The recent credit crunch has been characterized as “the first crisis of the age of mass securitization.”1 Over the past twenty years, large banks have refined strategies of securitizing credit. This means that they originate loans or purchase them from specialized brokers and transfer them to a special-purpose vehicle, which then packages them into collateralized debt obligations for sale to other investors. Some commentators have argued that this business model has simply set the stage for financial crisis. Securitization, they argue, weakens the incentive for the originator to asses the credit quality of those loans. Investors on the other hand lack the specialized expertise needed to undertake any reliable scrutiny of creditworthiness. Thus, while securitization spreads risk, it also has a tendency to raise it. More risk is created to be spread and ultimately to be borne by someone.
According to this view, the conclusion to be drawn from the recent subprime crisis is that the costs of securitization and related practices, in the form of risks to financial stability, have exceeded the benefits. The implication is that we should return to the simpler days of “good-old-fashioned banking” in which commercial banks originate loans to households and firms and hold them on their balance sheets, rather than slicing them, dicing them, and selling them off.
Central bankers and public regulators have been reluctant to acknowledge any direct responsibility for the recent subprime meltdown and crisis in worldwide financial markets.2 The crisis has, to the contrary, been interpreted rather generally as evidence of a need for more intervention, by both public regulators and central bankers. Nevertheless the role and responsibility of central bankers and regulators with respect to the recent turmoil need to be reassessed.
The Case Against Financial Innovation
Comments blaming financial innovations over the last three decades for the financial bubble and subsequent crisis have come from several quarters. Alan Greenspan has not been alone in pointing to “the immense and largely unregulated business of spreading financial risk widely, through the use of exotic financial instruments” as one of the causes, and perhaps the main cause of today’s crisis.3 Within academia, several authors working in the tradition of Hyman Minsky have identified financial innovations as the main culprits for the current crisis. The story runs somewhat as follows:
The whole housing sector, which had been made very safe by the New Deal reforms, has now been transformed into a huge global casino by certain developments such as the globalization of finance and the declining importance of banks in favor of managed money. The New Deal reforms related to home finance had been spurred by a common belief that short-term mortgages, typically with large balloon payments, had contributed to the Great Depression. The long depression-free period that followed World War II created global managed money-seeking returns. Packaged securities with risk weightings assigned by respected rating agencies were appealing for global investors trying to achieve the desired share of dollar-denominated assets. This occurred as the bank share of all financial assets fell from around 50 percent in the 1950s to around 25 percent in the 1990s. At the same time, the financial markets were freer from the New Deal regulations that had made these markets safer. By the time of the real estate boom in the United States that eventually led to the subprime crisis, there was no longer any essential difference between a “commercial bank” and an “investment bank.” Ironically, the innovations in home-mortgage finance leading up to the speculative boom — including, most prominently, securitization — largely recreated the conditions which led up to the Great Depression.
As one author concludes:
“Today, we can surmise that the financial innovations of the past decade greatly expanded the availability of credit, which then pushed up asset prices. That, in turn, encouraged not only further innovation to take advantage of profit opportunities, but also ever more debt and greater leveraging…. I expect that the combination of Big Government and Big Bank, plus the remaining safeguards built into the system by the New Deal, will prove once again to be sufficient to prevent a recurrence of a great depression.”4
The major problem with such analyses is that authors arguing along these lines seem to entirely lack any consistent notion of “the free market.” Some authors are so confused that they characterize the current economic and financial system as somehow both, and at the same time, “big government” and “neoliberal” (in the sense of centered on deregulation, privatization, and reduced oversight etc.).
