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?).