Securitization, mortgage lending, and the 2008 financial crisis

Securitization and Bank Liquidity

The objective of this work is to examine securitization and how it is currently used in the banking industry with a focus on real estate and the current problems banks are facing recently regarding mortgages and how that banks lend easy money to anyone and then are unable to recover the money. This work seeks to examine what the future holds for mortgage markets and banks.

Securitization: A process of creating new financial instruments by pooling the cash flows from a number of similar assets such as mortgages or credit card accounts, and putting them into a separate entity often with some explicit guarantee or extra collateral. (Loutskina, 2004; 7)

Liquidity: According to the Federal Deposit Insurance Corporation (FDIC), liquidity is "the ability to fund future asset growth and/or pay liabilities in a timely manner, at a reasonable cost." (2007)

Market liquidity: Refers to the speed and ease with which an asset can be sold at a price close to its fair value and with low transaction costs, is a property of assets or financial instruments and of the markets in which they are traded. (Buiter, 2008; 1)

Funding liquidity: Is provided by the authorities at the discount window (on demand against suitable collateral) and, in extreme circumstances, through lender of last resort (LoLR) facilities. Market liquidity is provided by the authorities through open market operations (OMOs), both repos, reverses repos and outright purchases/sales, and, when markets become illiquid, by the authorities acting as market maker of last resort (MMLR), buying normally liquid but temporarily illiquid instruments at punitive prices and discounts. (Buiter, 2008; 1)

INTRODUCTION

Some researchers hold that securitization has "greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk." (the Economist, 2008) According to an article published in 'The Economist' magazine entitled: "Fear and Loathing, and a Hint of Hope" the volume of outstanding securitized loans had by 2006 reached the sum of $28 trillion and in 2007, the volume of securitized loans that were outstanding totals "three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold." (the Economist, 2008) the following chart illustrates the 'securitized loans outstanding as stated by the Federal Reserve and NERA Economic Consulting as cited in 'The Economist'.

Securitized Loans Outstanding

Source: 'The Economist'

The Economist' report states that during this time "banks cooked up a simmering alphabet soup..." which included ingredients of 'collateralized-debt obligations (CDOs) "which repackage asset-backed securities, and collateralized-loan obligations (CLOs) which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets." (2008) the prospect for the 'CDO-squareds' which are 'resliced and repackaged CDOs' is not good because they are unpopular and their value has fallen during the housing industry mortgage crisis. 'The Economist' states prospects for SIVs being "bleaker still' because the SIVs "borrow short-term to invest in long-dated assets and investors will no longer tolerate such mismatches in vehicles shielded from standard banking." (the Economist, 2008) Funding sources for SIVs have disappeared which means: "...banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion of subprime-related write-downs, over a third of which has come at three banks" which are those of (1) Citigroup; (2) Merrill Lynch; and (3) UBS. (the Economist, 2008)it is stated in the research report of 'The Economist' that the subprime crisis has brought to the light four flaws that are "very deep...in the practice of securitization: (1) by cutting the link between those who scrutinize borrowers and those who take the hit when they default, securitization has fostered a lack of accountability; (2) the second flaw is the sheer lack of understanding of some instruments; (3) some securities were poorly structured, often because their risks were not fully understood; and (4) the market's over-reliance on rating as a short cut to assessing risk. (the Economist, 2008)

The FDIC states of the methods utilized by banks in their strategies for funding are comprised by a "mixture of borrowing, brokered deposits, and securitization activities, and, as such, banks with substantial credit card holdings might exhibit a relatively high volatile liability dependency ratio. The advent of credit card securitizations dramatically expanded funding avenues for credit card portfolios." (FDIC, 2007) the Market Oracle presentation entitled: "Judgment Day for Wall Street" published in the Stock-Markets/Credit Crisis 2008 segment of March 31, 2008 states as follows:

In the first days after the Fed's history-breaking Bear Stearns bailout, a parade of Wall Street pundits preached the theory that..."The worst of the crisis is behind us...The dollar has hit rock bottom..., and "The great investor flight to hard commodities is over. Markets that had been surging fell. Markets that had been falling surged. Investors cheered. And everyone who wanted to believe believed. But nothing changed. All across America, home prices were still falling, home sales were still plunging, and consumers continued to suffer withdrawal pains from the greatest debt addiction of all time. That's why we learned last week that consumer confidence is in a free-fall, consumer spending has just taken a huge blow, J.C. Penney sales are swooning, and retail stocks are getting hammered. That's why Wall Street firms such as Lehman Brothers are rumored to be on the brink of collapse, while commercial or savings banks -- like Fremont in California with $7 billion in deposits -- are known to be near failure." (Market Oracle, 2008)

IV. CREATION of BANKING LIQUIDITY

The work of Allen N. Berger and Christ H.S. Bouwman entitled: "Bank Liquidity Creation" published in January 2007 states: "Although the modern theory of financial intermediation portrays liquidity creation as an essential service provided by banks, comprehensive measures of bank liquidity creation do not exist. We have therefore little understanding of how banks create, how this liquidity creation changes over time and the key factors that affect it." Berger and Bouwman relates that when conducting analyses of the role banks play in the creation of liquidity resulting in economic growth being spurred date traditionally back to 1776 and Adam Smith. Modern reincarnations of the idea that liquidity create is central to banking appear most prominently in the formal analyses in Bryant (1980) and Diamond and Dybvig (1983)."(2007) the argument of these theorists is that liquidity is created on the balance sheet by banks through finance of "less liquid assets with more liquid liabilities, an insight that is also closely related to the literature on financial intermediary existence." (Berger and Bouwman, 2007)

It has been suggested in the work of Kashyap, Rajan and Stein (2002) that liquidity is created off the balance sheets by banks "through loan commitments and similar claims to liquid funds." (in Berger and Bouwman, 2007) While the creation of liquidity by the banks is a generally well accepted fact of the economy, "the striking absence of empirical measures of bank liquidity creation makes it difficult to assess the size or pervasiveness of this effect. That is, we do not know the magnitude of the bank liquidity creation, the intertemporal behavior of bank liquidity creation, and the factors that affect bank liquidity creation." (Berger and Bouwman, 2007) the construction of liquidity creation measures is accomplished in the work of Berger and Bouwman through a three step process involving first the classification of assets, liabilities, equity and off-balance sheet activities of the bank as being:

1) Liquid;

2) Semi-liquid; and 3) Illiquid. (Berger and Bouwman, 2007)

The second step involves assigning weights to the activities in the first step of the process. The weights assigned as "consistent with the theory - maximum (i.e. dollar-for-dollar) liquidity is created when illiquid assets are transformed into liquid liabilities and maximum liquidity is destroyed when liquid assets are transformed into illiquid liabilities or equity." (Berger and Bouwman, 2007) Step three of the process involves construction of "four liquidity creation measure by combining the activities according to classification in the first step of the process and as weighted in step two of the process in a different manner. Berger and Bouwman state that calculations indicate that banks created in excess of $1.5 trillion in liquid assets ion 2003 which is "approximately equal to 22% of bank gross total assets or GTA and about two and half times the overall level of bank equity capital." (Berger and Bouwman, 2007) the total then is approximately $2.5 of liquidity per $1 of capital." (Berger and Bowman, 2007) the creation of liquidity is stated by Berger and Bouwman to have grown "dramatically over time." (2007) Furthermore, creation of liquidity "differs dramatically between large banks (GTA exceeding $1 billion) and small banks (GTA up to $1 billion)." (Berger and Bouwman, 2007) These writers relate incidentally that these calculations are "...in real 2003 dollars." Calculations stated by Berger and Bouwman for large banks responsibility towards the creation of industry liquidity is at a rate of 85% and further calculations shown that these banks are also responsible for creation of 80% of the industry assets as well, yet comprise merely 5% of the sample observations according to Berger and Bouwman (2007). A capital structure that is fragile is one that "encourages the bank to commit to monitoring its borrowers, and hence allows it to extend loans. Additional equity capital makes it harder for the less-fragile bank to commit to monitoring, which in turn hampers the bank's ability to create liquidity." (Berger and Bouwman, 2007) Liquidity creation may also be reduced due to crowding out of deposits."

