The packaging of loans into securities is one of the financial innovations most deeply implicated in the financial crisis. It is not only closely associated with the explosive growth of sub-prime mortgages and credit derivatives but responsible for transforming the U.S. financial structure from a system based on prudent bank lending to one based on highly speculative securities markets.
The creation of a market for mortgage--backed securities came about as a response to the banking crisis of the inflationary 1970s. Lending institutions were making 30-year fixed-rate mortgage loans but financing them with short-term deposits at newly deregulated market interest rates. As inflation increased, banks lost money on their mortgage portfolios. In response, Congress called on the government-sponsored secondary mortgage-market enterprises (known as GSEs) -- Ginnie Mae, Fannie Mae, and Freddie Mac -- to support savings institutions and small banks by buying their low-interest-rate mortgages. At that time, the GSEs were the only entities converting loans into bonds, which were fairly straightforward and not divided into securities with different degrees of risk, known as "tranches."
By the close of the 1970s, however, a second and larger inflationary spike overwhelmed the safety valve provided by the GSEs. And in the 1980s, private competitors to Fannie, Freddie, and Ginnie began offering far more complex securitized products. In principle, this innovation allowed a lender to go on making fixed-rate mortgages, shedding risks to third-party investors willing to bet on the future movement of interest rates and housing prices. But in practice, securitization without regulation sowed the seeds of the great collapse three decades later.
In the mid-1980s, Congress explicitly authorized private financial institutions to market securitized products, but without the most basic safeguards that apply to other securities markets. Mortgage-backed securities were exempt from registration and disclosure. Congress authorized a "safeguard" in the form of required ratings by government--recognized credit-rating agencies as a substitute for due diligence, but these ratings were soon corrupted as securitized packages of highly risky mortgages were nonetheless awarded triple-A ratings. Moreover, mortgage-backed securities were not traded on organized exchanges, so information on the volume and price of transactions was not available to investors. In addition, capital backing along the chain from loan origination to issuance of securities was minimal or nonexistent.
Attracted by the laissez faire nature of the market, new, unregulated loan originators such as mortgage brokers became major players. Banks and savings institutions increased their lending for housing because they could earn fees for originating and servicing mortgages without having to raise the capital required had they held the loans in their portfolios. In the 1990s, securitization expanded to include car loans and consumer receivables and, together with mortgage-backed securities, issuance and trading of asset-based securities came to dominate capital markets and credit flows. Between 1977 and 2007, the share of total credit-market assets accounted for by GSEs, mortgage pools, and asset-backed securities issuers rose from 5.3 percent to 20.5 percent while banks' share shrank from 56.3 percent to 23.7 percent. The result was a transformation in the traditional U.S. bank-based system and an erosion of the protections so carefully crafted in the 1930s.
The role of securitization in the crisis
The sub-prime scandal is a major and well-recognized outcome of this massive experiment in deregulation. The laxity and conflicts of interest inherent in the role of rating agencies is another. The diversion of so large a share of credit flows into the market for mortgage-backed securities facilitated the buildup of the housing bubble. It also ensured that mortgage-backed securities were held and traded by all financial sectors, all of which inevitably experienced distress when loss of confidence caused trading to dry up and prices to fall.
As the bubble inflated, large profits were made by financial institutions, and rising house prices gave a boost to the savings of households. When the bubble burst, homeowners experienced a double whammy: Their net worth fell because of the drop in the value of their homes and dropped further as the value of mortgage-backed securities in their pension and mutual funds declined. In a third blow to households, damaged financial institutions grew more resistant than in the past to negotiate loan workouts -- a factor that exacerbated the rate of foreclosures. As the International Monetary Fund noted as early as 2005, households became the shock absorbers in a market-based system.
The bill passed by the House last December and the one introduced by Sen. Christopher Dodd this March address only some of the abuses. Both provide for more oversight of the credit-rating agencies and create an agency to protect consumers from harmful financial products. The Dodd bill requires that sellers of securitized products retain 5 percent of the credit risk and provide more disclosure about the underlying assets in the pool.
