Tim Worstall has a good headscratcher of an article about an aspect of the recent financial crisis: what is called securitisation. To those not familiar with this term, it is the process by which banks and other financial institutions that lend money out – such as mortgages – use the repayments as collateral to take out loans of their own, at a (hopefully) lower rate of interest, and thereby make a profit on the difference between the two. The idea is that by packaging loans and other IOUs into big parcels, and then selling these packages to end-investors such as pension funds or life firms, that the risks inherent in the individual mortgages and loans are spread out among a wide circle of investors.
On the face of it, that sounds smart: spreading risk is, after all, the basis of insurance. However, unlike say, fire insurance, defaults on bonds tend to rise and fall in line with the economic cycle: you do not usually get a massive uptick in fires every three or four years, for example, although in bad periods a combination of natural disasters can hammer insurers.
A lot of this financial engineering, and the associated alphabet soup of acronym terms for the various products involved, has come under fire from all those books that got published in the aftermath of the crisis. A typical example is Gillan Tett’s effort, Fool’s Gold, which tends to play to the “evil bankers” schtick that has become so familiar. I prefer this and this.
As Tim says, the problem, however, is that banks did not – contrary to the conventional wisdom that has condemned securitisation – done nearly enough of this sort of thing. In fact, when the shit hit the fan in 2007/08, many banks and other lenders had not managed to securitise their loans and had to make massive writedowns as defaults mounted. Case in point: HBOS and Royal Bank of Scotland in the UK.
The trouble, though, is that beating up on banks for not doing enough to remove credit risk from their balance sheet ignores, I think, the underlying problem that has been mentioned before here, which is that in a world where central banks set interest rates and cut them at any sign of economic trouble, banks will be under enormous commercial pressure to chase yield where they can, by lending money to high-risk ventures. Until and only when borrowing is financed from real savings rather than central bank Monopoly money, the underlying causes of such recent messes will not go away.
Even so, Tim has raised a smart point that kicks against the usual clichés, which is one reason why his blog is one of my daily reads.
Wasn’t it all “ultimately” down to the frauds committed by mortgage brokers both here and in the US which resulted in the mortgages being valued based on blind faith alone?
Whatever issues the system had, without that huge amount of fraud there would be no problem.
One should note that this past month the level of home ownership in the US, the big liberal badge proving that upward mobility was alive and well in the US, has now fallen back to the same level it was at in the year 2000, when the Community Reinvestment Act really started motivating the creditless class to buy homes they could not afford (Remember all those ads: “It’s now easier to own a home now than ever!” “Why rent when you can own?”).
Congress is only now starting to make noises about addressing the real root of the subprime problem: FannieMae and FreddieMac, which conspired to poison the securities markets with toxic credit swap securities poisoned with mortgages made on the basis not of the borrowers ability to pay, but because they belonged to a favored minority group. Who wants to bet that they won’t really fix the problem like it should be?
@Mike FannieMae and FreddieMac may be unwise and illiberal in themselves, but were they not defrauded by the brokers? We can’t blame FannieMae and FreddieMac without giving the (pro-free-market?) brokers a roasting as they were (at least) the proximate cause.
What often isn’t appreciated is that the growth in securitisation was primarily a response to regulations. The first Basel Accord required banks to hold capital in proportion to their loan book, so it created an incentive to sell off loans as packaged assets, in order to reduce capital requirements for the lending bank, whilst passing the assets on to organisations which would not need to hold the same level of capital.
It’s another case of good old-fashioned unintended consequences.
I’m not sure I’m on the right track here, but isn’t one problem the problem that if a bank counts an IOU as an asset, then if that IOU suddenly loses its value, the bank’s asset base disappears, so that the hypothetical fraction in reserve disappears?
Ian B,
It depends what you mean by “fraction in reserve.” If you mean it in the sense of Fractional Reserve Banking, the answer would be no, as the IOU would have never formed part of those reserves.
Weren’t the banks buying each others debts and counting them as assets?
I left the following comments on Tim’s post.
“Banks did what they did and will continue to do what they did as long as they know that their respective governments will bail them out, as has been demonstrated over and over again. The only way to ensure that such melts down do not recur is for all governments to insist that banks will either sink when things go bad or swim when the profits are good. In this case, better risk management will be ensured. Non banking businesses do this, why can’t the banks?”
Yes, as with any loan, they would be classed as an asset; however, they aren’t classed as either cash reserves or capital reserves. The capital reserves are made up of much more stable assets, with the intention being to maintain a buffer to protect against any degradation in riskier assets.
The political side of this should not be forgotten.
Many financial enterprises had doubts about lending money to people they knew next to nothing about (the basis of the “affordable housing policy”), but they were told (by Fannie Mae and Freddie Mac – and by the politicians behind them such as Congressman Barney Frank and Senators Chris Dodd and Barack Obama)…..
They were told (via nods and winks) not to fear – that they could pass the risk on – by turning the home loans into securities and selling them on. “The securities will not be worthless – you can mix in good mortgages with the bad ones…..”
Of course a whole inverted pyramid of debt was based on these securities.
“What about the debt rating agencies” – remember they are de facto based on GOVERNMENT confidence (a debt rating agency that said the affordable housing policy was insane would have been in serious trouble).
So they just rated thesecurities “triple A”.
One of the big American ratings agencies (I forget which one) actually did have a pang of conscience – but it not blow the whistle, it just got out of the market (so it did not have to tell any more lies – in order to keep sweet with the financial interests and politicians).
Still one could always tell one’s self the following……
“I am not lying – the Federal Reserve will never allow the market to crash, so it is not a lie to rate all this crap Triple A”.
And every step of the way Alan Greenspan pushed out more funny money to stop a market crash.
Of course each time he did that the bubble got BIGGER, but people tried very hard not to see that.
Sorry, but I think Worstall’s article is extremely superficial and betrays a very weak grasp of both securitization and finance.
The collapse (or near-collapse) of banks when the US residential mortgage market tanked was not caused by the loans then on their books. Those loans were not particularly bad (certainly no worse than the ones in securitization pools; they were, after all, destined for such pools when the music stopped), and most of them were being held on a temporary basis until sufficient quantity had been accumulated for an effecient securitization transaction. For most banks there really weren’t all that many of them, as a percentage of total assets, and what there was could generally be carried at face value when the securitization market collapsed. For this reason they generated no immediate accounting losses.
The larger problem was the securitization bonds held by the banks. Insurance companies, pension funds, etc., weren’t the only buyers of those bonds, as Worstall seems to think; banks were huge buyers of them, too, and for valid reasons (not the least of which was the fact that under the Basel Accords those bonds were classified in the 50% risk-weighting category and so required less capital to hold than, say, commercial loans). Essentially, the banks were all holding tiny pieces of each others’ loans via the securitization process, which was good for risk diversification purposes but turned bad when the wheels fall off all over the country essentially simultaneously. This is a very complicated matter and I don’t want to get into a lot of technical detail here, but in the end Worstall is simply wrong to assert that banks didn’t securitize enough of their loans. They securitized most of them; all that was on hand was the inventory in the pipeline.
And he is also wrong to suggest that they should be securitizing all the sovereign debt they hold. The poor quality of Greek, Spanish, etc., debt isn’t somehow “sanitized” by securitizing it. Worstall isn’t suggesting that it does, but he is saying that all that risk will transferred to the bond investors. Unfortunately, though, that’s still largely the banks themselves, and always will be.
Look, banks have to invest their cash in something; it can’t all be lying around the vault. He seems to want to turn them into mortgage banks instead of commercial banks. That’s a perfectly valid business model, but not if every bank in the world adopts it. Historically, banks have always made loans and held them in portfolio. They were stuck with the all the risks (not just the credit risk, but also interest rate risk and asset-liability mismatches). The best they could do was lay off portions of it to other banks via a process called “participation”. That works reasonably well (one can even allocate credit risk by creating senior and junior participations), but is relatively inefficient except for very large loans. The development of securitization permitted, for the first time, broad-based sharing of the lending risks even of small loans. This was a truly wonderful development, of immense value for the financial system as a whole, but in the end the banks collectively still are the primary owners of the loans, merely in different form.
Securitization does many very useful things, but unfortunately not what Worstall seems to think it does.
Methinks there is a bit of possible misconception (over-simplification?) in JP’s opening to the effect that in “securitization” the originating lender uses the prospective repayments as collateral “for loans of its own.”
That was not the function of the origins of true securitization.
A “Security” representing ownership of debt obligations was created. The interest on debts held was not assigned as collateral to secure lenders’ borrowing.
In a case ot auto loans or others consumer credits (charge card balances, e.g.) The actual ownership of the blocs of diverse debtwould be transferred, thus accelerating the earnings to be made and often retaining a “servicing” (fee source) function.
True, some transfers involved repurchase or replacement commitments or other forms of contingent exposures; but, they were not largely used as collateral.
Thus, you will note that the geniuses on the Senate Staffs put requirements into FinReg Omnimbus that originators must retain a specific exposure on their loans of passed on.
Among the challenging aspects of securing loans(Link) is the research process. It seems to become difficult to compare numerous offers, providers, and a complex plethora of confusing options. A competing loans offer could make all the difference and let you save hundreds of dollars every month in interest payments.
