Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Securitization

I wrote a column
in the Financial Express today about the role of
securitization.

The global financial crisis began two years counting from the first
liquidity crisis in Europe and the US on August 9, 2007. Over these
two years, we have found that many of the conclusions that we came to
in the early days of the crisis were simply wrong.

In 2007, we thought that the problem was about subprime mortgages,
that it was about securitisation and that it was about CDOs
(collateralised debt obligations). Now we know that these initial
hasty judgments were mistaken. Defaults are rising in prime mortgages,
huge losses are showing up in unsecuritised loans, and several banks
have needed a bailout.

In 2007, when the first problems emerged in CDOs, people thought
that these relatively recent innovations were the cause of the
problem. Pretty soon, we realised that a CDO is simply a bank that is
small enough to fail and conversely that a bank is only a CDO that is
too big to fail.

Both banks and CDOs are pools of assets financed by liabilities
with various levels of seniority and subordination. As the assets
suffer losses, the equity and junior debt get wiped out first, and
ultimately (absent a bailout) even the senior tranches would be
affected. In retrospect, both banks and CDOs had too thin layers of
equity.

Over the last two years, our understanding of securitisation has
also changed significantly. As global banks released their results for
the last quarter, it became clear that bank losses are now coming not
from securitised assets but from unsecuritised loans or whole loans.

The Congressional Oversight Panel (COP) set up by the US Congress
to “review the current state of financial markets and the
regulatory system” published its latest report a few days
ago. The report focuses entirely on whole loans and paints a very
scary picture. Losses on troubled whole loans in the US banking system
are estimated to be between $627 billion and $766 billion.

The COP report also states that “recent reports and
statistics published by the FDIC indicate that overall loan quality at
American banks is the worst in at least a quarter century, and the
quality of loans is deteriorating at the fastest pace ever. The
percentage of loans at least 90 days overdue, or on which the bank has
ceased accruing interest or has written off, is also at its highest
level since 1984, when the FDIC first began collecting such
statistics.”

It is becoming clear that what the US is witnessing is an
old-fashioned banking crisis in which loans go bad and therefore banks
become insolvent and need to be bailed out. The whole focus on
securitisation was a red herring. The main reason why securitisation
hogged the limelight in the early stages was because the stringent
accounting requirements for securities made losses there visible
early.

Potential losses on loans could be hidden and ignored for several
quarters until they actually began to default. Losses on securities
had to be recognised the moment the market started thinking that they
may default sometime in the future. Securitised assets were thus the
canary in the mine that warned us of problems lying ahead.

Until recently, it could be argued that securitised loans were of
lower quality than whole loans and that at least to this extent
securitisation had made things worse. But this statement is true only
for residential mortgages and not for commercial mortgages, where the
position is the reverse. Securitised commercial mortgages (CMBS) are
of higher quality than whole loans.

The COP report states: “While CMBS problems are undoubtedly a
concern, the Panel finds even more noteworthy the rising problems with
whole commercial real estate loans held on bank balance sheets. These
bank loans tend to offer a riskier profile as compared to CMBS,
suggesting high term default rates while the economy remains
weak.”

Two years into the crisis, therefore, we find that the initial
knee-jerk reaction against securitisation was a big mistake.

Securitisation doubtless redistributed losses throughout the world
so that losses from the US real estate emerged in unexpected places
– German public sector banks, for example. But securitisation
was not responsible for most of the losses themselves.

We must also remember the US home owner gets a bargain that is
available to few home owners elsewhere in the world – a 30-year
fixed rate home loan that can be repaid (and refinanced) at any time
without a prepayment penalty. This is possible mainly through
securitisation and deep derivative markets that allow lenders to
manage the interest rate risks.

In India by contrast, the home owner gets a much worse deal: most
home loans are of shorter maturity (20 years or less) and are usually
either floating rate or only partially fixed rate. The few ‘pure
fixed rate’ loans involve stiff prepayment penalties when they
are refinanced. It would be sad if we keep things that way because of
an irrational fear of securitisation.

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