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The new argument against securitization
We used to see only virtues in having loans packaged and resold to third parties, but now there are critiques:
1. It is harder (impossible?) to renegotiate loan terms if something goes wrong (this is from Brad DeLong, and Paul Krugman today).
2. The loan holder no longer has market-stabilizing, special information about the value of the loan (see Avinash Persaud in yesterday's FT). This decreases the likelihood of anyone "supporting the market" and holding or buying up the assets in hard times.
3. Selling the loan means it is harder to pinpoint where capital losses are falling, should the loans decline sharply in value.
4. The market for packaged loans is (maybe) more prone to herd behavior than the market for individual, idiosyncratic loans. The packaged loans are being judged in very gross terms as part of a relatively broad reputational class.
5. If real estate is relatively cyclical, securitization is easing or subsidizing a sector which makes the macroeconomy more vulnerable.
The WSJ Op-Ed page version of this argument (Ethan Penner, yesterday) blames Fannie Mae and Freddie Mac for having subsidized lending to the extent they did.
One month from now, we will know much more about the new argument against securitization. Dare I say one week from now? Who knows, we might even find out today.
As for yesterday, Brad DeLong offers information on normal mortages. My best guess is that we are seeing a return to sanity in the risk spread on lower-class assets. Financial blood will be shed, but as problems go we will deal with it. But until we all know who the losers are, investors will continue to exercise option value and equities will be volatile. Here is a very good FT forum on the issue. Might the real story end up being the lack of transparency in European banking and bank supervision? That wouldn't surprise me one bit...
Posted by Tyler Cowen on August 17, 2007 at 07:42 AM in Economics | Permalink
Comments
I'll give you just one argument in favor of securitization, it's called Basel II.People respond to incentives.
Securitization cuts risk capital requirements and therefore borrowing costs.
If there is no market for securitized paper, expect borrowing costs to rise sharply, it makes little sense for banks to hold that paper on the balance sheet at current spreads levels.This is why there is some "dislocation" in the market as the pundits say.The wholesale price is a long way from the retail one.
Posted by: jck at Aug 17, 2007 8:08:15 AM
I am all in favor of renegotiation but is there any real evidence that securitization has made it more difficult? Maybe since the 1950s when you literally had a mortgage from the local bank but that was a long time ago. I'd be curious to hear from someone who might actually know.
Posted by: Alex Tabarrok at Aug 17, 2007 9:01:38 AM
Just to clarify the above: this is a deliberate feature, not a bug, of Basel II.
Posted by: sammler at Aug 17, 2007 9:07:09 AM
#2: Why is special information market stabilizing? Banks lending money have traditionally had more information, which increases the accuracy of the information they receive. I've never heard of it "stabilizing" a borrower. You're going to have to argue this point in more detail.
Posted by: jult52 at Aug 17, 2007 10:09:13 AM
I have been asking this question for a while with no answer: how big is the problem?. Supposing you could find someone who services the loan who also has authority to renegotiate it --- contrary to Krugman's claim that "...there’s nobody to deal with." which I find very odd -- how big is the problem? How much would it cost (forget about who pays quite yet) to bring monthly payments to a level where "enough" people wouldn't default? If the "teaser" rate is 2% and the current market is 7% that's a 5% spread. There's a finite number and there is also a finite number of potential defaultee. How big is the shortfall on a monthly basis?
Posted by: David Sucher at Aug 17, 2007 10:10:53 AM
A criticism not listed above is that a time of panic no one knows where the bad credits are located. This is one of the critical differences between this panic and the Long Term Capital crises. With LTCM we were only dealing with one firm in trouble. So the problem was resolved by finding buyers for the securities that would not immediately dump them back on the market depressing everyones portfolio. This time we have no idea where the securities are held and where the problem will emerge-- we saw it come from Germany and France. Consequently the problem of restoring market confidence and liquidity is much more sever. Thus the Feds actions this week can stop the panic selling, but it does not solve the fundamental problem that the poorly priced securities are still out there depressing various financial institutions value.
Posted by: spencer at Aug 17, 2007 10:26:06 AM
Spencer,
Are you suggesting that no one knows who is getting behind in their home payments? I recognize that there are many many players in the mortgage business but surely these sub-prime loans are being serviced and so there are real numbers somewhere to tell us both the general scale and the specific address (literally) of the problem. No?
Posted by: David Sucher at Aug 17, 2007 10:39:09 AM
Regarding the claim there is no one to deal with.
There is a post at calculated risk that deals with the problem or renegotiating the loans.
http://calculatedrisk.blogspot.com/2007/04/ranieri-on-mbs-market-its-broke.html
Short very simplified answer. If the servicer can renegotiate the loan he didn’t really sell it because he has control over it.
There is also conflicts of interest between the actual owners because the loan was split into different tranches, with senior holders having lower interest rate in return for taking loses later.
Posted by: sort_of_knowledgable at Aug 17, 2007 10:58:14 AM
Given that the percentage of loans that are in default is still small and given that this risk was factored into the way the loans were repackaged why is there even a panic? Obviously the cause lies elsewhere.
I think it is best to look at how highly leveraged the hedge funds and buyout firms are. They even brag about how much money they control compared to their capital. If some owns a subprime portfolio and, say, 6% of the loans are in default then the value of the fund should drop by less than 6% (some of the capital will be recovered). This is not a very big risk. On the other hand if you have borrowed 90% of the value of a deal to fund a takeover or buyout and the asset drops 10% in price you are wiped out.
Even if the asset drop 2-3% you will most likely get a margin call. If you can't cover it you will be sold out. If too many people get caught trying to exit at the same time they all get stuck in the doorway.
This is what happened in 1929 and to prevent a recurrence the SEC put into effect margin and trading rules. The hedge fund and allied industries have been explicitly exempted from these requirements. The result is the classic crash.
Stop looking at the subprime market and focus instead on the financial speculators. It is likely that they will be bailed out by the government. Rich people don't lose money. The US has even sent in the marines to protect the interests of American investors, so some loan guarantees or other measures will be much easier to implement.
Posted by: robertdfeinman at Aug 17, 2007 11:25:19 AM
Regarding renegotiation: apparently, some hedge funds that own derivatives that would pay off in the event of loan defaults are (or were) attempting to prevent loans from being renegotiated to prevent defaults...
http://fintag.com/archive/2007/06/01/ (See the second post which references an FT article "Funds attack banks' aid for subprime borrowers".)
Could the financial system currently be configured in such a way as to prevent loan-holders from making decisions which are in both their own and their borrowers' financial interests?
Posted by: Alex R at Aug 17, 2007 11:26:57 AM
The problem with the securitization of mortgages was that ratings agencies were paid by the investment banks to rate the securities. This put pressure on them to give the securities marketable ratings. The ratings clearly masked their risk and lifted demand for the securities which encouraged banks to loosen lending standards to supply the market’s appetite. The ratings agencies had a conflict of interest, and that was the real problem. Spreading risk is fine, but not when the risk is not understood, or worse yet, deliberately hidden.
Posted by: Dave at Aug 17, 2007 11:31:39 AM
I agree with David Sucher. The mortgage servicing companies should have information about borrowers' ongoing behavior as the single firms that used to do everything. Wells Fargo & Co, Countrywide and the like are serious, capable modern banks that are likely to use the information gained in servicing loans to advantage their propietary trading desks.
That doesn't help with renegotiation but it does help with keeping the information on ongoing borrower quality in the market.
Posted by: OneEyedMan at Aug 17, 2007 11:41:05 AM
How can such a brilliant economist know virtually nothing about banking or business in general? Krugman implies the government should not bail out hedge funds and investment banks because it will create a moral hazard. What about the role played by borrowers who purchased homes they obviously couldn’t afford? Doesn’t this “workout” plan suggested by Krugman create the same moral hazard on the individual level?