Fannie and Freddie loans did not bring down the global financial markets.
The CRA related loans, at least the original ones, have performed close to historical norms for mortgages, or at least were in late 2008 when the stuff was hitting the fan. The problem was the loans that came later – the home refinancing, the second homes, the ultra-large mortgages for your 6500 sq ft mansion in New Jersey and so forth.
Problems at Fannie and Freddie didn’t bring down the banks.
Laird outlines a lot of the problem. The rest of the problem developed in late 2008 when the major banks started playing chicken with each other over liquidity and the people they were playing with had to start looking at their balance sheets properly with a view to actually realizing that liquidity.
Fannie and Freddie failing? That would have been a problem, but not a large one.
AIG failing and with it the confidence in the Balance Sheets of every single major bank on the planet who had their CDSs insured by them. That’s the catastrophe we were facing.
If it hadn’t been quite so scary and bad I’d actually be laughing that the run on Lehmans wasn’t made by their conventional customers, but by OTHER banks.
The “catastrophe” of AIG failing was a second-order artifact of the irrational “mark-to-market” of the securitization bonds (as if writing them down overnight to the fire-sale prices being offered by the few bottom-fishers remaining in a totally gridlocked market somehow reflected their true value; thanks, FASB and SEC). AIG’s problem was simply one of liquidity: its counterparties saw bond values collapsing, applied their own (extremely conservative) valuation models to the collateral they were holding as security for their credit default swaps, and demanded that AIG post additional collateral. When it couldn’t meet all the demands AIG teetered on the brink. But the problem was the irrational demands by its counterparties (especially the ever-opportunistic Goldman Sachs); their “valuations” were no more valid than the bogus “mark-to-market” on MBS bonds. Had Geithner and Bernanke not panicked, and allowed AIG to buy time through an orderly Chapter 11 process (run by one of the extremely experienced and financially sophisticated bankruptcy judges in the 2nd Circuit), reasonable values would have been established and the crisis averted. In the long run the market would have been more stable, not less, and it is highly unlikely that AIG would have failed. And even if it had, that would not have affected any of its insurance subsidiaries (all of which were over-capitalized), and any losses would have been diffused throughout the financial system via the bankruptcy process. There would have been pain (much of it overseas), but no widespread house-of-cards collapse.
The clumsy hand of government is all over the financial collapse of 2008. That’s what comes of trusting pig-ignorant politicians and inexperienced lightweights (i.e., Geithner) to run the nation’s monetary system.
OK, so assuming that Timmy’s analysis is superficial and therefore wrong, can any Samizdatista recommend one book that would adequately explain the situation for non-economists, preferably from an Austrian point of view?
“Meltdown”, by Thomas Woods.
Daveon:
Every time (year after year) it looked like there was going to be a real market correction the Federal Reserve of Alan Greenspan came “to the rescue” with yet more credit money.
And what the money was used for?
In the past it was thinks like Greenspan’s dot.com bubble – but what brought down the system was the real estate bubble.
And who directed the money at housing?
Barney Frank, Chris Dodd and (yes) Barack Obama (even before he was a Senator) and the whole parade of politicians. (including many Republicans).
They used Fannie Mae and Freddie Mac (neither of which should have been created in the first place – any more than the Federal Reserve should have been) to direct the money – but they had other tools and other influence.
If you will not read the book Laird suggests – Thomas Woods’ “Meltdown”, then read Thomas Sowell’s “The Housing Boom and Bust” (he is not a naughty Austrian School man).
Or you can just go along with the establishment Charlie Rose types – blaming everything on greedy businessmen (in a show that goes out on a supposedly business network – it comes from PBS but it goes out on Bloomberg) and ASSUMING that yet more gevernment regulations (on top of the thousands of pages that already exist) will improve matters.
One of the few things that scare me is the thought that some businessmen actually take the establishment propaganda of Mr Rose (and the rest of the Legion) seriously.
Philip specifically asked for a book with an Austrian perspective, and “Meltdown” is explicitly so (Woods even includes a section clearly describing Austian economics). It’s also eminently readable, and I can’t praise it highly enough. But of course anything by Sowell is worth reading, too.
“The larger problem was the securitization bonds held by the banks. Insurance companies, pension funds, etc., weren’t the only buyers of those bonds, as Worstall seems to think; banks were huge buyers of them, too,”
But that’s exactly what I’m complaining about!
The loans they had in the pipeline to be securitised were a trivial part of the problem. That banks either bought or kept the AAA tranche of their securitised loans is what I’m complaining about.
preferably from an Austrian point of view? dont you agree ?