This is referred to as the "first set of theories jointly" in the work of Berger and Bouwman as "financial fragility-crowing out' hypothesis of capital." (2007; p.3) Stated as a different manner in which to view this is to attain the perspective that the bank's capacity for absorption of risk is improved by capital and therefore liquidity is created. The bank's exposure to risk is increased by liquidity and the more the creation of liquidity occurs the "greater the likelihood and severity of losses associated with having to dispose of illiquid assets to meet customers' liquidity demands." (2007; p.3) the role of capital is one which has a well-known feature of risk absorption and expansion of the capacity of banks to bear risk. (Bhattacharya and Thankor, Von Thadden, 2004) Thus, capital rations that are higher enable the creation of more liquidity by the banks which is referred to in the work of Berger and Bouwman and 'risk absorption' hypothesis. It is these two theories, the risk absorption theory and the financial fragility-crowing out theory together which "produce this prediction."(2007)

V. SECURITIZATION and the IMPACT to BANK LENDING

The work of Elena Loutskina (2004) entitled: "Does Securitization Affect Bank Lending? Evidence from Bank Responses to Funding Shocks" reports a study conducted on banking lending and the effect of securitization and states that the market for securitized loans since the 1970s in the U.S. "has grown to dominate the mortgage market and has become an increasingly important factor in lending to both consumers and businesses." (Loutskina, 2004) Loutskina relates that $5.5 trillion in loans were securitized in 2003, which is approximately forty percent of outstanding loans. The securitization market presently "exceeds the size of the corporate bond market...and despite its importance, there is little research on how securitization has changed the behavior of banks." (2004) the work of Loutskina "...illustrates three ways that advancements in financial services have changed the nature of banking..." And includes the following:

Securitization has become an integral part of bank liquidity-risk management;

Securitization increases banks credit supply across sectors; and Banks' ability to securitize liquid mortgages increases their willingness to supply illiquid business loans. (Loutskina, 2004)

Loutskina states: "The major contributors to the development of bank loan securitization have been the so-called Government-Sponsored Enterprises (GSEs) that were created by the U.S. Congress to provide stability and ongoing assistance to the secondary market for residential mortgages and to promote access to mortgage credit and home ownership in the U.S.11 GSEs foster securitization by being the largest buyers of mortgages in the U.S. Fannie Mae and Freddie Mac, combined, purchase almost one-half of all conventional single-family mortgage loans originated each year. More importantly, GSEs facilitate small bank access to the securitization market by standing by to purchase individual mortgages as well as mortgage pools. They create an environment where the ability to securitize mortgages is similar across banks of different size." (2004)

Securitization of Loans in the Economy of the United States

Source: Loutskina (2004)

Securitizability of a Bank Loan Portfolio, Liquidity and Size Relationship

Source: Loutskina (2004)

Panel a is representative of the "relationship over time between average level of liquidity maintained by banks and the average securitizability of a bank loan portfolio. Panel B. is representative of the evolution of the average level of liquidity for the full sample of bank-quarters, as well as for the lowers and higher size quartiles of the sample." (Loutskina, 2008) the following figure presents "the value weighted C&I loan growth for two types of banks under the monetary tightening of 1993-1995 and monetary loosening of 2001-2003. I consider banks with the securitizability of the bank loan portfolio in the top 10% of Sit distribution to have liquid loan portfolios, and banks with the securitizability of the bank loan portfolio in the bottom 10% of Sit distribution to have illiquid loan portfolios." (Loutskina, 2004)

Securitizability of a Bank Loan Portfolio and Commercial and Industrial Growth

Source: Loutskina (2004)

The findings stated in this study state that securitization "acts as a substitute for banks' on-balance-sheet liquidity as it provides deposit institutions with an effective channel to convert illiquid loans into liquid securities. It alleviates the advantages of large banks in terms of liquidity management allowing the liquidity levels of small and large banks to converge." (2008) the ability of the bank to securitize has "become an integral part of their liquidity-risk management. Overlooked earlier loan liquidity should now be considered along the traditional liquidity measures. Second, securitization increases credit availability across sectors as it reduces the sensitivity of bank loan portfolios towards availability of the traditional sources of financing (e.g., deposits). The credit supply of banks with more liquid (securitizable) loan portfolios is less susceptible toward shocks in the costs of external financing than the credit supply of banks with less liquid loan portfolio. As a result, banks now seem to hold more of their assets in loans than in the past. In addition, large banks are able to exploit the benefits of securitization for loan origination to a greater extent relative to small banks. Finally, the evidence indicates that access to the securitization market can potentially offset the impact of Fed policies on banks loan supply. With securitization, it might be necessary to make a larger policy moves to achieve a significant contraction in banks' lending." (Loutskina, 2004)

VI. SECURITIZATION and MONETARY POLICY

The work of Arturo Estrella (2002) "Securitization and the Efficacy of Monetary Policy" published in the Economic Journal and investigates the impact of growth in asset securitization over the past few decades has influenced the effectiveness of monetary policy." (2002) Estrella (2002) gives consideration to whether a monetary policy move by the central bank, such as raising or lowering of the federal fund rates, has ultimate effects on the economy that differs from its effect before the advent of securitization." (Estrella, 2002) Estrella writes that the popular or "mainstream views" relating to "the monetary policy transmission mechanism contended that the central bank influences the economy by affecting the pricing or the volume of credit instruments, or of financial assets more generally." (Estrella, 2002) Simultaneously, securitization greatly impacts the credit market. The following chart shows the growth of the mortgage-backed securities market and demonstrates that since 1980 has been relatively steady in nature.

Growth of Mortgage-Backed Securities Market (Steady since 1980)

Source: Estrelle (2002)

Estrella writes that the visibility of the trend of securitization is clear in the following chart and it is shown as having intensified in the 1980s and that this trend grown substantially in terms of new market entrants and a wider variety of assets securitized.

Securitized Proportion of Mortgage and Consumer Credit Markets (2002)

Source: Estrella (2002)

The study of Berger and Bouwman states that in the realm of banking theory "an important economic role of banks is to create liquidity, but the absence of comprehensive measures of bank liquidity creation makes it difficult to determine the magnitude of liquidity creation and its inter-temporal patterns." (2007) Berger and Bouwman relate findings that indicate that more than $1.5 trillion in liquidity in 2003 was created by banks and that the creation of liquidity grew by "approximately two-thirds in real terms between 1993 and 2003" despite a slight decline in the period beginning 2000 and through 2003. The work of Berger and Bouwman makes examination of the manner in which capital impacts the creation of liquidity and state that it is predicted by some theorists that "higher capital may suppress liquidity creation by reducing financial fragility and/or crowding out liquid deposits..." while it is suggested by others that "banks with higher capital may create more liquidity because capital gives them greater capacity to absorb the risks associated with liquidity creation." (Berger and Bouwman, 2007) the findings of Berger and Bouwman are those each of these sets of theories "have empirical validity and that the relationship between banks capital and liquidity creation depends on a bank's size as well as its capital ratio." (2007) Further stated in the findings of Berger and Bouwman is: "...the effect of bank capital on bank liquidity creation differs across large and small banks..." (2007) raising "interesting policy issues." (Berger and Bouwman, 2007) Finally it is stated that the liquidity measures utilized in the study of Berger and Bouwman "may be used to address a number of other issues of research and policy relevance that are beyond the scope of this paper, but may be pursued in future research" and these are stated to include, while not being limited to: (1) a comparative analysis of bank liquidity creation across nations; (2) the impact of liquidity creation on economic growth; and (3) an assessment of liquidity created by various financial markets relative to banks." (Berger and Bouwman, 2007)