Secondly, Krugman states that “there’s nobody to deal with.” Who does he think is servicing the loans? If a work out is the best option for the banks, then they will certainly offer this option to the homeowner. If the bank can make more money with a foreclosure then the bank will exercise this option. In this market (falling real estate prices and high loan to value ratios) in most cases the bank will offer to a work out but in my opinion many homeowners will realize that they owe more than the home is worth and they will simply walk away from the home. This scenario played out in the Los Angeles real estate market in the early 1990s.
Finally, what does Krugman think will happen if a few hundred thousands borrowers lose their homes to foreclosure? They will exchange their $3000 a month mortgage payment for the $1500 a month rent payment they should have opted for before they bought the house they couldn’t afford.
This is not a “market failure” by any stretch of the imagination. Did the market lower borrowing rates to their lowest level in 40 years after September 11th? Did the market keep those rates that low for several years? I seem to remember it was the Federal Reserve who did that and the market responded the way any market will respond to cheap money, the market make a lot of bad loans.
Why is it the de facto position of Krugman that the government should step in and help whenever people make bad decisions? Did the lenders engage in shady practices in some cases? Yes, they did and if they broke the law they should be prosecuted. Should the taxpayers insulate everyone from bad financial decisions? I don’t think so.
Posted by: kingstu at Aug 17, 2007 11:44:53 AM
Didn't the S&L crisis result in part from a lack of securitization? Banks held a bunch of loans from their local area, subjecting them to the high risk of a regional recession.
securitization avoids that by pooling risk from numerous mortgages throughout the country.
Posted by: ah at Aug 17, 2007 12:56:25 PM
Alex, for the record, I have a mortgage that's held by the local bank. (A purchase-money loan originated January of this year, not 1950.) They hold all their own paper.
Posted by: mph at Aug 17, 2007 1:22:26 PM
"The problem" is not sub-prime loans. The failure of many sub-prime loans is only a symptom.
"The problem" is a typical market bubble in all real estate, now working itself out.
One could argue that the Federal tax incentives to write off mortgage interest may have made the bubble larger than needed (it sure worked into my thinking when I bought my house recently :)
Posted by: Mr. Econotarian at Aug 17, 2007 1:42:37 PM
Echoing a comment above, I'm shocked at how Krugman manages to blow this. Well, ok, maybe "shocked" isn't the right term, his credibility with me was already low when he burned off the rest of it during the CNOOC deal.
But I'm still surprised at how little of the detail he understands. Sub-prime delinquency has increased drastically in period-to-period % terms, but from an unnaturally low base. What has driven the current crisis is the extreme effective leverage applied by some of the ABS buyers. You can make a AAA tranche out of sub-prime paper, but only by putting it in a last-loss position vis-a-vis a first-loss "equity" tranche. Buy that equity tranche and you've already applied leverage. Buy it on deep margin and you've got a lever big enough to shift the Moon. And the slightest bump wipes you out. This has very little to do with work-out difficulties (and work-outs often don't, um, work out anyway) or less info on the part of new-style lenders (they have less info, to be sure, but it shows in pricing differentials; I regularly see us undercut by credit unions that know their customers well). It has to do with the risk that must exist if you're getting outsized returns, even if you don't see it.
Posted by: Bernard Guerrero at Aug 17, 2007 1:45:28 PM
Loans get sold in one of two ways: one way, the original lender continues servicing the loans - the borrower keeps sending checks to the same name and address. The other way, the borrower gets notices every two or three months telling him to send his checks somewhere new. The second way, in itself, creates a slightly higher risk of technical default, because the borrower doesn't always keep up with the notices (and sometimes checks and notices cross in the mail if the borrower pays early).
I believe, but don't know for sure, that these two methods of selling correspond with securitization techniques: in one method, what is securitized is the income stream from the loans - the lender has a contract with the holder of the securities to make payments based on the income received on the loans. In the second method, which I'm not entirely sure is used in securitization, the security-holder is the "heir and assign" of the lender per the terms of the original contract.
