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?).

22 thoughts on “Securitisation and Risk

  1. John I suggest you pass this on to the Queen and Prince Phillip, as they would be most impressed.

    HRH: “why didn’t anybody see it coming”

  2. US Dept. of Justice has filed a lawsuit against S&P for knowingly inflating ratings of mortgage debt. Anyone want to bet that the Fed, bank regulators, congressmen, Freddie/Fannie or Clinton administrarion officials, or banks will be charged? This is simply one more, though unprecedentedly destructive, case of government, quasi-government and Wall Street conspiracy to fleece people.

  3. Aziz says “Without the incentive of failure for lenders who lend to those who cannot repay, standards become laxer…” Quite right.

    And that flaw lies right at the heart of traditional fractional reserve banking. That is, when I deposit money in my bank and the bank makes a hash of lending the money on, I don’t suffer any consequences. Either the bank’s shareholders take a hit or if the bank failure is much more serious, the taxpayer comes to the rescue.

    In contrast, under full reserve, depositors do take a hit. At least that’s the case with full reserve as advocated by Laurence Kotlikoff and by this lot:

    Click to access NEF-Southampton-Positive-Money-ICB-Submission.pdf

    • Depositors should become shareholders. Risk versus reward.

      I am seeing a big increase in interest for Bank Securities that are similar to unsecured loans. Read the terms of these, and you will find this is not your ordinary term deposit:

      “the regulator has stressed that hybrids are subordinated to other forms of debt and are unsecured – which means investors in these products are at the back of the queue if the issuing company fails”

      How do Australian Banks fund themselves?

      Chasing Yield? Should we bail out greed?

      Perhaps, if people realised they could lose their life savings, they will ask their bank manager, “why should I place my hard earned savings with you”?

    • Ralph and John, you evoke an epiphany. Whereas we know why lawyers have ridiculous power and privilege*: all judges are lawyers and most legislators and other politicians are lawyers; but why do bankers have such power and privilege? There must be quid pro quo — not only legal campaign contributions (bribes), but insider information, sweetheart loans, and other illegal payola. Right?

      * Many lawyers, especially in Washington and state capitals, are on “retainer” — on standby waiting for work. Try billing clients/customers, including government, for such overhead for engineers and others.

      • “…but why do bankers have such power and privilege?”

        Those who control money [the abstraction of labor-value], controls labor itself, and this is the most important way you can control society.

        It’s not the counterfeiting nor the insider deals nor even [necessarily] the political power won through bribes, etc., but instead, its the ability to control flow and value of labor through the manipulation of currencies [though money supply and therefore interest rates].

        Human labor is the source of all value. Control IT and you control the world.

    • The thing about banning shadow banking is that it was never really legal or legitimate in the first place… and was created to get around reserve requirements and liquidity constraints.

      Ultimately, I think it’s very difficult to think of a way to police this exogenously. Ban current forms of shadow intermediation, and you’ll just get new forms…

  4. Pingback: Securitisation and Risk | My Blog

  5. In a debt-money system, the most important thing is creating enough debt money to keep the system moving forward [i.e., enough new money (debt) to pay off the existing debt, which is, btw, the main reason that governments are running gargantuan deficits].

    Securitisation is simply the most efficient method in creating the most amount of debt/unit time. Although anybody with an IQ over 50 can figure out that doing such a things is not such a good idea, when people are making billions off of such a ruse, rule number 23 comes to mind, which is, when it comes to putting cash in ones pocket, people will rationalize any of everything to this end.

  6. “… dual phenomena of lax lending standards and securitisation…”

    “When you pull the pin on these grenades, boys, don’t forget to throw them as far from you as possible. Hold one too long, well…..”

    Make them hold these loans on THEIR books with clear knowledge there will be no bailouts. That’ll ensure Mr. No Doc and Mrs. Zero Down get full physicals before being given a loan.

    They play nice or risk losing their charter – simple as that.

    Separate commercial and investment banking, then let them blow each other up. Oddly, I don’t think that would happen somehow.

  7. In Nassim Taleb’s terms securitization shields one’s skin from the perils of the game while keeping the spoils coming in…
    At a deeper level of analysis this is nothing but the latest symptom of our state of confusion: we believe ‘money’ to be a legitimate goal while it is nothing but a means to an end, one that should be determined by each of us…

  8. People are trying to find the silver lining in finance, that is, if we can only steal from people and do it so people are OK with it.

    Are people so far removed from taking care of themselves that they actually have to buy into all of these scams to conceive of a life? Even under the best possible conditions, banking and finance is THEFT!!

    How about taking care of yourselves?

  9. Student Debt, The next bubble? Since this money is not owed to banks, there is no securitisation rick right? Wrong. How many corporations rely on this student debt to fund their earnings? Once austerity measures kick in, the tap will turn off.

    Best comment analysis:

    Thu, 02/07/2013 – 22:46 | 3225064 Dewey Cheatum Howe

    “Interesting article on student loans and how the increase is driving down the unemployment numbers. They even use some source material from ZH there to make the case.

    I noticed in digging through the line items of today’s report that one line item contributed substantially to the overall headline number of 155,000: Education and health services, 65,000.

    Anyone see anything wrong with that number? 65,000 is 41% of the total headline number. But think about the “quality” of that number. How much of that number do you think is the result of direct or indirect Government spending, and thus dependent on taxpayer revenue?

    Table B of the BLS report, LINK, attributes 55k of that number to “health care and social assistance.” Without knowing the breakdown of that number, I think we can assume most of the jobs in that particular category are funded by Medicare, Medicaid and now, Obamacare. Even the private hospital and nursing service companies that would be considered “private companies” and who hire the people in this category have a large portion of their revenues derived from Government reimbursement/entitlement programs.

    Let’s examine the “education” part of that line item, which does not get further line item detail in the BLS report. I can summarize the quality of that number with two graphs. This graph shows the recent parabolic growth rate in student loan debt

    And this graph shows the growth in student loan delinquencies

    The total amount of outstanding student loan debt according the latest quarterly Federal Reserve report as of September 30, 2012 was $956 billion, with a $42 billion increase in during Q3: NY Fed. It’s safe to say that number is now around $1 trillion.

    That trillion dollars in student loans is primarily comprised of loans directly owned by the Federal Government and student loans that are guaranteed by either the Federal Government or State Governments. In other words, a significant portion of education is funded directly and indirectly by the Government/Taxpayer. This means that a significant amount of the employment that makes up the BLS’ employment report is directly attributable to Taxpayer funding.

    In the context of the accelerating level of student loan delinquencies per the above chart, any respectable financial analyst will admit that the growth in student loans, and therefore the portion of jobs growth that is directly attributable to this significant source of direct or indirect Government funding, is unequivocally not sustainable.

    Any job growth connected to the student loan source of taxpayer revenue will not be recurring and will likely reverse when real budgetary austerity is imposed on the Government. Furthermore, to the extent that any healthcare related jobs are directly or indirectly connected to Government/Taxpayer funding, they are not sustainable and any real growth in that area will also reverse.

    It thus looks like the Government has engineered another questionable monthly employment report in order to make the headline number appear as if the economy is back on track to economic health. But the truth is that even if the number is real, it is clearly not sustainable unless the Government intends to continue on its path of accelerating spending deficits and new Treasury debt issuance”.

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