Financial booms and busts are as old as finance itself, but the current global financial crisis has the distinction of being the first post-securitisation crisis. Securitisation refers to banks’ practice of parcelling and selling loans to other investors. Securitisation was meant to disperse risks associated with bank lending so that deep-pocketed investors who were better able to absorb losses would share the risks.
But in reality, securitisation worked to concentrate risks in the banking sector. In a paper published this week (Shin 2009)), I argue that there was a simple reason for this. Banks wanted to increase their leverage – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself.
Against received wisdom
To understand the true role played by securitisation in the current financial crisis, we need to dispose of two pieces of received wisdom concerning securitisation - one old, one new. The old view, now discredited, emphasised the positive role played by securitisation in dispersing credit risk, thereby enhancing the resilience of the financial system to defaults by borrowers.
But having disposed of this old conventional wisdom, the fashion now is to replace it with a new one that emphasises the chain of unscrupulous operators who passed on bad loans to the greater fool next in the chain. We could dub this new fashionable view the “hot potato” hypothesis. The idea is attractively simple and blames a convenient villain, so it has appeared in countless speeches given by central bankers and politicians on the causes of the subprime crisis.
But the new conventional wisdom is just as flawed as the old one. Not only does it fall foul of the fact that securitisation worked well for thirty years before the subprime crisis, it fails to distinguish between selling a bad loan down the chain and issuing liabilities backed by bad loans. By selling a bad loan, you get rid of the bad loan from your balance sheet. In this sense, the hot potato is passed down the chain to the greater fool next in the chain. However, issuing liabilities against bad loans does not get rid of the bad loan. The hot potato is sitting on your balance sheet or on the books of the special purpose vehicles that you are sponsoring. Thus, far from passing the hot potato down the chain to the greater fool next in the chain, you end up keeping the hot potato. In effect, the large financial intermediaries are the last in the chain. They are the greatest fool. While the investors who buy your securities will end up losing money, the financial intermediaries that have issued the securities are in danger of larger losses. Since the intermediaries are leveraged, they are in danger of having their equity wiped out, as many have painfully learned.
Figure 1. Total subprime mortgage exposure
Source: Greenlaw, Hatzius, Kashyap and Shin (2008)
Indeed, Greenlaw, Hatzius, Kashyap and Shin (2008) report that, of the approximately $1.4 trillion total exposure to subprime mortgages, around half of the potential losses were borne by US leveraged financial institutions, such as commercial banks, securities firms, and hedge funds (see Figure 1). When foreign leveraged institutions are included, the total exposure of leveraged financial institutions rises to two-thirds. So, far from passing on the bad loan to the greater fool next in the chain, the most sophisticated financial institutions amassed the largest holdings of the bad assets – they were the greatest fools.
It’s all about leverage
Securitisation should be viewed in the larger context of balance sheet management by banks. Financial intermediaries manage their balance sheets actively in response to shifts in measured risks. In the name of modernity and price-sensitive risk management, banks load up on exposures when measured risks are low, only to shed them as fast as they can when risks materialise. The supply of credit is the outcome of such decisions and depends sensitively on key attributes of intermediaries' balance sheets. Three attributes merit special mention – equity, leverage, and funding source. The equity of a financial intermediary is its risk capital that can absorb potential losses. Leverage is the ratio of total assets to equity and reflects the constraints placed on the financial intermediary by its creditors on the level of exposure for each dollar of its equity. Finally, the funding source matters for the total credit supplied by the financial intermediary sector as a whole to the ultimate borrowers.
At the aggregate sector level (i.e. once the claims and obligations between leveraged entities have been netted out), the lending to ultimate borrowers must be funded either from the equity of the intermediary sector or by borrowing from creditors outside the intermediary sector. Aggregate lending to end-user borrowers by the banking system must be financed either by the equity in the banking system or by borrowing from creditors outside the banking system. For any fixed profile of equity and leverage across individual banks, the total supply of credit to ultimate borrowers is larger when the banks borrow more from creditors outside the banking system.
In a traditional banking system that intermediates between retail depositors and ultimate borrowers, the total quantity of deposits represents the obligation of the banking system to creditors outside the banking system. However, securitisation opens up potentially new sources of funding for the banking system by tapping new creditors. The new creditors who buy the securitised claims include pension funds, mutual funds, and insurance companies, as well as foreign investors such as foreign central banks. Foreign central banks have been a particularly important funding source for residential mortgage lending in the US.
As balance sheets expand, new borrowers must be found. When all prime borrowers have a mortgage, but balance sheets still need to expand, banks have to lower their lending standards in order to lend to subprime borrowers. The seeds of the subsequent downturn in the credit cycle are thus sown.
When the downturn arrives, the bad loans are either sitting on the balance sheets of the large financial intermediaries, or they are in special purpose vehicles that are sponsored by them. This is so since the bad loans were taken on precisely in order to utilise the slack on their balance sheets. Although final investors such as pension funds and insurance companies will suffer losses, too, the large financial intermediaries are more exposed in the sense that they face the danger of seeing their capital wiped out. The “hot potato” was sitting inside the financial system, carried by the largest and most sophisticated financial intermediaries. The severity of the current financial crisis attests to this feature.
Greenlaw, David, Jan Hatzius, Anil Kashyap and Hyun Song Shin (2008) “Leveraged Losses: Lessons from the Mortgage Market Meltdown” US Monetary Policy Forum Report No. 2.
Shin, Hyun Song (2009) “Securitisation and Financial Stability” paper presented as the Economic Journal Lecture at the Royal Economic Society meeting, Warwick, March 2008.