As one author writes:
“Minsky used to argue that the Great Depression represented a failure of the small-government, Laissez-faire economic model, while the New Deal promoted a Big Government/Big Bank highly successful model for financial capitalism. The current crisis just as convincingly represents a failure of the big-government, neoconservative (or, outside the U.S., what is called the neoliberal) model. This model promotes deregulation, reduced supervision and oversight, privatization, and consolidation of market power. … The New Deal reforms transformed housing finance into a very safe, protected business, based on (mostly) small, local financial institutions that knew their markets and their borrowers. … The Big Government/Neocon model, by contrast, replaced the New Deal reforms with self-supervision of markets, with greater reliance on “personal responsibility” as safety nets were shredded, and with monetary and fiscal policy that is biased against maintenance of full employment and adequate growth to generate rising living standards for most Americans.”5
And further,
“(f)rom his earliest work, Minsky recognized that private-led expansions are inherently more prone to creation of financial fragility because they imply deterioration of private balance sheets as borrowing tends to increase faster than ability to service debt out of income. For this reason, he advocated policy that would encourage consumption, but with a major impetus for growth coming from government spending.”6
Contrary to Minsky and his followers, it does not seem reasonable to assume that market processes are “inherently unstable” or “fundamentally destabilizing.” It seems more reasonable to assume that when property rights of all market participants are correctly defined and strictly enforced, market processes tend to be self-correcting rather than “fundamentally destabilizing.” Accordingly, so long as property rights are not adequately defined and enforced in the monetary and financial domain, fully self-correcting financial markets will not be observed. And it is obviously nonsensical to blame “the free market” for the dysfunctions of what is actually a highly collectivized financial system. In particular, a “free market” in the field of money and banking is inconsistent with the existence and the actions of central banks. On the other hand, to the extent that the present crisis only reveals the errors and malinvestments of the past, it illustrates the existence of a self-correcting potential even of markets characterized by a heavy dose of government intervention.
A Few Elements about the Economics of Securitization and the Use of CRT Vehicles
In past years, financial innovation led to a dramatic growth in the market for credit-risk-transfer (CRT) instruments.7 Most commentators of recent events have recognized the role of financial innovation in rendering financial markets more liquid and in providing investors with a much wider range of instruments at their disposal to price, repackage, and reallocate credit risk throughout the financial system. Since these CRT instruments, in particular collateralized debt obligations of subprime mortgages, have also played some role in the events leading up the current credit crisis, commentators such as those already quoted have pointed to financial innovation as one of the main culprits or fundamental causes of the crisis. Nevertheless the main culprits of the current crisis are to be found elsewhere. To clarify matters, it may be useful to give a sketch of some of the mechanics of securitization.
A particular form of credit risk transfer (CRT) vehicle is securitization. Developed in the 1980s, securitization means that a financial institution originates loans, pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow on the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE.
Securitization is a tool of financial transformation; as such, it is not a tool of credit expansion. Suppose a company has receivables on its balance sheet that represent installment loans that borrowers are repaying over time. Because the company has originated the loans, it is referred to as the “originator.” The originator identifies a pool of receivables that satisfy certain features, that make them acceptable to be securitized. This pool of receivables is transferred to a special purpose entity (SPE), also referred to as a special purpose vehicle (SPV). The pool of loans, also referred to as the “asset pool,” is transferred at par value, that is, at the outstanding principal of the loans being pooled. The SPE holds the asset pool, paying for it by issuing securities. The securities issued by the SPE are referred to as asset-backed securities. The credit rating of those securities will be based solely on the strength of the asset pool.
The asset-backed securities are a claim on an isolated pool. Once the isolation of the pool happens, investors in the transaction are only impacted by the risks of those specific assets, and not by the general business risks of the mortgage lender. Creating the legal preference that an asset-backed investor enjoys over a traditional investor is the key to securitization. The investors are, however, exposed to the risks of the asset pool and these may be multifarious: delays, defaults, prepayments, legal challenges and so on. The critical point is that investors in the asset-backed securities are exposed to the risks of the asset pool and not to the risks of the originator company’s business.
As for the securities issued by the SPE, they are structured into different classes of securities. These various classes are created in order to generate differentiated interests in the pool, such that the senior investors have superior rights over the pool than the subordinated investors.
Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to a SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs. Summarizing, a CDO issues debt and equity and uses the money it raises to invest in a portfolio of financial assets, such as corporate debt obligations or structured debt obligations. It distributes the cash flows from its asset portfolio to the holders of its various liabilities in prescribed ways that take into account the relative seniority of those liabilities.
While several concerns had been raised with respect to CRT vehicles, in particular issues related to the problem of “clean” risk transfer, the risk of failure of market participants to understand associated risk, potentially high concentration of risk and adverse selection, the overall assessment of trends in this market, also by central bankers, had been largely positive. In a 2004 report by the ECB it was stated that “Improvements in the ability of banks and other financial institutions to diversify and hedge their credit risks are helping the financial system to become more efficient and stable.”8
On the other hand there can be no serious doubt that the securitization process of subprime mortgage credit had been subject to certain informational frictions, several of which involve moral hazard, adverse selection, and principal-agent problems. In particular, such frictions have arisen (1) between mortgagors and originators (predatory lending), (2) between asset managers and investors (principal-agent problem), (3) between arrangers and third parties (adverse selection problem), (4) between the originator and the arranger (predatory borrowing and lending), and (5) between investors and the credit rating agencies (model error).9
By way of example, consider the first friction in securitization, viz that between the borrower and the originator. While subprime borrowers can be financially unsophisticated, many products offered to sub-prime borrowers were very complex and subject to misunderstanding and/or misrepresentation. This is thought to have opened the possibility of both excessive borrowing and excessive lending. Moreover, mortgage originators did not assume default risk of risky mortgage loan. To reduce capital requirements, banks employed an “originate to distribute” mode of operation and had little incentive to perform due diligence.
