Securitisation and Risk

João Santos of the New York Fed notes what forward-thinking financial writers have been thinking for a long, long time:

There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.

Historically, banks kept on their books the loans they originated. However, over time they increasingly replaced this originate-to-hold model with the originate-to-distribute model, by syndicating the loans they originated or by selling them in the secondary loan market. The growth of securitization provided banks with yet another opportunity to expand the originate-to-distribute model of lending. The securitization of corporate loans grew spectacularly in the years leading up to the financial crisis. Prior to 2003, the annual volume of new collateralized loan obligations (CLOs) issued in the United States rarely surpassed $20 billion. Since then, this activity grew rapidly, eclipsing $180 billion in 2007. 

Corporate loan securitization appealed to banks because it gave them an opportunity to sell loans off their balance sheets—particularly riskier loans, which have been traditionally more difficult to syndicate. By securitizing loans, banks could lower the risk on their balance sheets and free up capital for other business while continuing to earn origination fees. As with the securitization of other securities, the securitization of corporate loans, however, may lead to looser underwriting standards. For example, if banks anticipate that they won’t retain in their balance sheets the loans they originate, their incentives to screen loan applicants at origination will be reduced. Further, once a bank securitizes a loan, its incentives to monitor the borrower during the life of the loan will also be reduced.

Santos’ study found that the dual phenomena of lax lending standards and securitisation existed as much for corporate debt as it did for housing debt:

To investigate whether securitization affected the riskiness of banks’ corporate lending, my paper with Bord compared the performance of corporate loans originated between 2004 and 2008 and securitized at the time of loan origination with other loans that banks originated but didn’t securitize. We found that the loans banks securitize are more than twice as likely to default or become nonaccrual in the three years after origination. While only 6 percent of the syndicated loans that banks don’t securitize default or become nonaccrual in those three years, 13 percent of the loans they do securitize wind up in default or nonaccrual. This difference in performance persists, even when we compared loans originated by the same bank and even when we compared loans that are “similar” and we controlled for loan- and borrower-specific variables that proxy for loan risk.

This is an important study, because it emphasises that this is a universal financial phenomenon, and not one merely confined to mortgage lenders that were encouraged by the Federal government into lending to risky mortgagees. The ability to securitise lending and so move the risk off your balance sheet leads to riskier lending, period.

This exemplifies the problem with shadow finance. Without the incentive of failure for lenders who lend to those who cannot repay, standards become laxer, and the system begins to accrue junk loans that are shipped off the lenders’ balance sheets and onto someone else’s. This seems like no problem to the originating lender, who can amass profits quickly by throwing liquidity at dubious debtors who may not be able to repay without having to worry about whether the loan will be repaid. The trouble is that as the junk debt amasses, the entire system becomes endangered, as more and more counterparties’ balance sheets become clogged up with toxic junk lent by lenders with lax standards and rubber-stamped as Triple-A by corrupt or incompetent ratings agencies. As more laxly-vetted debtors default on their obligations, financial firms — and the wider financial system, including those issuers who first issued the junk debt and sold it to other counterparties  — come under pressure. If enough debtors default, financial firms may become bankrupt, defaulting on their own obligations, and throwing the entire system into mass bankruptcy and meltdown. This “risk management” — that lowers lending standards, and spreads toxic debt throughout the system — actually concentrates and systematises risk. Daron Acemoglu produced a mathematical model consistent with this phenomenon.

In a bailout-free environment, these kinds of practices would become severely discouraged by the fact that firms that practiced them and firms that engaged with those firms as counterparties would be bankrupted. The practice of making lax loans, and shipping the risk onto someone else’s balance sheet would be ended, either by severely tightened lending standards, or by the fact that the market for securitisation would be killed off. However, the Federal Reserve has stepped into the shadow securities market, acting as a buyer-of-last-resort. While this has certainly stabilised a financial system that post-2008 was undergoing the severest liquidity panic the world has probably ever seen, it has also created a huge moral hazard, backstopping a fundamentally perverse and unsustainable practice.

