Prof. Jayanth R. Varma's Financial Markets Blog

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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.

Posted at 10:16 am IST on Sat, 22 Aug 2009         permanent link