With respect to most of these frictions, it is far from obvious that additional regulation was or is warranted. Market participants can be expected to take remedial steps in the right direction. In many instances, therefore, it would have been advisable for policymakers to give the market a chance to self-correct. For instance, the credit rating agencies had already responded with greater transparency and had announced significant changes in the rating process. In addition, the demand for structured credit products generally and subprime mortgage securitizations in particular has declined significantly as investors have started to reassess their own views of the risk in these products.
Recalling Some Facts
The facts which preceded and explain the financial crisis are by now well-documented.10 Interest rates were relatively low in the first part of the decade. This low interest rate environment spurred increases in mortgage financing and substantial increases in house prices. It encouraged investors to seek instruments that offer yield enhancement. Subprime mortgages offer higher yields than standard mortgages and consequently have been in demand for securitization. The demand for increasingly complex, structured products, such as collateralized debt obligations (CDOs), which embed leverage within their structure, exposed investors to greater risk of default. Nevertheless, with relatively low interest rates, rising house prices, and the investment grade credit ratings (usually AAA) given by the rating agencies, this risk was not perceived as excessive.
During the same period, financial markets had been exceptionally liquid, which fostered higher leverage and greater risk-taking. Spurred by improved risk management techniques and a shift by global banks towards the “originate to distribute” business model, financial innovation led to a dramatic growth in the market for CRT instruments. In less than five years, the global amount outstanding of credit default swaps had multiplied more than tenfold, and investors now have a much wider range of instruments at their disposal to price, repackage, and disperse credit risk throughout the financial system.
CDOs of subprime mortgages are the CRT instruments at the heart of the current credit crisis, as a massive amount of senior tranches of these securitization products has been downgraded their ratings from triple AAA to noninvestment. Clearly, the initial credit ratings were almost certainly incorrect. Four reasons are commonly invoked why delinquencies on subprime loans rose significantly after mid-2005. First, subprime borrowers are typically not very creditworthy, and often highly levered with high debt-to-income ratios; the mortgages extended to them have relatively large loan-to-value ratios. Second, in 2005 and 2006 the most common subprime loans were of the “short-reset” type. These loans had a relatively low fixed teaser rate for the first two or three years, and then reset semiannually to a much higher rate. Short-term interest rates began to increase in the U.S. from the mid-2004 onwards. Sometime later, debt service burdens for loans increased, which led to financial distress for some group of borrowers. Third, many subprime borrowers had counted on being able to refinance or repay mortgages early through home sales in a market where home prices kept rising. As the rate of U.S. house price appreciation began to decline after April 2005, it became more difficult for subprime borrowers to refinance and many ended up incurring higher mortgage costs than they expected to bear at the time of taking their mortgage. Fourth, a decline in credit standards by mortgage originators in underwriting in recent years, was a major factor behind the sharp increase in delinquency rates for mortgages originated during 2005 and 2006.
The Causes
Securitization and related practices are not, and cannot be, the cause of the kind of excessive credit expansion that led up to the financial crisis, nor are financial innovations as such to be blamed for the real-estate boom and bust.
As previous commentators have argued convincingly, this chain of events can be adequately comprehended only against the background of the particular macroeconomic context of this period, in particular the variability of the monetary policy led by Greenspan’s Fed: first a reduction of the federal funds target form 6.5% in 2000 to 1% in 2003; then from 2004 back up to 5.25% in 2006.11 The connection between the Fed’s actions and the housing bubble is indeed not a coincidence, but rather an archetypal illustration of a classic boom-bust cycle.
Nevertheless, the inefficiencies and misallocations created by credit expansion have in this instance been aggravated by the inadequacy of the regulatory environment. In particular, acute problems were raised by the resource allocation effects of inefficient capital regulations.
Concerns about the supposed “dangers” inherent in securitization and related practices should thus better focus upon the question to what extent such practices have actually been a by-product of inappropriate regulatory capital standards. These standards, whether too low or too high in specific circumstances, can entail significant economic costs.