Shadow finance is still deleveraging (although not as fast as it once was):

But so long as the Federal Reserve continues to act as a buyer-of-last-resort for toxic junk securities produced by lax lending, the fundamentally risk-magnifying practices of lax lending and securitisation won’t go away. Having the Federal Reserve absorb the losses created by moral hazard is no cure for moral hazard, because it creates more moral hazard. This issue soon enough will rise to the surface again with predictably awful consequences, whether in another jurisdiction (China?), or another market (securitised corporate debt? securitised student loan debt?).

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Does Easy Monetary Policy Enrich the Financial Sector?

Yesterday, I strongly insinuated that easy monetary policy enriches the financial sector at the expense of the wider society. I realise that I need to illustrate this more fully than just to say that when the central bank engages in monetary policy, the financial sector gets the new money first and so receives an ex nihilo transfer of purchasing power (the Cantillon Effect).

The first inkling I had that this could be the case was looking at the effects of quantitative easing (monetary base expansion) on equities (S&P500 Index), corporate profits and employment.

While quantitative easing has dramatically reinflated corporate profits, and equities, it has not had a similar effect on employment (nor wages).

However there are lots other factors involved (including government layoffs), and employment (and wages) is much stickier than either corporate profits or equities. It will be hard to fully assess the effects of quantitative easing on employment outcomes without more hindsight (but the last four years does not look good).

What is clear, though, is that following QE financial sector profits have rebounded spectacularly toward the pre-2008 peak, while nonfinancial sector profits have not:

Yet it is not true that in recent years the growth of financial profits or financial assets has been preceded by growth in the monetary base; the peak for financial profits occurred before QE even began. In fact, the growth in the monetary base from 2008 reflects a catching-up relative to the huge growth seen in credit since the end of Bretton Woods. During the post-Bretton Woods era, growth of financial assets in the financial sector has significantly outpaced growth of financial assets in the nonfinancial sector, and growth of household financial assets:

This disparity has not been driven by growth in the monetary base, which lagged behind until 2008. Instead it has been driven by other forms of money supply growth, specifically credit growth.

This is the relationship between financial sector asset growth, and growth of the money supply:

And growth of the money supply inversely correlates with changes in the Federal Funds rate; in other words, as interest rates have been lowered credit creation has spiked, and vice verse:

The extent to which M2 is driven by the Federal Funds rate (or vice verse) is not really relevant; the point is that the Fed’s chosen transmission mechanism is inherently favourable to the financial sector.

The easing of credit conditions (in other words, the enhancement of banks’ ability to create credit and thus enhance their own purchasing power) following the breakdown of Bretton Woods — as opposed to monetary base expansion — seems to have driven the growth in credit and financialisation. It has not (at least previous to 2008) been a case of central banks printing money and handing it to the financial sector; it has been a case of the financial sector being set free from credit constraints.

This would seem to have been accentuated by growth in nontraditional credit products (what Friedrich Hayek called pseudo-money, in other words non-monetary credit) in the shadow banking sector:

Similarly, derivatives:

Monetary policy in the post-Bretton Woods era has taken a number of forms; interest rate policy, monetary base policy, and regulatory policy. The association between growth in the financial sector, credit growth and interest rate policy shows that monetary growth (whether that is in the form of base money, credit or nontraditional credit instruments) enriches the recipients of new money as anticipated by Cantillon.

This underscores the need for a monetary and credit system that distributes money in a way that does not favour any particular sector — especially not the endemically corrupt financial sector.


Tyler Durden answers my question in one graph:

The Absurdity of Sandy Weill

I’m suggesting the big banks be broken up so that the taxpayer will never be at risk, the depositors won’t be at risk and the leverage will be something reasonable.

This from the guy who provided the impetus and the funds to end Glass-Steagall? Totally absurd — akin to Joe Stalin renouncing Marxism-Leninism and the gulag archipelago on his deathbed.

Glass-Steagall’s separation between depository and speculative institutions — especially during the Bretton Woods period — was a relatively robust system; there was never a large-scale banking calamity of the nature of 2008 or 1929 under its regime. Certainly, it had its imperfections — above all else that it never prevented bankers like Weill from chipping away at it up to the point of repeal — but the proof of the pudding is in the eating, and Glass-Steagall presided over a period of growth and stability.