Posted by: Anthony at Aug 17, 2007 1:55:45 PM
No, I was not suggesting no one knows who is behind on the payments.
What no one knows is who holds the paper. In previous financial crises it was
relatively easy for the Fed to identify what financial institutions were in trouble.
But that is no longer true. This made it easier for the Fed to keep money markets liquid and deal with potential defaults situations. Now the risk of default is much more dispersed and that makes it more difficult to handle.
Posted by: spencer at Aug 17, 2007 2:37:37 PM
The liquidity problem in the market is not that people are not making mortgage payments.
Rather the market liquidity problem is that some holders of the paper are so leveraged they are in danger of bankruptcy. But since nobody knows who they are other financial institutions are pulling in their horns and not making the normal
loans to each other. That is what creates the liquidity crises and it is one step removed from the actual servicing of mortgages.
Posted by: spencer at Aug 17, 2007 2:50:33 PM
As sort_of_knowledgable puts it above, "If the servicer can renegotiate the loan he didn’t really sell it because he has control over it."
So, to the extent that securitization creates multiple independent legal claims to the income stream, and to the extent that these claims complicate renegotiation, the real issue concerning possibility of market failure has to do with re-assembly (you might call it unsecuritization) of all legal claims to the income stream from a mortgage.
Here's a cross-post of my comment over at voxbaby.blogspot.com (specifically, at this post):
The securitization of pieces of mortgages surely increases the transactions costs of workouts. One view of this fact is that we're stuck with it. Another view is that it creates an opening for further innovation---namely, firms specializing in re-assembling troubled mortgages.
It seems to me that re-assembly is a necessary part of workouts, as well as outcomes like your
In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender.
If the mortgage hasn't been fully assembled, there would surely be title/lien problems with this otherwise-sensible approach.
So one way to reconcile your dispute of Krugman's market failure claim, I think, is that there are market failures only if there is some reason to think that the re-assembly market has a failure.
If there is a failure, then the issue isn't just your point about higher TC "in the event of default". Rather, the event of default is the event of a (most likely unforeseen) market failure. On the other hand, if re-assembly can be done competitively without market failures, then what we really have is a situation in which the higher transaction costs "in the event of default" can actually be reduced via further financial innovation.
Could markets in re-assembly be competitive? Well, obviously there are already secondary markets in these securities--that's how we got to this point. The key question is not whether these markets exist, or even whether there are short-term liquidity problems like those that have hit the markets recently. Rather, the key question is whether there is some distinct failure related specifically to the re-assembly of all chunks of a mortgage.
To be sure, there are some conceivable hitches. For example, holdup problems could arise if a holder of the last non-re-assembled chunk of a mortgage figures out its status. Obviously being the last holder conveys bargaining power, and this could cause inefficient delay.
(As usual the efficiency problem isn't the case of the last holder that uses bargaining power, but rather jockeying on the part of multiple agents to achieve that bargaining power.)
To the extent that auctions or hiding any given loan's re-assembly status can avoid such holdup problems, it seems likely that such a market could avoid serious failures.
Suppose that market failures turn out to exist in re-assembly and be severe enough to cause non-existence of the market. I'm skeptical that this would happen, but let's say it did.
Perhaps the most reasonable government policy (leaving aside Dean Baker's) intervention might then be to have Fannie Mae do the re-assembly and then re-sell the fully titled mortgage security on open financial markets. There would, by hypothesis, be high costs for Fannie Mae in re-assembly. But surely we could expect the demand side of such markets to be competitive. The sort of workouts that Krugman proposes or re-sales that you mention would then be feasible via direct negotiations between residents and their new creditors.
Obviously this isn't my field of expertise, so I'm curious as to your thoughts.