Whenever there are significant inconsistencies between internally required economic capital and the — always relatively arbitrary — regulatory capital standard, banks will face an incentive to negate the capital standard, or to exploit it. The major tool used by large U.S. banks to engage in regulatory capital arbitrage has indeed been securitization. The possibility that regulatory capital ratios may mask true insolvency probability becomes more acute as banks arbitrage away inappropriately high capital requirements on their safest assets by securitizing these assets.12 Empirical evidence suggests that in cases where existing risk-based capital requirements for mortgage loans are too high, lenders have an incentive to retain higher risk loans in their portfolio while selling lower risk loans into the secondary market.13
In this context the controversial role of the housing-related government-sponsored enterprises (GSEs), better known as Fannie Mae and Freddie Mac, can again be brought to mind. Fannie and Freddie played a critical role in developing and promoting mortgage securitization, the process whereby mortgages are bundled together into pools and then turned into securities that can be bought and sold alongside other debt securities. Much has now been written about how Fannie and Freddie “caused” the subprime breakdown.14 Fannie Mae and Freddie Mac were quasi-private entities. Thus, although their shares were publicly traded on the New York Stock Exchange, they had federal charters conferring unique regulatory provisions.
The crucial fact about Fannie Mae and Freddie Mac was the advantage they derived from their preferential and anomalous legal status: financial markets treated their obligations as if those obligations were backed by the federal government — even though the federal government did not do so explicitly. The implied federal guarantee of Fannie Mae’s and Freddie Mac’s financial obligations created a moral hazard problem. Because of the implied guarantee, creditors did not monitor the firms’ activities as closely as they otherwise would have. As a consequence of this reduced monitoring, the managements of Fannie Mae and Freddie Mac could engage in activities that involve greater risk since the companies’ owners benefit from the “upside” outcomes while being buffered from the full consequences of large “downside” outcomes — because of the limited liability of corporate owners.
Regulation, by contributing to the expanded role of Fannie Mae and Freddie Mac in residential mortgage markets, had aggravated the problem. This happened in at least two ways. First, since 1988, the regulatory risk-based capital (net worth) requirements that apply to banks and savings and loans had included a lower requirement of 1.6 percent for holding mortgage-backed securities issued by Fannie Mae and Freddie Mac, compared with the 4 percent requirement for holding whole (unsecuritized) residential mortgage loans. At the margin, the lower capital requirements for mortgage-backed securities would strongly encourage the institution to substitute mortgage-backed securities for “whole” mortgage loans. Second, Fannie Mae and Freddie Mac were required to hold at least 2.5 percent capital against mortgages (or their own mortgage-backed securities) that they retain in their portfolios. In comparison with depositories that are bound by the 4 percent minimum leverage requirement (such as savings and loans that tend to specialize in mortgage lending), the purchases by Fannie Mae and Freddie Mac for their own portfolios had a capital cost advantage.
More generally, capital regulations are also thought to exacerbate the procyclicality of assessments of the riskiness of assets over the business cycle. As a result, regulation not only renders bank crises more likely but could also destabilize the economy as a whole by exaggerating fluctuations.15
Conclusion
The subprime crisis is to be characterized as a “regulation failure” or, still better perhaps, as a “failure of the regulatory state,” rather than as a “market failure.” The recent financial turmoil involves a number of idiosyncratic elements. Commentators have pointed out that in particular it has been a stress test of the innovation wave of credit risk transfer instruments, which had gathered momentum in recent years. It has also brought to light some limitations of the “originate to distribute” model as it had developed over the last few years. Nevertheless these idiosyncratic elements, important as they are, should not blind us to the more fundamental nature of the turmoil. It represents the archetypal example of a classic credit-driven boom — bust cycle. The financial crisis is the natural result of a prolonged period of policy-induced credit expansion, accompanied by generalized and aggressive risk-taking.
Some critics have argued that the recent crisis illustrates the “inherent financial instability” of the market economy. The most enduring factors that drive this financial instability are of an institutional character, however, and these factors are incompatible with the market economy properly defined. As long as these fundamental institutional factors driving financial instability are not removed, ideally and ultimately through the abolition of central banks, financial instability will remain a recurring characteristic of capitalist economies.
