Arnold Kling  

Gillian Tett on the Financial Crisis

The Three S's of Finance... More Thoughts on Masonomics...

The talk is here.

Near the end, in response to a question about the Lehman Brothers failure, she explains something that I did not really understand before. My working hypothesis has been that the faliure of securitization was no big deal--we could always just fall back on old-fashioned banking. She says that to do so would be like falling back on snail mail if we woke up one day to find the Internet and cell phones had broken down.

It's an interesting metaphor, and it conveys the sense of loss that financial industry participants and regulators are feeling right now. However, I continue to think that securitization is not really sound. In terms of my view that signaling is important in finance, I think that securitization depended on false signals of soundness. I guess the more standard view is that securitization is truly sound, and we are now experiencing false signals of its unsoundness.

Given my view, I think that going back to old-fashioned banking is the most natural thing in the world. Given the alternative view, which Gillian Tett articulated, you can see why so many bankers and policymakers cannot accept that notion.

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The author at Jim's Blog in a related article titled Securitization writes:
    Securitization leads carelessness with large sums of other people’s money. Such carelessness leads to crime, destroying the trust necessary for capitalism to function. Securitization must stop. ... [Tracked on May 5, 2009 6:30 PM]
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Milton Recht writes:

"In terms of my view that signaling is important in finance, I think that securitization depended on false signals of soundness."

Signaling is important in finance, but there were economic incentives to misread the signals of mortgage securitization. Additionally, there were regulatory structure issues that prevented corrections to the misread signals. Both problems are fixable.

Both investment banks and commercial banks must maintain capital against their assets. In both, the amount of capital (not identical for the two types of entities) for mortgage securities was determined by formulas that used the credit ratings of the SEC recognized credit rating agencies, NRSROs. A better credit rating required less capital.

Mortgage originators derive their income from fees, which need a continuing volume of new mortgages. Originators did not hold mortgages for their interest income and a principal agent problem occurred. As long as there were buyers of packaged mortgages (securitization), including lower quality mortgages, originators could replenish their limited amount of lendable funds and continue to generate fee income without regard to the deteriorating quality of the new mortgages.

The commercial banks and investment banks (buyers) preferred securitized mortgages with lower capital requirements, which were the higher NRSRO credit rated securitized mortgages. The buyers could put up less capital against these assets, purchase more of them with their existing capital base and derive a higher income.

If the buyers, the commercial banks and investment banks, monitored and analyzed the quality of the securitized mortgages correctly and read the signals, these buyers would have had to put up more capital against theses investments, purchase less of them and reduce their income.

The regulators accepted the credit rating agencies' ratings and their lower capital requirements. For a buyer to question the ratings, the buyer would have to accept lowering its income, putting higher capital against the assets and investing in fewer of them. To the commercial banks and investment banks, it was a clear cost benefit decision. The benefits were lower capital versus higher capital, higher income versus lower income, and more securitized mortgages versus fewer securitized mortgages. The costs were higher potential defaults and higher potential losses. Post WWII history made the benefits appear to outweigh the costs even on a risk-adjusted basis.

The NRSRO rating agencies depended on the volume of their ratings of mortgages to produce a continuing fee income stream. A lower rating meant the buyers would use more capital and there would be fewer mortgages for ratings. Each of the rating agencies jeopardized their reputations and brands through lowering the quality of their rating methodology for securitized mortgages. However, the SEC's NRSRO limitations and designation hurdles protected the ratings agencies, limited competition and ensured the existing NRSROs that they would not lose their current or future business clients or ratings income stream.

The regulatory structure for NRSRO designation prevented customers from turning to other rating agencies for mortgage securities ratings. The regulatory structure for capital, which depended on NRSRO ratings, economically inhibited the commercial banks and investment banks from doing their own analysis of the potential for losses in the packaged mortgage securities.

The problem that occurred was not lack of proper signals of the deteriorating quality of mortgage securities. There were many, including who was sourcing the mortgages, the existing decline in home prices and the increasing level of defaults. The buyers ignored the signals.

The prevalent signals were overridden and ignored due to the structural problems created by the regulatory structure for NRSRO designation and the NRSRO credit rating used for determining capital levels.

A successful securitization process does not need credit ratings and NRSROs. However, since commercial banks and investment banks are required to hold capital against their investments, a new methodology for determining capital levels without NRSROs and credit ratings is needed.

