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Source link: http://archive.mises.org/7778/and-now-its-securitization/

And Now, It’s Securitization!

February 14, 2008 by

The media have made us all aware of how rapacious lenders and (in a few cases) mendacious borrowers foisted the subprime mortgage mess (SMM) on us. Here and there may have come a whisper about chronically forcibly depressed interest rates and profligate creation of money by the Fed, and never, ever will the elephant in the living room of affirmative-action lending gain any traction (just not nice, you know).

But from the University of Chicago via The Economist now comes yet another demon: securitization, and with “hard proof,” no less. Never mind that securitization has worked notably well for several centuries now for ownership and operation of corporations, for example – it’s securitization.

The Economist has the estimable virtue of providing links to the reports and studies that articles like this are about, so go to the article, and from there, link on to the “hard proof.”


John February 14, 2008 at 9:53 am

They make a good point at the end of the article.

“It is a strong argument for requiring lenders to keep some “skin in the game”—or a share of the securitised bundle of loans on their books.”

I’m not convinced by their premises, but I find their conclusion appealing. There is a huge principal-agent problem with the creation of securitization that could largely be avoided by keeping some of the loans on their books.

Essentially though the paper is arguing that securitization leads to easier access to credit which leads to the problems we have seen. I’m not yet sure if securitization has had no effect, but I’m pretty convinced that home price appreciation caused by lower interest rates has had the largest effect. And those conclusions are from hard evidence and theory.

Bill Ott February 14, 2008 at 11:49 am

Securitization is just the assumption of risk by another. In this case it is Fannie Mae or Freddie Mac. Of course these organizations are GSE, meaning the tax payers pay for any risk so they could care less what mortgages they securitize?

The best term in this whole GSLoW(Government Sponsored Loss of Wealth) is the old word security. Did you ever notice that when the government secures something it makes it worse:
Social Security, Airline Security, Border Security, Terrerrists Seccerrit (Bush Pronounciation) etc.

fundamentalist February 14, 2008 at 12:10 pm

I think people should calm down about the mortgage mess or we’ll end up with another millstone around the economy’s neck similar to SOX. Securitization of mortgages was a new development in the ’90′s, and with all new types of securities, people get the risk factor wrong. Something very similar happened with junk bonds in the ’80′s.

Securitization of mortgages led some financial types to think that they had completely eliminated risk in mortgage lending. As a result, banks lowered their lending standards. After all, the bank would sell the mortgage to the feds, so the bank had no risk in loaning to risky individuals. The financial types thought that by pooling the mortgages the risky loans would wash out. They were wrong. They won’t make that mistake again.

Of course, the Fed played the leading role. But it can also take a while for people to really understand the risks involved in new financial instruments.

ed February 14, 2008 at 1:25 pm

The other problem is the fractional aspect of getting the loan off the books. Banks are highly motivated to get a loan off the books so the profit can be booked and it doesn’t take up precious capital to allow for new loans.

Securitization allowed the pricing to be more efficient. so banks could get better prices for garbagey loans. If the buyers of securitization didn’t understand what they were buying (or relied on ratings agencies who were in bed with the creators of the garbagey CDO’s and MBS’s) the thats too bad for them. Amazingly the banks that created the paper in many cases bought it themselves and are now in the process of writing down. WSJ had a good article on that a few weeks back – in a nutshell the banks did hold the assets but thought they were safe by holding the secure tranches. In reality ther weren’t safe at all.

Now that the subprime and Alt A loans don’t have a market to sell to, banks aren’t lending. To blame securitization on this mess is pretty lame. The principle agency problem is pretty easy to fix but at root it may not get the paper off the books of the bank which is the entire purpose of selling the loan.

John February 14, 2008 at 4:57 pm

They don’t have to take the entire loan off of their books, just sell 95% of it. That way, they still have a vested interest in the remaining 5%. The principal-agent problem is all over the securitization structure though, such as in the ratings agencies. The problem is that the brokers are interested in one thing: selling mortgages. The bond insurers are interested in one thing: rating paper. Due to home price appreciation caused by the Fed’s interest rate policies, these entrepeneurs were deceived into extending too much credit and the raters gave too high of ratings (they still get fees if wrong). The structures are so complicated that the buyer generally has no recourse. They don’t know where to go to get relief. I don’t think anyone proposes getting rid of securitization altogether. However, by keeping a small amount on their balance sheets, the brokers would still keep an eye out for the long-term that they didn’t pay attention to previously. There’s probably no need for regulation, but the mortgage companies should do it on their own and advertise that. “We’re in this with you” etc etc.

Eliza February 14, 2008 at 5:34 pm

Sustained inflation of the money supply causes malinvestment. But then, a fact so well known cannot easily form the basis for original research, so a very useful financial innovation must be scapegoated.