While the data tends to show that the end of Bretton Woods in 1971 was the real catalyst of the financialisation, globalisation, deindustrialisation and debt buildup that ultimately flung the US into a depressionary deleveraging trap, the end of Glass-Steagall was profound.

Depositors’ funds became a medium for the creation of the huge and sprawling shadow banking and derivatives webs.

The blowout growth in shadow banking was presaged by the end of Glass-Steagall in 1999:

And the slow contractionary deleveraging of shadow banking has been a significant force in keeping the economy depressed since 2008. Any contrition on the part of Weill for his role in repealing Glass-Steagall might as well be an attempt to close the stable door after the horse has bolted. It’s like trying to uninvent the atom bomb after Hiroshima. Weill was the guy who — above anyone else — was responsible for the damage done.

Coming out and claiming that reimposing Glass-Steagall would fix the problem is inadequate. If he wants to be taken seriously he should match every dollar he spent trying to get Glass-Steagall repealed with new lobbying funds to reimpose a separation between banks that accept deposits and the shadow banking and derivatives casinos.

Beyond that, I think that this is very telling. The financial institutions will do anything to avoid the ultimate free market solution — the disorderly liquidation of the system they created via default cascade. If high-ranking members of the financial elite are willing to talk about reimposing Glass-Steagall, they must be seriously concerned that the system they built is getting dangerously close to self-destruction.

Shadow Banking 101

This article originally appeared in the May 1st edition of The Occupied Times.

Meet James. James bought a house. It cost him $150,000, of which $30,000 had come from his own savings, leaving him with a $120,000 30-year fixed-rate mortgage from the WTF Bank, with a final cost (after 30 years of interest) of $200,000. Now, up until the ’80s, a mortgage was just a mortgage. Banks would lend the funds and profit from interest as the mortgage is paid back.

Not so today. James’s $200,000 mortgage was packaged up with 1,000 other mortgages into a £180 million MBS, (mortgage backed security), and sold for an immediate gain by WTF Bank to Privet Asset Management, a hedge fund. Privet then placed this MBS with Sacks of Gold, an investment bank, in return for a $18 billion short-term collateralised (“hypothecated”) loan. Two days later Sacks of Gold faced a margin call, and so re-hypothecated this collateral for another short-term collateralised $18 billion loan with J.P. Morecocaine, another investment bank. Three weeks later, a huge stock market crash resulted in a liquidity panic, resulting in more margin calls, more forced selling, which left Privet Asset Management — who had already lost a lot of money betting stocks would go up — completely insolvent.


You should be. This is of course a fictitious story. But the really freaky thing is that this kind of scenario — the packaging up of fairly ordinary debt into exotic financial products, which are then traded by hundreds or even thousands of different parties, has occurred millions and millions of times. And it is extremely dangerous. When everybody is in debt to everybody else through a complex web of debt one small shock could break the entire system. The $18 billion debt that Privet owed to Sacks of Gold could be the difference between Sacks of Gold having enough money to survive, or not survive. And if they didn’t survive, then all the money that they owed to other parties, like J.P. Morecocaine, would go unpaid, thus threatening those parties with insolvency, and so on. This is called systemic risk, and shadow banking has done for systemic risk what did the Beatles did for rock & roll: blow it up, and spread it everywhere.


The banking system has blown up multiple times in history, when depositors have panicked and withdrawn funds en masse in what is known as a bank run. So traditional banks have become party to a lot of regulations. For example, banks must keep on hand 10% of deposits as a reserve. This reserve is a buffer, so that if depositors choose to withdraw their money they can do so without the bank having to call in loans. Of course, banks can still suffer from a liquidity panic if a large proportion of their depositors choose to withdraw their money. Under those circumstances, traditional banks have access to central bank liquidity — short term loans from the central bank to guarantee that they can pay depositors.