Posted by: jonah gelbach at Aug 17, 2007 2:56:58 PM
1) It is harder to renegotiate loans terms because without the investor being able to hang their hat on what the collateral is, they will not buy the paper. Think about it, would you buy a bond that had the risk of not meeting interest payments because the issuer could change the rates for all of the borrowers in the deal? Every issuer is different, but typically issuers cannot modify more than 10% of the loans in a deal and then within certain band (e.g. weighted average loan rate cannot drop by x basis points).
2)-4) Loan level analysis is possible given your ability to create a model that is worthwhile. These days models derive prepayment and loss curves based on loan size, age, zip code, refinance incentive, fico, ltv, occupancy type, property type, purpose, loan type, and prepayment penalty term. There are a few data providers that sell this information (albeit after the deal is done) at steep prices from which you can contruct your models. Most major issuers contribute their data in exchange for access to all of the other issuer's data. This data is updated monthly so any prepayments or losses are recorded on a loan level basis for any subscriber to see.
5) Real estate is cyclical, but until recently the historical home price appreciation rate was 3%, roughly that of inflation. People need a place to live and will always want to buy regardless of rates and prices, the two being inversely related. Although, financial innovation (3/1 IOs, option arms, 40 year terms) can also affect prices because borrowers can stretch into homes they cannot afford (with brokers helping them along), the Fed is really the one who decides when to inflate home prices or not by controlling the fed funds rate. Remember, it was Alan Greenspan, who, went rates were at historic lows, instead of saying that consumers should lock in fixed terms, said that consumers should consider arms. The federal government missed the boat here too, by actually discontinuing the 30 year temporarily. The only sector who wisely refied into lower fixed rates was corporate amercia.
robertfeinman is correct about the role of leverage being a much bigger problem once defaults started to pick up.
Dave - The rating agencies did their job in assesing risk and giving loss coverage levels. They fell down by not acting fast enough to downgrade bonds. All of the loss scenarios that are palying out are in the deal docs for investors to read. By the same token, the rating agencies rated just about all of Enron's bond deals poorly and some even junk, but investors still lapped them up.
ah-The S&L crisis stemmed from deregulation and the competition they faced from the ensuing rise of money magagers. They lived in a world of 3-6-3: pay depositors 3, lend at 6, on the golf course at 3. Then the world changed because others were able to lure away depositors with better rates of return. Leveraging their FDIC insurance, they proceded to take risks into areas where they din't really have any expertise and got burned.
Posted by: Patinator at Aug 17, 2007 3:00:41 PM
AH -- the S&L crises was much more a mismatch of maturity spreads than a problem of mortgages going bad. The S&Ls were borrowing short and lending long. that worked well under Req. Q that forced them to stop lending when the yield curve turned negative. But this time they kept lending because every time they believed short rates were peaking. But they went all the way to 18% and the S&Ls were having to borrow short at these rates to finance long term loans they were making at much lower rates. So the S&L crises was a very different beast.
Posted by: spencer at Aug 17, 2007 3:01:49 PM
we know very well who holds the paper: in the case of a subprime mortgage pool, it would be a SPV (special purpose vehicle), and the mortgage borrower knows very well where he sends his monthly payments, that's the servicer for the trustee of the SPV and the point of contact for "renegotiating" if needs be, in any case the servicer the servicer will be in touch if the loan goes delinquent..To claim as Krugman does "And the result is that there’s nobody to deal with." is absurd.
Posted by: jck at Aug 17, 2007 3:02:50 PM
jck,
I suggest (assuming that you have a mortgage) that you try and contact your mortgage lender and renogotiate anything. I remember when rates were falling, I tried to negotiate a lower (but higher than current) rate on my existing loan. I just got blank stares when I suggested that they might prefer to keep my loan at 6% (I was paying slightly more than 7)...so I just refied to 5 at a different institution.
Now of course, non payment may focus them...but as servicers only where exactly is the incentive?
Posted by: RobbL at Aug 17, 2007 3:35:55 PM