The problem was not false signals, but structural and regulatory issues that prevented buyers from reading and using the available correct signals.

Richard writes:

I think a standard adverse selection and moral hazard modeling of the issue could show that securitization is perfectly OK as long as the seller keeps a sufficient stake on the security send the proper signal about the quality of the collateral and to align incentives. Not very different from any other financial intermediation model.

The question is why during the securitization madness of the last years basic results from the theory of asymmetric information were completely ignored and banks were so happy to buy lemons.

fundamentalist writes:

I read about 15 years ago that traditional banking made up only about one third of total lending in the US. It's probably much less today. Bonds take up most of the rest, followed by other securities. If true, then going back to traditional banking would involve a major collapse in credit in the country.

I don't think there is any possibility of putting the securitization genie back in the bottle. And there may be no need, since securitization of mortgages worked just fine until the artificial bubble in housing prices and it pop. I would look at the housing bubble as the real problem and not securitization.

floccina writes:

What about something new rather than falling back? I think that had Government let the big banks fail we might have seen a new manor of finance grow up.

Floccina writes:

One of the great thing about the invisible hand is that it means we do not need to know the solutions to the problems. (In some cases we do need to know if a solution is possible but we can really on principle.) The principle is that among free people that some people will find a better way.

Gary writes:

Gillian Tett is essentially correct, that the credit crisis truly began with the freezing of the securitization market in August 2007 and that without restarting securitization, the world will suffer from insufficient balance sheet to float the global economy.

Moreover, the correctness of this analysis is being evidenced by the number of global regulators seeking to restart securitization and the recent comments by Neil Barofsky, the Special Inspector General for TARP which was highlighted in a recent WSJ editorial.

Securitization 1.0 proved to be a doomsday machine, not simply because the securities were complex, but because they were deliberately structured to be opaque, preventing any meaningful due diligence from being accomplished after issuance.

Unfortunately, investors did not realize the full extent to which the securities were opaque until too late. Early, investors mistakenly believed that the ratings companies had the data they needed to make timely adjustments in the ratings of structured finance securities. However, Moody's issued a report on Sept 25, 2007 that stated that they did not have access to such data and that their efforts to correctly rate the securities was hampered by a lack of continuous, third-party standardized data.

Recently, Philip Swagel, a former Assistant Secretary of the Treasury, confirmed that is 2007 the Treasury realized that a better database of information was required. Unfortunately, it has not come into existence.

What we now require is Securitization 2.0. The next generation in structured finance would include real-time, collateral-level performance data collected and disseminated on a next-day basis by an independent, third-party database paid for by the government(s). This would not only satisfy the buy side and prompt them to return to the market, but would also give rise to independent, third-party pricing services helping to effect price convergence between buyers and sellers.

If you want a more detailed explanation of this, The Transparency Wars and the Transparency Database, my blog has been discussing it since July 2008.

Carl writes:

My working hypothosis is that what was unsound was the underlying financial transaction and not the securitization of that transaction. Had the loans not been securitized and had the loans been retained by the originators, those institutions still would have seen huge losses.

Mr. Econotarian writes:

I don't buy the "opaque securitization" arguments.

Securitization was done to deal with packaging diverse loans to deal with random, occasional pre-payment or default on mortgages.

It was never designed to deal with everyone's real estate prices going down 20-30% and massive default levels in prime and sub-prime mortgages.

What we should be asking is why banks held on to mortgage-backed securities rather than passing them on to hedge and pension funds with long-term, low-liquidity needs. The answer seems to be Basel 1 saying that ABS could be held with less capital than commercial loans.

Yet the wealth effect issues of the housing bubble burst and death of the building industry itself could have been bad for banks even if they only held non-real-estate loans:

"The percentage of middle-market loans on nonaccrual rose for the ninth consecutive quarter and is now 2.0% of total outstanding balances...

...Key industries experiencing above average default rates include Manufacturing (2.9%), particularly manufacturers of wood, paper, plastics, rubber, nonmetallic mineral products, and motor vehicle parts; and Information (2.8%), especially sub-sectors related to publishing, broadcasting, and wired telecommunications carriers. Conversely, Health Care (0.7%), Wholesale Trade (1.3%), and Finance and Insurance (1.3%) continue to outperform the market. Nonaccrual levels in the Retail Trade industry (1.9%) approximate the market average."

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