Tuesday, October 2, 2012

Securitized Banking: A Brief Explanation

Here is an excerpt I dug up from the first part of Henry C.K. Liu's series Greenspan - The Wizard of Bubbleland concerning a possible housing bubble:
Through mortgage-backed securitization, banks now are mere loan intermediaries who assume no long-term risk on the risky loans they make, which are sold as securitized debt of unbundled levels of risk to institutional investors with varying risk appetite commensurate with their varying need for higher returns. But who are institutional investors? They are mostly pension funds who manage the money the working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their own house mortgages. When a home owner loses his/her home through default of its mortgage, the home owner will also lose his/her retirement nest egg invested in the securitized mortgage pool while the banks stay technically solvent. That is the hidden network of linked financial land mines in a housing bubble financed by mortgage-backed securitization to which no one is paying attention. The bursting of the housing bubble will act as a detonator for a massive pension crisis.
Liu is referring to securitized banking (coined by Gary Gorton).  Loans backed by someone else's debt have security not available in purely credit-based loans.  Mortgages represent the largest component of consumer debt and represent the so called "American Dream".  Mortgages are prevalent in securitizing loans because of the enormous volume and demand for mortgage debt - due in large part to reduced lending standards in the early to mid-2000's and low interest rates (also due to reduced lending standards!).

Securitization, Sale and Supply
Mortgages issued by banks or lenders are not always kept on their books.  Mortgages are oftentimes sold and pooled together into a single investment by an underwritter (usually an investment bank).  The investment, which is usually a mortgage-backed security (MBS), is then sold to investors in the secondary-market.  These investors can be pension funds, institutional investors or other banks.
Investors in the secondary-market purchase a variety of mortgage-linked securities such as mortgage-backed securities, collateralized-debt obligations, collateralized-mortgage obligations and asset-backed securities.  Investors in the secondary-market also purchase other securities, and the most important securities are the high-rated (low risk) US treasuries.  US federal government debt is the near equivalent of gold. 

Once securities have been purchased in the secondary-market they may again pass from one investor to another.  These securities can be lent, usually overnight, in what is called the repo market (extra link). 

In the second part of his series, Liu explains that repos are the most important and fastest growing sector of the money market:
The repo market is the biggest financial market today. Domestic and international repo markets have grown dramatically over the last few years due to increasing need by market participants to take and hedge short positions in the capital and derivatives markets; a growing concern over counterparty credit risk; and the favorable capital adequacy treatment given to repos by the market. Most important of all is a growing awareness among market participants of the flexibility of repos and the wide range of markets and circumstances in which they can benefit from using repos. The use of repos in financing and leveraging market positions and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full participation in today’s financial markets. 
A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of a top-rated financial asset. On termination date, the seller must repurchase the asset at the same price at which he sold it, pay interest for the use of the funds, and if the asset was borrowed, the borrowed assets will be returned to the lending owner who also receives a fee for lending. If the repoed security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. Institutions with excess assets routinely avoid holding unproductive idle assets by lending them for a fee to institutions in need of more assets. A well defined legal framework has developed to facilitate repo transactions.
The cash acquired in a repo deal can be used to purchase additional securities, conduct other business operations, or fund reserve requirements.  On the other side of the transaction (known as a reverse repo) the securities can be used for short selling or to close out a position - perhaps another repo deal.  Tri-party repo deals are brokered through a clearing house - usually another bank - and allow an extra degree of leverage not available in a two-party repo deal.

Credit-Financed Debt
Additionally from the second part of the series:
Because repos are essentially secured loans, their interest rates do not depend upon the respective counterparties’ credit ratings.
Repo deals depend upon the security's credit rating and do not depend upon the lender's or borrower's credit rating.  Another, very imortant, detail is that a security's rating also effects the capital requirements of the bank when it holds that particular security.  Known as the recourse rule (discussed in more detail), banks are required to hold a certain amount of capital against the securities they hold.  As you can imagine, they must hold less capital for high-rated securities and more capital for low-rated securities.  That means high-rated securities are most desirable and low-rated securities are least desirable (obviously!), and a credit-downgrade on securities can have an enormous impact on capital requirements

Aptly named the recourse rule, there is a recourse around the higher capital requirements for low-rated securities.  A low-rated security with a default-swap becomes a high-rated security.  This happens because a third party pledges to cover the low-credit of the security, and they insure against non-payment cash flow of the security.  High-rated MBS usually have their mortgage loans insured by government enterprises such as Fannie Mae and Freddie Mac.

panic. Panic. PANIC. PANIC!!!
What would happen if the securitized banking sector experienced a mortgage-default based credit-downgrade on its securities?  The securities, without a default swap, would lose their value - the price of the security would go down - and there would be a drop in cash flow from the securities.  More importantly for the banks, the credit-downgrade would increase their capital requirements and it would eliminate the securities' use in a repo deal.  Finally, if mortgage defaults were large enough to place deafault swap underwritters in insolvent position, it would put all other participants on the hook for solvency-challenging  losses.

To deal with such an event, Liu suggests that government intervention is built into the system:
Selective government intervention into markets to relieve business of external costs will be the cornerstone of the new normalcy. “Too big to fail” becomes a dogma for believers of the free market. Corporate strategy quickly adjusts to this game by getting bigger through mergers and acquisition to secure the added protection from government based on its size. Would the government allow Citigroup to fail? No one expects Fannie Mai to fail.

Liu suggests that too big to fail and (later in the article) too important to fail will become the rally-cry of an overleveraged volatile market.  According to Liu, the US manufactures a fiat currency which it exports abroad to purchase goods produced by the rest of the world for the purpose of collecting US fiat currency.  This is known as dollar hegemony.  The rest of the world cannot manufacture and export goods to the US in the event of a credit crunch, unless they wish to produce goods for a more solvent, abundant currency.

Technical Difficulties
Liu concludes the second part of the series with a critique of US central bank policy:
The individual management of risk, however sophisticated, does not eliminate risk in the system. It merely passes on the risk to other parties for a fee. In any risk play, the winners must match the losers by definition. The fact that a systemic payment-default catastrophe has not yet surfaced only means that the probability of its occurrence will increase with every passing day. It is an iron law of an accident waiting to happen understood by every risk manager. By socializing their risks and privatizing their speculative profits, risk speculators hold hostage the general public, whose welfare the Fed now uses as a pretext to justify printing money to perpetuate these speculators’ reckless joyride. What kind of logic supports the Fed’s acceptance of a 6% natural rate of unemployment to combat phantom inflation while it prints money without reserve, thus creating systemic inflation to bail out reckless private speculators to fight deflation created by a speculative crash?
The Federal Reserve's mandate of structurally low unemployment comes at the cost of increased inflation, reduced saving rate and lower confidence in the system.  A quasi-government's inflation driven mandate for low unemployment bails out the very speculative entities which create such a need for a central bank.  Imagine a world in which fires do not exist, what then is the purpose of funding a fire department?

Without having done anything more than played by the rules of money market speculation, participants are guranteed reputational decay in place of criminal charges.  The Federal Reserve and the US federal government become more than regulators in such a system, they become willing particpants in a perverted scheme.  What will happen when gold turns to silver?

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