But these reforms are far from sufficient. It is likely that pressure for securitizing mortgages, car loans, and other forms of consumer credit will continue. For banks, ongoing exposure to a volatile interest-rate environment means that holding long-term mortgages and even medium-term car loans in portfolio presents a level of uncertainty and an ongoing threat of insolvency that even increased capital requirements cannot alleviate. At some point, the larger concerns raised by this innovative financial technique will have to be addressed.
What kinds of reforms are needed?
Higher Capital Requirements. In the aftermath of the crisis, the seriously undercapitalized status of the U.S. financial system was glaringly apparent. As a result, higher capital requirements have become the one-size-fits-all solution for any area that has been identified as needing reform. In the case of securitized exposures, given the widespread distribution of asset-based securities throughout the system, all institutions that originate, underwrite, or hold such securities must have even higher capital requirements.
Adequate Disclosure. Capital alone will not address all the problems that caused damage to financial markets and households. The Financial Stability Board -- a multinational organization of central bankers and regulators -- -proposes reforms that require greater disclosure and transparency at each stage of the securitization process. The losses experienced by pension funds and other pools of household savings were attributable in part to incomplete information. Many believe the issuance of mortgage-backed securities should not be permitted going forward without the same requirements for disclosure that apply to the issuance of all other securities. As spelled out in the Dodd bill and a recent Bank of England report, this must also include disclosure about the underlying assets in the pool so that the risk of each underlying mortgage can be evaluated. That level of disclosure is also needed both for investors and to ensure that mortgage borrowers can be identified to facilitate workouts if needed.
Standardizing Contracts and Reporting Trades. The fact that there was no real-time information about prices and the volume of trading in what had become the dominant credit market in the U.S. was another structural failure that contributed to the crisis by destroying confidence in securitized products and the institutions that held them. Many analysts have proposed that these products be simplified and standardized and that transactions be documented. But real reform will require that mortgage--backed securities be traded on an exchange so that trading arrangements do not obscure what is happening in the market for a given product.
Improved Lending Standards. Allowing lenders to relax (or even ignore) loan-to-value ratios and borrowers' ability to pay ensured that securitized assets would develop into the toxic assets they became. The systemic threat posed by securitization will not be lessened unless more stringent and prudent loan--origination standards are reinstated and enforced. Comprehensive regulation of all institutions that make loans -- bank and nonbank -- and the creation of a Consumer Financial Protection Agency are needed.
"Skin in the Game." As reflected in the Dodd bill, there is substantial agreement that mortgage originators should be required to retain a meaningful share of the credit risk they are packaging into securities as a way to improve due diligence. But there is a better way: using so-called covered bonds as a complement or replacement for securitized products.
Covered Bonds. This strategy, used by Europe's large "universal" banks, would give banks access to capital markets and help solve the liquidity and other risks they face when holding longer-term assets. Loans and other assets backing bonds issued by the banks would be segregated ("ring fenced") to protect investors against the credit risk taken by the bank. Issuing long-term bonds to finance those assets would protect the banks against the interest-rate risks of having to roll over short-term deposits or borrowings while holding loans with longer maturities that can't be sold or traded.
The investors take on the interest rate and price risk while the bank remains fully exposed if one or more of the loans defaults. This would encourage both the lending banks and the buyers of the bonds to screen the credit risks they are assuming. It would also make it easier for banks to do the workouts needed to prevent foreclosure when loans become nonperforming.
Covered bonds would accomplish the objectives of those who advocate reforming securitization by simplifying and standardizing the mechanism for funding longer-term credits like mortgages and ensuring improved due diligence and disclosure. It is possible that, like securitization itself in its early years, such a change in funding strategies would require public-sector encouragement. But it would make possible a needed structural change that could help rebalance the U.S. financial system by reinstating a larger role for traditional portfolio lending. This would revive previous protections to homeowners and consumers by reducing the exposure to the credit, interest-rate, and market risks they were forced to assume both as borrowers and savers when securitization took hold.
All of these reforms are needed if innovation in credit markets is to serve its advertised purpose of improving liquidity and accurate pricing of assets rather than just increasing speculation and risk.