The market for mortgage backed securities has been facilitating the flow of funds from the capital markets to the housing market since the 70s. It’s brilliant: GSEs like Fannie or Freddie buy mortgages from primary lenders, pool them into groups with similar characteristics, then sell interests in the pools which represent a pro rata monthly payment stream of principal and interest payments which they guarantee. Private securitizers will sometimes have third parties guarantee or partially guarantee the assets and the payments. Often there is no credit guarantee, but other methods of credit enhancement are used. And in the case of fixed rate mortgages (which Fan and Fred prefer) the risk of default isn’t the primary risk. The interest rate risk is, as the S&Ls discovered when interest rates spiked in the early 80s. These are fun if you like betting on interest rates.

The genius of it is that it transforms illiquid assets into highly liquid instruments that are attractive to investors. Investors are able to decide exactly how much risk they want to assume, and lenders have the option to move most (residual risks remain) of the risks associated with mortgages off their balance sheets as well as free up capital to originate more mortgages. These transactions aren’t terribly profitable for banks–the money is to be made in holding mortgages–but it’s a reliable strategy nonetheless.

The system has been a resounding success for ages–not just with mortgages but with every other kind of asset backed vehicle you can imagine. Sure, investors have gotten over reliant on ratings agencies–which are often riddled with conflicts of interest–when they should be combing through the SEC mandated disclosures available for all publicly traded securities. But that’s just the sort of behavior we would expect when money is cheap for a long time. And that’s why the market must punish these careless investors so harshly. They will be more careful next time.

So let’s be clear: banks were under a lot of pressure to make loans as a result of the strong demand for them in the secondary mortgage market. Primary responsibility for that lies with the Fed, not market innovation.

Bill Ott February 14, 2008 at 8:38 pm

GSEs, brilliant? If what you say is true then the GSEs would willingly drop their safety net (Taxpayers) for the increased risk and profit. The reason they don’t dare do this is that they have no idea of the risk of their giant pools of mortgages.

Also, you assume that transforming illiquid assets into liquid ones is a good thing for the economy. I disagree with this on the logic that if it was a good idea then the economy would do this anyway and would not need force to accomplish it.

The GSEs are simply the product of government forcing tax payers to guaranteed a giant pyramid scheme of government paying lenders to take risk off of their balance sheets and transfer that risk to someone else (Taxpayers).

Eliza February 15, 2008 at 12:16 am

You misunderstand me Bill. It’s the innovation itself I admire, not Fan and Fred. On the contrary, I’ve been an advocate of their privatization since my school days.

Let me explain my position point by point.

The government takes every opportunity to emphatically deny it guarantees the siblings’ debt and requires them to do so as well. But because of certain explicit advantages Fan and Fred enjoy (like their $2.25 billion emergency line of credit from the Treasury), plus the fact that since they own 75% of the market for prime, conforming, conventional and single-family homes (80-90% of the residential market) and a failure of one or both would be a global catastrophe, the market doesn’t believe the government would ever let them fail. (I’m sure we all remember the S&L bailout, the FCS bailout and the LTCM debacle.) Of course the market is right about that.

So the implicit guarantee of their debt translates to a de facto public subsidy of their borrowing practices. The degree to which the market believes that Fannie and Freddie are under government protection is measured by the very low rates it charges them to borrow money. Their securities are priced below Treasury securities but above corporate AAA debt, in spite of the fact that they are both highly leveraged companies whose securities would, without the implicit guarantee, have a AA or even an A credit rating instead.

It is by leveraging this subsidy that they have been able to dominate the residential mortgage market and force private mortgage securitizers to scrounge around in markets OFHEO (the siblings’ nanny) thinks are too risky for Fan and Fred, like subprime and alt A. It’s nothing to do with them not knowing the risks they are dealing with. Nothing could be further from the truth. Their risk managers are very clever people, but my god do they like to cut things close to the bone. They use a hedging strategy called “imperfect dynamic hedging.” In effect, the siblings bear the expense of passing some of their interest rate risk (the main risk they face, as it effects prepayments) to the derivatives market (interest-rate swaps, swaptions, interest rate floors and caps, foreign currency swaps that hedge the risk of issuing foreign currency denominated debt, etc.) and reap the profits of leaving a portion of their portfolios unhedged. The cost of this retained risk is borne by taxpayers, though they will not know it unless and until one of the companies fails.

Privatization will not immediately end the implicit guarantee, simply because the “too big to fail” argument will still have teeth. However, over time competition from the other mortgage securitizers allow them to find their optimum size, shape, scope, market share and risk–even though that means they will become less profitable. The government’s goal should be stability and efficiency in the financial system as a whole, not to amass profits for two sets of shareholders.

And now to address your points:

Also, you assume that transforming illiquid assets into liquid ones is a good thing for the economy. I disagree with this on the logic that if it was a good idea then the economy would do this anyway and would not need force to accomplish it.

Your logic is sound, it’s the premise that’s flawed. Everything Fan and Fred do private companies do as well. The problem is that the market insists on lending to the siblings’ at below market rates that their competitors can only dream of.

The GSEs are simply the product of government forcing tax payers to guaranteed a giant pyramid scheme of government paying lenders to take risk off of their balance sheets and transfer that risk to someone else (Taxpayers).