Shadow banking arose out of bankers’ desire to not be bound by these restrictions, and so to create more and more and more financial products, and debt, without the interference or oversight of regulators. Of course, this meant that they did not have access to central bank liquidity, either.

Essentially, shadow banking is still banking. It is a funnel through which money travels, from those who have an excess of it and wish to deposit it and receive interest payments, to those who want to borrow money. Shadow banking institutions are intermediaries between investors and borrowers. They can have many names: hedge funds, special investment vehicles, money market funds, pension funds. Sometimes investment banks, retail banks and even central banks. The difference is that in the new galaxy of shadow banking, these chains of intermediation are often extremely complex, the shadow bank does not have to keep reserves on hand, and shadow banking institutions raise money through securitisation, rather than through accepting deposits.


With securitisation, the financial industry creates the products which populate the shadow banking ecosystem, and act as collateral. Rather than accepting deposits (and thus accepting regulation as traditional banks) shadow banking gets access to money through borrowing against assets. These assets could be anything — mortgages, credit card debt, commodities, car loans. These kinds of products are packaged up into shares, sold and traded. There are various forms: collateralised debt obligations, collateralised fund obligations, asset-backed securities, mortgage-backed securities, asset back commercial paper, tender option bonds, variable rate demand obligations, re-hypothecation, and hundreds more exotic variants. (Hypothecation is where the borrower pledges collateral to secure a debt – i.e. a mortgage, and re-hypothecation is where that collateral is passed on and someone else borrows against it, even though it remains in the original debtors hands). The function of these assets are essentially the same; securitisation is a way of creating products with an exchange value, and bringing money into the shadow banking system; so much money that the shadow banking system in 2008 was much larger than the traditional banking system:

Plummeting Junk

So securitisation — as well as its siblings hypothecation and re-hypothecation, allowed for pre-existing securities to be re-posted again and again as collateral, sucking more and more money into the system — became a pretty significant way of funding lending. The problem in the financial crisis beginning in 2007 was that a lot of the assets securitised to bring money into the shadow banking system turned out to be junk.

Think back to the MBS bundle containing James’s mortgage: if 90% of the mortgages in the MBS were defaulted upon, that MBS would yield a huge loss for whoever was currently holding it. If that MBS had been posted as collateral against further lending, those debts would be called in. For shadow banking institutions that were highly leveraged this turned out to be a huge problem. To raise capital, they started selling just about anything that wasn’t bolted down. This meant that prices — even of securities that weren’t fundamentally weak — plummeted. And because of the problems with a lot of existing securities, the funding source for a huge part of global lending completely dried up, worsening the economic contraction.

The risk — that debtors would default upon their loans — rather than being confined to a single bank, came to be spread about the entire economy, with bad debts that had been securitised, hypothecated and re-hypothecated coming to sit on the balance sheets of tens or even hundreds of financial institutions.


This entire system creates another problem. Securities came to be a kind of pseudo-money. In other words, they became a unit of exchange and a means for payment between banking institutions. With the 2008 shadow banking implosion, this meant that many prices, including prices of products like equities that were superficially disconnected from the shadow banking system, fell precipitously simply because there was less money floating around in the system.

Friedrich Hayek wrote about this problem long before anyone coined the term shadow banking:

There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

Thus, as the shadow banking system expanded, it caused inflation, and as it imploded it caused deflation. It was a big toxic bubble waiting to burst.

The Future

Ultimately, markets are a little crazy. People will do all manner of wacky things trying to turn a profit. All kinds of weird and wonderful systems will emerge. Some systems work better than others. And — as might be sensibly expected — the shadow banking system’s wacky idea of financing banking operations through the securitisation of debt failed. But because of the wider implications for the financial system, central banks began throwing money around in order to save these broken institutions and systems.

The Federal Reserve’s first quantitative easing program bought up tranches of defunct MBS. This stabilised markets to the extent that while securitisation virtually ground to a halt in 2009, by 2011 the shadow banking system was growing again. But this is surely just a temporary measure. Simply, there is no reason whatever to doubt that the same problem — of bad debt coming to be spread around the entire financial system through securitisation and re-hypothecation — will take root once again, causing similar turmoil in the future.

