Bankers: Quit selling your loans by Eleanor Bloxham @FortuneMagazine January 11, 2011, 10:50 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons There are significant risks when banks originate loans that they don’t want to keep on their books. So why do banks persist with securitizing and selling off their loans? By Eleanor Bloxham, contributor Despite the risks that loan securitization and sales pose to the financial system, several banks, including Bank of America, continue to oppose requirements that they retain some portion of the loans they issue. There’s a battle going on that goes to the heart of the financial crisis and the way banks will operate going forward. And it all comes down to risk. Wells Fargo’s WFC John Gibbons says banks should retain at least some credit risk from most of the loans they originate. I agree, but I’d go a step further. It’s time for banks to rethink the value of holding loans versus selling and securitizing them. Why? Risk management. The risks associated with loan securitizations and sales are tangible. I’ve watched financial executives sweat because they originated subprime loans and couldn’t get them off their books. I have also participated in economic valuation analyses that showed that when you took into consideration the full risks and costs of subprime loans, a bank was better off not making the loans if it didn’t plan to keep them. That’s because the risks and costs of the loans are significant. As the recent financial crisis has revealed, there are significant funding and liquidity risks to originating loans you don’t want to keep. These risks aren’t theoretical. In fact, they are so real that it has been suggested that the government provide a liquidity resource as a safety net for those who want to grant securitized loans. There are other tangible risks to this business approach, namely disputes and litigation, which are becoming an all too common effect of doing business this way. For example, SunTrust STI is in the midst of a lawsuit related to a case with AIG AIG concerning “a product SunTrust created in 2005, which allowed borrowers to get an interest-only first-lien mortgage plus a second-lien mortgage, with the two loans adding up to 100% of a home’s value,” according to the Wall Street Journal, which notes, “banks, insurers and investors [are] jostling over who should shoulder painful losses on subprime loans.” (SunTrust does not favor new requirements that banks retain credit participation in loans they originate.) SunTrust isn’t alone. Allstate ALL has sued Bank of America BAC , claiming Countrywide (Bank of America purchased Countrywide in 2008) misrepresented mortgage investments it sold. The bank received a letter in October from a number of institutions that invested in mortgages originated by Countrywide, including the Federal Reserve Bank of New York, calling for Bank of America to repurchase the mortgages. At this point, Bank of America “will continue to have discussions with them,” says Jerry Dubrowski, a spokesman. “If there is a valid defect, Bank of America will act responsibly. If there is not a valid defect, Bank of America will vigorously defend against a claim and protect the interests of the company and its shareholders.” An example of a valid defect would be a situation where there is a problem with the way a loan was processed, which includes documentation problems that should have been caught when a loan was originated. Bank of America’s CEO is not in favor of a requirement included in the Dodd-Frank Act that mandates that banks hold a portion of the interest in some of the mortgages they originate. In another example reported by DailyFinance, a whistleblower sent a letter to the SEC on November 30 claiming that she was fired by Chase JPM after “refusing to participate in the sale of 23,000 credit card accounts Chase had packaged” in which “5,000 of the accounts listed the wrong amount owed, and thousands more had other problems.” Chase denies her claims. The risk of these kinds of loan sales are growing as issues with mortgage ratings continue to mount. As Jesse Eissenger at Propublica reports: “Two weeks ago, Standard & Poor’s put out a news release warning that it was poised to lower its ratings on almost 1,200 complex mortgage securities,” and “two-thirds of these mortgage bonds were rated only last year.” The odd thing is that leaving loans on bank’s books is called “risk retention.” And the opposite of risk retention involves selling or securitizing loans, which includes all the risks and costs that arise from packaging them and readying them for sale, not to mention issues from all the players who become involved on the back-end. These risks include funding and liquidity issues, the cost of investment bank fees, credit rating risks and costs, insurance costs, repurchase/“put back” risk, litigation risks and costs, and the potential for additional regulations. Of course, those are just the risks to the bank — not the risks to the larger economy and to society. Investors are concerned the risks are being ignored. On January 9, a coalition of seven major public pension systems led by New York City Comptroller John Liu released a letter they had sent to the boards of Bank of America, Citigroup C , JP Morgan Chase, and Wells Fargo. That letter stated: “We urge the Audit Committee to immediately retain independent advisors to review the Company’s internal controls related to loan modifications, foreclosures and securitizations”… [and] “disclose its findings and recommendations in the Company’s 2011 proxy statement.” So why do banks want to persist with this behavior? One argument is that sales and securitizations free up bank capital for additional lending. But coming changes in bank capital requirements will affect that benefit, according to Michael Krimminger, acting general counsel at the FDIC. And even if loan securitization frees up some capital, large, prudent banks generally have access to less expensive capital through other means. Given all the risks associated with loan sales and securitizations, the cost of the capital that is made available is actually very high — and expensive capital can lead to financial institutions taking on even greater risk. A few years back, I had a conversation with a banker who oversaw a business that engaged in loan securitization and sales. He likened the process to using cocaine because you get the money from the sale (the hit) up front. It’s easy to get hooked, but eventually, it all catches up to you. Catch-up time has come. Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm.