Inadequate securitisation

One of the things we\’re told about the recent financial troubles is that all of this securitisation was one of the causes of it.

People made loans and then flogged them off as bonds instead of hanging on to said loans until maturity.

However, there\’s one thing that rather militates against this story.

No, not that securitisation, flogging off the loans, led to lower quality loans being made (that\’s a slightly different question) but that too many people flogged off said loans. Actually, the problem in the financial markets was that not enough people flogged off said loans.

When the music stopped and the dancers started looking around at the inadequate number of chairs left, some still had great steaming piles of those securitised loans on their books. That\’s why those banks fell over. If they had really been sold on then the economic loss would have been the same of course: but the financial system wouldn\’t have frozen over. It would have been private investors (few of them though), insurance companies, pension funds, which took the hit of losing…but the losses would have been rather less as the prices were, during the crash, deeply depressed by the fact that every bank was trying to unload at the same time.

This isn\’t to say that such a result would have been perfect of course: but if the banks really had flogged on those securitised loans, as they were supposed to, we\’d have had a recession, yes, a housing collapse, yes, but not a financial system collapse. And it\’s that last that marks out recent events as being different from previous asset bubble collapses.

So we can argue that it was insufficient securitisation, assuming that there\’s going to be any bonds at all rather than direct loans held to maturity, which caused the problems.

OK, that\’s all past stuff: but it has great relevance to sovereign debts problems here in Europe.

Arguably, places like Greece, Portugal, Spain, should get out of the euro, devalue, default (even if only partially, by redenominating into the new local currencies) and then get on with life.

But they cannot be allowed to do that: because it\’s the banks which hold great wodges of this debt that they\’ll be defaulting upon. So the entire European banking system (I exaggerate) will fall over and that cost would be far greater than having to stump up a trillion or two to help out the PIIGS.

However, if the banks had not bought and held the bonds but had, as a proper securitised market would ensure, simply facilitated the trade of those bonds onto long term investors then we wouldn\’t have this problem. Yes, of course, we\’d still have the same losses on defaulted bonds, losses which would need to be absorbed somewhere, but we wouldn\’t have a banking system with the potential to implode.

Which leads to a policy prescription. We should be insisting on legally binding full securitisation. No bank (our definition of a bank here being someone with a banking licence, thus someone able to tap deposit protection schemes, central bank liquidity windows etc) should be allowed to hold any portion of a loan that they or any other such bank has originated. All such loans must be turned into bonds which must find a home with terminal investors (who can then go on and trade them to their hearts\’ content).

We\’re not going to stop asset bubbles or incontinent governments in the future after all: but we might be able to stop such bringing down the entire financial structure.

So, what are the powers that be doing at present? Yup, the EU and others are insisting that any originator of a loan must hold 5% of it to maturity. They\’re actually insisting that banks must do in the future what has just caused the last fuck up.

It\’s said of generals that they\’re always ready to fight the last war. It takes politicians to insist that we\’ll be ready to lose the last one.

11 thoughts on “Inadequate securitisation”

  1. You don’t move risk out of the banking sector if a) you aren’t actually getting the loans off your books, just promising a portion of the income stream to someone else and b) the people investing in such sham securities are other banks.

    So why did they do it; credit ratings and insurance policies making banks think they were covered? Some insurance companies were said to be massively over exposed

  2. Mmmmmmmmmmmmmm

    I’m not convinced Tim.

    The reason for requiring banks to take and hold part of the loan they have originated is that it gives them an interest in ensuring that the loan is a sensible one that can be repaid.

    The problem with the originate and distribute model is that the only question the bankers asks is “can i sell the loan?”. Now whilst the borrower’s ability to repay the loan ought to be central to the banker’s ability to sell the loan in practice we have seen that loan investors will buy any old guff because they don’t really understand credit risk analysis.

    Originate and distribute creates a massive principal and agent problem.

    Now if the terminal investors were just hedge funds serving the mega rich then maybe this wouldnt matter as they can afford to take the hit.

    But the loan market is so huge that it requires insurance companies, pension funds and other financial institutions to participate in a big way to function. And we cannot afford for insurance companies and pension funds to go tits up any more than we can banks.

    Your proposal only makes sense if we can fully securitise to Martian or Jovian terminal investors.

  3. Sorry, I forgot a piece of the picture I was trying to paint.

    Megabank’s loan origination team would back some stupidly over-levered LBO. They all pat themselves on the back with big bonuses all round when they sold all the debt to other investors.

    What happens is that another bit of Megabank – an in-house CLO, a SIV, a prop desk, whatever – would then buy a chunk of it. Why? Maybe flow trading. Maybe they just think they are cleverer at credit analysis than the loan origination guys. Lots of reasons. So Megabank to a large extent securitises itself (with structure arbitrage using ratings being used to make it look like risk had been reduced).

    Risk was not spread around the system – it was just redistributed into different business units of the usual suspects.

    The problem was at core one of bad lending decisions not inadequate distribution. And securitisation facilitiated and encouraged bad lending decisions.

  4. As someone whose expectation of life was securitised by the property management company which them managed our flats as well as our buildings insurance whith their subsidiary insurance company (which never paid out on claims) and used our maintenance funds as security for such loans, you must allow a little disquiet about the nature of securitisation. Perhaps a key issue is that too much came to depend on this market and too many people went in big with the wrong kind of loan product and wrong kind of loans. This mess is never going to be sorted out either in the short or long term.

  5. Nope.

    1. By and large, ordinary customer deposits are only a small % of total bank liabilties – the majority of finance is in bonds issued to “private investors (few of them though), insurance companies, pension funds…”

    2. Therefore whether these groups invested directly or indirectly in crappy mortgages makes little difference, i.e. whether they write down and take a loss on the actual MBS issued by a bank or write down and take a loss on the bond issued by the bank (which is ultimately sectured on the self same mortgages) is neither here nor there.

    3. The latter can be dealt with by a debt-for-equity swap, and there is no need for ordinary depositors to lose a penny (i.e. for the govt to have to pay up on the £50,000 guarantee).

    4. In any event, the much vaunted financial system is not in the slightest danger of collapse, that is just a myth put about by subsidy-hungry banks. However high the losses are, it’s usually about a quarter or a third of the nominal value of all bank bonds etc in existence.

  6. 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?

  7. My problem with the banks that became saturated with toxic debt is that they never paid the price for their folly. They reaped the bonuses by false valuations on the securitisation and then passed on the loss to the taxpayer.

  8. Philip Scott Thomas

    I was under the (apparently incorrect) impression that it was Fannie Mae and Freddy Mac who did much of the original securitisation.

    Also, where do the rating agencies who vastly over-rated the safety of the toxic bonds come in to this?

  9. Tim, why aren’t you willing to ban maturity transformation, but are willing to force total securitisation? Your solution is rubbish. Banning maturity transformation is much more sensible. Your contention that “borrowing short and lending long is exactly what we want banks to do” is wrong.

    http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html

    Tim adds: Someone’s got to do maturity transformation and if not the banks then who?

  10. Tim adds: Someone’s got to do maturity transformation and if not the banks then who?

    Why?

    Tim adds: Because people always want to borrow long but only ever want to lend short.

  11. Dubious. Surely putting money into your pension pot is an excellent reason to want to lend long. And what about bonds?

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