This statement is a bit more problematic. For one thing, these companies bear no resemblance to pyramid schemes, nor do the private companies who use the same business model.

Finally, the government does not “pay lenders to take risk off of their balance sheets and transfer that risk to taxpayers.” Why would it? If the government wanted taxpayers to bear the risk it would return Fan and Fred to their status as wholly-owned government corporations. Instead it is constantly looking for ways to convincingly squash the implicit guarantee in the market’s eyes while still maintaining the power to regulate both companies.

George February 15, 2008 at 12:58 am

What about the problem of borrowing short and lending long term?

A lot of the “purchase” of mortgage securities was financed with short term borrowing using the mortgage security as collateral. When the short terms loans couldn’t be refinanced problems occured.

In some sense a borrowing which can only be paid off by rolling it is fraud as the promise to pay in 90 days is in reality subject to being able to borrow again.

This short/long problem is everywhere. Even homeowners” with ARMs who planned on a refi before their rate adjusted.

P.M.Lawrence February 15, 2008 at 1:48 am

Just as the original core business of banks was lending to merchants and thus providing working capital, so also the original use of securitisation provided more permanernt forms of capital that were still linked to a revenue stream via the operations of a business. Just as bank loans that don’t match the original core business of banks don’t meet the criteria of Real Bills Doctrine and thus make bank notes less sound than bullion, so also securitised debt that connects to non-operating assets like housing lacks any inherent connection to a revenue stream of the sort needed to service the debt. The problem is compounded by the lack of “disintermediation”, the technical term for “no skin in the game” on the part of the – sorry about this – Loan Arranger, so it’s Hiyo, silver (=money) away.

It’s always been a good rule of thumb never to guarantee someone else’s debt but instead borrow the funds from the principal yourself and then make a personal loan of them to the person who wanted them. If that’s too big a mouthful for you, then you shouldn’t do the guarantee either – it’s a bigger and more open ended risk for you. Similarly, all the insurers of securities should have bought the first level securities themselves, funding them with issues of their own securities to the end buyers – and if that looked like too big a problem (which it was), they should have faced up to the reality of what they actually did and not done that in the first place. That’s more disintermediation than making a guarantee, but less than a straight loan. This isn’t hindsight talking, I’ve known this rule of thumb for years.

Anyhow, the moral is that with securitisation you should have as much disintermediation as possible.

Eliza February 15, 2008 at 8:10 am

Borrowing short to lend long is the way mortgage portfolios are financed, and there’s nothing wrong with that. The strategy presents challenges like any other business strategy, primarily interest rate risk, but you can hedge as much of your risk as you like depending on how profitable you want to be.

The S&Ls are a great example of the pitfalls. When interest rates rise, there is an inevitable downturn in new home sales and refinancing so that low-rate mortgages remain on the books for longer than expected and must be financed with increasingly expensive short-term debt: there is a “mismatch” between asset and liability duration. The S&Ls made long term loans in the 1970s at what turned out to be negative real interest rates, funding themselves at skyrocketing short-term rates, and suffered a drastic loss of capital, often to insolvency, in 1979-82. At the same time and for the same reason, the market value of Fannie’s net worth also became negative.

But rising rates are only half of the interest rate risk; when interest rates fall, mortgage lenders face the contrary mismatch. When interest rates fall homeowners refinance their mortgages to lock in lower rates. An accelerated rate of prepayment creates a mismatch between asset and liability duration, as long-term funding now exceeds short-term assets. In other words, a portfolio of fixed-rate prepayable mortgages will always have an actual duration much shorter than the average contractual length of the mortgages because of refinancing and prepayments. Companies holding whole mortgages or MBSs know this, and structure their debt funding strategies to conform to predicted future interest rate changes. That’s when things get really interesting.

As for rolling over short term debt, an investor must take the time to research what he’s buying and know the risks. If he doesn’t, he hasn’t been defrauded, he’s been foolish, and it’s essential that he be punished for wasting capital that could have been put to better use elsewhere.

Peter L.Griffiths November 20, 2011 at 11:57 am

Mortgage backed securities were mostly issued by United States institutions to the world’s banks who then discovered they were toxic assets. Whose fault is this?

N. Joseph Potts November 20, 2011 at 2:10 pm

@Griffiths: I don’t think MBSes are actually ISSUED TO anyone in particular. They are SOLD to the people/institutions that BUY them.

To answer your question, it’s the fault of the (buying) banks that paid for something without first checking to see if they had value. Of course, if they were in some way defrauded, then the fraudsters share the blame.

Peter L. Griffiths December 10, 2011 at 12:09 pm

Mr Potts raises important questions which need to be answered. I use the word issue to indicate the first sale of the security. Foremost among the American institutions which issued mortgage backed securities was Fannie Mae in 1981 to acquire dollars and other currencies to fulfil its legal objectives. Instead of possibly suing the American issuing institutions for fraud, it seems that the world’s banks prefer receiving bailouts from their own countries, whose inhabitants can then be blamed for the budget deficits.

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