets). Bigger banks require a LOT more equity. Where will that come from?

So the inevitable result of more on balance sheet lending is less lending overall. Now many readers will regard this as a good solution, but they forget that this process of shrinking lending will be painful and is something policy markers are struggling mightily to avoid. This is the 21st century version of St. Augustine’s prayer, “Give me chastity and continence, but not jyet.”

One example of the discomfort that is resulting from this conundrum comes in tonight’s Financial Times. Citigroup is choking on some auto loans it would like to unload, but the securitization route isn’t open right now, and other possible buyers are not willing to bet on the market coming back to life (and note the implication: the pricing that Citi deems acceptable depends on the securitization market, neither Citi nor investors like the economics of owning and funding the loans):

The securitisation market’s failure to recover from its slump during the crisis is complicating efforts by Citigroup and other troubled financial groups such as AIG to sell unwanted assets and repair their balance sheets, bankers and executives say. People close to the situation said that Citi had opened talks with private equity groups and hedge funds over the sale of $3bn-worth of car loans as part of its efforts to cleanse its balance sheet of billions of dollars in troubled assets…. However, some private equity groups and hedge funds that have looked at the assets said that the lack of a thriving market for securitised bonds, which are backed by cash flow from loans, made the assets less attractive. They added that the absence of a fully functioning securitisation market increased the uncertainty over how buyers could fund the loans once Citi’s credit facility expired. “Private equity can’t make a bid on anything where the business model requires a bet that the external funding markets and securitisation comes back,” said the head of capital markets at a big private equity firm.

A second issue that is not getting the press it deserves is that banks are almost certain to take losses (and we don’t mean writedowns, as in recognizing impairments they arguably should have ‘fessed up to sooner, but hard dollar payments to third parties) on litigation and claims made under old mortgage securitizations.

The widespread perception is that the banks are off scott free on the bad loans they have sold to securitized vehicles. That isn’t exactly true. The banks made legal representations and warranties regarding the loans they sold. If the loans fell short of the contractually agreed upon standards, the seller has to make good in some form, say substitution of good collateral for the bad loan, or monetary damages. But the recoveries, by parties like Freddie, Fannie, AIG, MBIA, and Ambac, are going to come straight out of the bottom lines of banks. As Chris Whalen noted:

The wave of loan repurchase demands on securitization sponsors is the next area of fun in the zombie dance party, namely the part where different zombies start to eat one another. The GSE’s are going to tear 50-100bp easy out of the flesh of the banking industry in the form of loan returns on trillions of dollars in exposure, this as charge-offs on the several trillion in residential exposure covered by the GSEs heads north of 5%. The damage here is in the hundreds of billions and lands in particular on the larger zombie banks, especially Bank of America (BAC) and Wells Fargo (WFC). To put the growing combat in the loan repurchase channel into perspective, keen analysts will already know that a new item has appeared in the disclosure for non-interest income by many larger banks that have been active in the securitization markets. In the case of WFC in Q4 2009, gross income of $1.2 billion in mortgage loan originations was net of $316 million in loss reserves for loan repurchases. Imagine if we add a zero to the loss allocation, then another, and you get to the worst-case exposure on OBS loan repurchases.

MBIA’s latest financial statements (see the disclosure starting p. 53) illustrates how ugly this can get.

It appears that MBIA has requested and received almost 27,000 loan files, mainly from Countrywide relating to pools of second mortgages that MBIA had guaranteed. This is a small sample of the total (over 400,000) and represented 25% of the loans classified seriously delinquent at the time (I understand mid-2007) . Of the 27,000, 24,000 were fraudulent/non-conforming (FICO scores below what was repp’ed and warrantied, homes not primary residences). Those who have been watching the case believe the same percentage would apply to all of the remaining “seriously delinquent” loans, and perhaps even more of the rest of the loans, since those were the earliest vintages and those from later in the cycle were even more suspect. But their access to more files was blocked so they filed the lawsuits, etc. MBIA has already recorded $1.2 billion as “receivable” from this action, and that is based ONLY on those 27,000 loans.

As one reader noted:

The magnitude of the absolute liability of the mortgage originators to the bond insurers and securitization trusts themselves – on second mortgages alone – is, categorically and empirically, well into the tens of billions of dollars. The percentage of abjectly fraudulent second-mortgage loans made by Countrywide, ResCap, IndyMac, JPM, WFC is staggering. When the house of cards begins to come down, it will spread far and wide – to not only the bond insurers and mortgage insurers, but to the trusts themselves. The GSEs are just starting this process on their firsts, but it’s the private sector entities who are moving aggressively in court, but have been (temporarily) stymied by the aforementioned defendants who have thrown up all sorts of legal bs just to prevent even showing the original loan files to the very institutions that insured them on the basis of the originators’ reps and warranties! Some of this is on MBIA’s website, but I haven’t seen this really written about anywhere, despite (because of?) the impact it would have on the banks’ balance sheets.

This could become very interesting, and not in a good way, either.