The fundamental cause of the subprime crisis is the public policy partnership — spawned in Washington and comprising hundreds of companies, associations and government agencies, including the real estate, home building and GSEs lobbies — to enhance the availability of affordable housing via a policy of low interest rates and reckless credit expansion.16 The crisis has also been aggravated by an inappropriate regulatory environment distorting incentives. Bank rules in particular are a key reason behind the upset in financial markets. The Basel Accord had encouraged banks to push unrated loans off the balance sheets. Banks were required to hold less capital against rated positions than against unrated positions, making it optimal to invest in rated notes, rather than a comparable portfolio of unrated assets. It can be expected that the advent of Basel II will do little to improve the situation.17
On the other hand, turning back the clock by a return to “good-old-fashioned banking” would not be desirable because securitization has real benefits for the economy. It results in the creation of tradable securities with better liquidity from financial claims that would otherwise have remained bilateral deals and been highly illiquid. Very few individual investors would be willing to invest in residential mortgage loans, corporate loans, or automobile loans. Yet they would be willing to invest in a security backed by these loan types. By making financial assets tradable in this way, securitization may reduce agency costs, thereby making financial markets more efficient. It improves liquidity for the underlying financial claims, thereby reducing liquidity risk in the financial system. Combinations of securitization techniques with credit derivatives and risk transfer devices continue to develop innovative methods of transforming risk into a commodity and allows various market participants to tap into sectors which were otherwise not open to them.18
1.See Eichengreen (2008), “Ten questions about the subprime crisis,” Banque de France — Financial Stability Review, Special issue on liquidity, No. 11, February 2008, on which this paragraph is freely based.
- Greenspan is reported to have declared that “(t)he evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower. See “Greenspan Concedes Error on Regulation,”The New York Times, October 23, 2008.
3.See “Greenspan Concedes Error on Regulation,” The New York Times, October 23, 2008.
4.L. Randall Wray (2008/2), Afterword to Hyman Minsky, “Securitization,” Policy Note, p. 5, The Levy Economics Institute; see also L.R. Wray, 2007, “Lessons from the Subprime Meltdown,” for a statement of the idea that financial innovations created the real-estate boom and bust.
5.L. Randall Wray (2007), “Lessons from the Subprime Meltdown,” p. 53.
6.Ibid. 54.
7.The following is based freely on Fabozzi, F.J., “Securitization: The Tool of Financial Transformation,” Yale ICF Working Paper No. 07-07; Lucas, D.J., L.S. Goodman and F.J. Fabozzi, “Collateralized Debt Obligations and Credit Risk Transfer,” Yale ICF Working Paper No. 07-06.
8.ECB, “Credit risk transfer by EU banks: activities, risks, and risk management,” European Central Bank, May 2004.
9.See for instance the analysis in Asgcraft, A.B. and T. Schuermann (2008), “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York, Staff Report no. 318; see also Crouhy, Jarrow and Turnbull (2008), “The Subprime Credit Crisis of ‘07.”
10.Most of the following is freely based on Crouhy, Jarrow and Turnbull, “The Subprime Credit Crisis of ‘07.”
11.See e.g. R. Murphy, “Evidence that the Fed Caused the Housing Boom,” Daily Article posted on 12/15/2008; G. Selgin, “Guilty as Charged”, Daily Article 11/07/2008;
12.See Greenspan (1998), “The Role of Capital in Optimal Banking Supervision and Regulation,” FRBNY Economic Policy Review, October, 166.
- See Ambrose, B.W., LaCour-Little M. and Sanders A.B. (2003), “Does Regulatory Capital Arbitrage or Asymmetric Information Drive Securitization?”
14.See Frame, W.S. and White, L.J. (2004), “Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?” Working Paper 2004-26, Federal Reserve Bank of Atlanta.
15.For a prescient analysis, see Danielsson, Embrechts et al. (2001) “An Academic Response to Basel II,” LSE Financial Markets Group, Special Paper No. 130.
16.See Whalen, R.C. (2008) “The Subprime Crisis — Cause, Effect and Consequences,” Indiana State University: Networks Financial Institute Policy Brief No. 2008-PB-0488.
17.See Danielsson, Embrechts et al. (2001); op. cit. For a summary of the rules of Basel I & II, see also Portait R. and P. Poncet, Finance de Marché, Dalloz (2008), pp. 1014 ff.
18.See Fabozzi, F.J., “Securitization: The Tool of Financial Transformation”, Yale ICF Working Paper No. 07-07;
Ludwig Van Den Hauwe is an economist who lives and works in Europe; he received a PhD in economics from Paris-Dauphine University.
