How the RTC Became a Derivatives Pioneer
Until last month, the Resolution Trust Corporation held a quiet place in American financial history: It was merely a government-sponsored company that jump-started the lending market by buying up $400 billion in assets from the rubble of the 1980’s S&L debacle.
"It was sort of a financial Peace Corps," recalls Michael Jungman, the RTC’s former asset sales director, of the mix of civic-minded regulators and Wall Street types the venture attracted. As the economy recovered, the RTC sold off its distressed holdings, closing shop in 1996.
With the credit markets floundering and a $700 billion intervention in the works, the RTC has surfaced as a possible template. Omitted from the RTC’s legacy, in a high irony, is its role in pioneering and popularizing commercial mortgage backed securities market and familiarizing Wall Street with methods of securitizing non-standard, and potentially risky, assets.
"Before the RTC, people securitized fairly standard, conforming assets," Jungman says. "They didn’t securitize weird stuff like we did. And then it just got weirder and weirder as time went on."
When the RTC was created in 1989, William Seidman didn’t apply to run it so much as he was commandeered. Then head of the FDIC, he was handed the task of cleaning up one of banking history’s greatest messes by Congress.
Faced with unloading a mountain of distressed assets in a depressed market, the RTC initially sold off bundles of commercial real estate at big losses. But even doing that took time the RTC didn’t have: Even at the rate of $1 million in sales per hour, Seidman recalls, its assets would have taken until 2050. Congress had given the RTC six years. The RTC needed a way to earn better returns while moving assets faster, and it found one: Securitization.
Before the RTC, Wall Street had mainly securitized standard, interchangeable assets like prime mortgages. By packaging the revenue stream from a pool of loans together, traders like Salomon Brothers' Lewis Ranieri and First Boston’s Larry Fink created predictable securities that acted like bonds.
Securitizing commercial loans was far harder. The underlying properties were complex, prone to default, and difficult for credit agencies to score. Consequently, CMBS had been issued only infrequently and were almost never traded.
With the help of advisors from investment banks including Merrill Lynch, Bear Stearns, and Lehman Brothers, the RTC found a way. By supporting pools of commercial mortgages with large cash reserves and keeping the riskiest portions for itself, the RTC could bolster the ratings of the rest to investment grade. Bondholders would only face losses if defaults entirely consumed the RTC’s retained stake, which was unlikely--the Trust usually sold only 70 percent of the pool’s total value.
"The government had a risk just like everybody else," says Seidman.
Even with investment-grade ratings and reserves and generous cash reserves, however, the RTC still had to convince the market that its novel products could float. The job would have been nearly impossible for any entity without the RTC’s government credentials and massive loan inventory, says Jan Kregel, a scholar at Bard College’s Levy Economics Institute.
"They managed to convince people to buy these things because it was the RTC," he says of the Trust’s leadership. "People looked at them as government securities."
Within a year of its first CMBS issuance in August of 1991, the RTC was moving as much as $2 billion in the securities a month. But the banks the RTC partnered with to sell the securities were already issuing similar products themselves. By the end of 1993, private industry was responsible for 80 percent of new issuances.
C.J. DeSantis, a managing director at Pentalpha Capital Group who sold RTC securities for Merrill in the 1990’s, says the sheer volume of the RTC’s issuances put non-standard asset backed securities on the map. Nearly every major investment bank got a piece.
"The RTC generated a lot of revenue that allowed these firms to bulk up their mortgage securities business," he says. "It let them afford the research, the analytics, the trading desks, hire 10 or 20 people."
The securitization expertise available to Wall Street only increased after the RTC’s dissolution in 1996. A decade later, domestic CMBS issuances had reached $200 billion a year.
Top trust officials like Seidman and Jungman saw the RTC’s influence extend beyond the commercial mortgage market. Using credit enhancement to create investment grade securities from non-standard assets became more accepted in other areas, including the sub-prime lending industry. Banks found that even the un-rated slices of the securities would sell--allowing them to clear any connection to the securities’ underlying assets from their balance sheets.
"They took a good, efficient vehicle, and took the purchaser protection out of it," Seidman says.
Not everyone is convinced the RTC changed the course of securitization. Mark Adelson, Chief Credit Officer at Standard & Poors, says precedents for securitizing non-standard assets like car loans and credit card debt arose in the 1980’s.
"We would have gotten to a lot of where we are today without [the RTC]," he says, noting that the CMBS market accounts for only $700 billion of the approximately $13 trillion total outstanding asset-backed securities.
Even if the RTC played the broader role in securitization some of its alumni claim, however, they’re not apologetic for the contribution. Jungman, who worked as JP Morgan’s CMBS chief until 2003, says he knew the private sector had become less conservative in their issuances. But the scope of the sub-prime industry caught him off guard.
Seidman has a similar take. A few years back, he says, he lost track of a book project with the working title of The Free Market Doesn’t Work Without a Hell of a Lot of Regulation.
"It’s too bad," he says of his unfinished effort. "It would be particularly appropriate at the moment."