The status quo is that we have a broken and dangerous system that doesn’t really work, surviving on government subsidies. Sure, a full collapse of shadow banking in 2008 would have been painful. But we may have created a bigger and more painful collapse further down the road.

The Inevitability of Default?

From Buttonwood:

While Greece continues to inch its way towards a [now completed] deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that “the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

It’s nice to know I’m not just one lone voice in the wilderness.  But I think most readers already knew most of this. There is significant empirical evidence that when the problem is excessive systemic debt, neither austerity nor inflation are sufficient tools to really reduce the debt. Austerity tends to bring the problem to a head, while inflation tends to kick the can down the road. The latter may stabilise the system, but as we have seen in Japan, this does not necessitate recovery. If we want real debt erasure, we need measures that really erase debt.

By building a new system we can open a window onto whole new world of possibilities for reform. One possibility is the return of Glass-Steagall-style separation between investment and retail banking, and a complete ban on complex derivatives contracts.

And there is nothing morally wrong with default. Investors in government debt should do their due diligence, and be aware that for all the political bleating and obsequious promises from politicians, ratings agencies and Warren Buffet there is always a risk of default with sovereign debt. Debt is only ever as good as its issuers ability to generate sufficient revenues.

There was never any guarantee that this era of unrestrained credit creation, globalisation, job migration and American imperialism could go on forever.

Does the Fed Control the Money Supply?

It depends how you define money.

The Federal Reserve controls the monetary base, and has vastly increased it as a result of quantitative easing:

But that’s not the same thing as the money supply. The money supply is controlled by fractional lending by the banking institutions. More “money” comes into existence as more credit is extended. Banks can lend and lend and lend the monetary base up to the reserve requirement (ten times the monetary base, at present). You’d think that profit-hungry banks would lend all the way up to the reserve requirement, but right now that isn’t the case — a huge amount of the monetary base is sitting unused as excess reserves:

This means that while the monetary base has tripled, the money supply (M1) has not surged nearly as much:

But there is a much bigger factor here; M1 only deals with the obvious side of money supply — lending by financial institutions to businesses and consumers. There exists another banking system between banks and hedge funds where credit expansion takes places much less directly and obviously, via securitisation and rehypothecation — for example collateralised-debt-obligations (CDO), mortgage-backed-securities (MBS), etc. Here’s a recent chart of credit creation via these pseudo-monies:

Simply, the Fed’s huge expansion of the monetary base has still failed to prevent the contraction of this strange and exotic part of the “money” supply stemming from the 2008 Lehman incident, and surely to be significantly worsened by the ongoing implosion in Europe. It has failed to prevent the sector from deflating and sucking down the wider economy.

In the years preceding 2008 the definition of “money” became extremely loose. When securities made up of sub-prime mortgages which are in arrears comes to pass for “money” — and came to stand on balance sheets as debt — it should have been painfully obvious that modern finance had mutated into an uncontrollable monster, and that no amount of quantitative easing could prevent prevent the inevitable credit contraction from blown-up asset prices tanking.

The shadow banking sector was never “too big to fail”; it was too monstrous to succeed.

Six Weeks to Save the Euro? It was Dead on Arrival

Do we have six weeks to save the Euro?

From the Guardian:

George Osborne warned on Friday that the leaders of the eurozone had six weeks to end their political wrangling and resolve the continent’s crippling debt crisis.

Speaking in Washington, the chancellor said that the turmoil in the world’s financial markets meant there was now “a far greater sense of urgency” and mounting pressure on Europe from the G20 group of developed and developing nations.

“There is a sense from across the leading lights of the eurozone that time is running out for them. There is a clear deadline at the Cannes summit [G20] in six weeks time”, Osborne said. “The eurozone has six weeks to resolve this political crisis.”

 I don’t think so. I think the Euro was effectively dead on arrival. A fundamentally broken system; and that fundamental discord has now been transmitted around the world in the form of European sovereign debt, infecting the balance sheets of nations and institutions, creating huge counterparty risk, and raising the possibility of a tsunami of defaults.

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