It was reported in 'The Guardian' April 3, 2008 that pace gathered in the retreat from mortgage lending "as the Co-operation Bank said it was withdrawing all two-year deals and U.S. Investment Bank Lehman Brothers effective shut its two UK sub-prime home loan divisions." (Jones, 2008) Rupert Jones additionally states: "Before the credit crunch, Lehman had put a lot of effort into building its British mortgage divisions. These took £4bn of home loans between them in 2006, and by the end of that year Lehman was Britain's 18th-biggest mortgage lender, a position it shared with Yorkshire Building Society. Big U.S. banks were able to expand rapidly into residential mortgages and offer products to customers that mainstream lenders rejected because they used financial markets to package the loans and distribute them to other players. But this business model has now unraveled." (2008) the work of Ellen Brown entitled: April Fools: The Fox to Guard the Banking Henhouse" published March 30th, 2008 relates that the Federal Reserve accredited for having been the creator of the current bubble and bust in the housing market "just as it created the credit bubble of the Roaring Twenties and the bust of 1929 is now to be given vast new powers to oversee the regulation of the banking industry and promote 'financial market stability'." (Brown, 2008) Brown notes that the Wall Street Journal reported: "Many of the [Treasury's] proposals, like those that would consolidate regulatory agencies, have nothing to do with the turmoil in financial markets. And some of the proposals could actually reduce regulation. According to a summary provided by the administration, the plan would consolidate an alphabet soup of banking and securities regulators into a powerful trio of overseers responsible for everything from banks and brokerage firms to hedge funds and private equity firms.... Parts of the plan could reduce the power of the Securities and Exchange Commission, which is charged with maintaining orderly stock and bond markets and protecting investors.... The blueprint also suggests several areas where the S.E.C. should take a lighter approach to its oversight. Among them are allowing stock exchanges greater leeway to regulate themselves and streamlining the approval of new products, even allowing automatic approval of securities products that are being traded in foreign markets." (Brown, 2008; 1) Brown states that included in the mortgage-backed securities, collateralized debt obligations, credit default swaps and other forms of the great Ponzi scheme knows as 'derivatives' are 'securities products which have been greatly responsible for the banking industry teetering on the "brink of collapse." (Brown, 2008) Brown notes that the Wall Street Journal does note the fact that the plans could result in the investment banks and hedge funds of Wall Street to much greater future scrutiny however, according to Brown: "these suspect products are not to be more heavily scrutinized; rather, their approval will actually be 'streamlined' and may be automatic if they are traded in 'foreign markets'." Brown further notes that the regulation of fraudulent, predatory banking and overly-speculative banking practices is in the States jurisdiction and "not necessarily by law but by default." (2008)

SUMMARY & CONCLUSION

Cleary accountability has been a vital issue in the subprime housing mortgage industry. The work of 'The Economist' accurately notes that four flaws of a fatal type that exist in this area include first m by having cut the ties between those who check the borrowers in terms of the likelihood that they will repay the loan and those who actually suffer the consequences when those individuals default on their mortgage there has been a lack of accountability which has been driven by this separation. Secondly, many instruments are simply not understood by the individuals signing these documents and many of these securities were of the nature of being very poorly structured due to failure on the part of lenders to understand the associated risks; and finally, the fourth flaw is that of the market tending to over-rely on "rating as a short cut to assessing risk." (the Economist, 2008) Securitization and bank liquidity, while having been historically and traditionally utilized and considered to be acceptable, have resulted in a crisis stated by many to appear to be as strong as that of the Roaring 1920s leading into the Great Depression. Many writers and researchers believe that the Federal Reserve has certainly played a role during both of these crises.