Illusions of Liquidity: Systematic Risk and the Capital Markets

On July 10, 2008, Chairman of the Federal Reserve, Ben Bernanke and Secretary of the Treasury, Henry Paulson appeared before the House Financial Services Committee in the first of a series of hearings to examine the nature of risk presented by significant global financial institutions and the need for regulatory oversight of hedge funds and investment banks. The origins and intended purposes of commercial mortgage securitization offers valuable insight on the recovery of the capital markets and what lies ahead. How will investor confidence and the creation of new investment vehicles impact that recovery?


While the Federal Reserve evaluates regulatory oversight of investment banks, and the Department of Treasury promotes covered bonds as an alternative to mortgage-backed securities, does anyone remember FIRREA?

FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act of 1989), among other things, established the Resolution Trust Corporation (RTC) to liquidate assets of insolvent thrifts. By 1995, the RTC sold off commercial mortgage loans resulting in Wall Street’s issuance of $17.8 billion in commercial mortgage-backed securities (CMBS). Prior to the RTC, the CMBS model, though an existing investment vehicle, was neither strongly developed nor highly sophisticated. Today, the CMBS market is valued in excess of $900 billion.

Of the $521 billion-plus of commercial mortgages securitized from 1996–2006, only 12 percent currently are on master servicers’ watch lists, a sharp contrast to 16 percent of the $300 billion-plus of mortgages securitized in 2007 that are on those same watch lists.

While no one will deny that the underwriting standards of commercial mortgages securitized in 2007 were lax, there is no expectation that any resulting deterioration of the credit instruments backed by these pools of mortgages could affect the capital markets the same way that the $426 billion in write-downs and credit losses associated with the fall-out from the sub-prime securitization crisis did. Yet, as Congress prepares to legislate and other government institutions look to regulate, thought should be given to the nature of the risk and appropriate regulation, if any, of uniform underwriting standards and prudent balance sheet or portfolio allocation limitations on the part of institutional investors or certificateholders.

To understand where CMBS will be tomorrow, and any regulatory scheme that might ensue, one needs to understand the factors that influenced how the CMBS market got to where it is today.


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