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How a Flawed Story Hides the Real Danger of Securitization

A common narrative to explain the last financial crisis goes like this: Banks used securitization to unload crappy loans on unwitting investors and thus did no longer uphold proper lending standards. This is a dangerously misleading story, particularly in light of recent developments in marketplace lending.

If banks on Wall Street offloaded all the crappy loans to unwitting investors, why would they have suffered mind-staggering losses?

The “unload-crappy-loans-to-unwitting-investors-caused-the-crisis” narrative interprets securitization as a financial technique to distribute risks. Its proponents argue that banks did no longer care about risks which they distributed with securitization, so lending standards fell. Sounds intuitive, right? The only problem is that securitization is not a technique to distribute credit risk. The purpose of securitization is the exact opposite.

Securitization concentrated risks

Remember the mind-staggering losses reported by the major banks during the financial crisis of 2007-08? The same banks that were believed to have offloaded the credit risk lost hundreds of billions of dollars on subprime loans during the crisis. In fact, Banks did not offload the actual risk when they securitized loans. Instead, they held on to the most toxic tranches. In addition, they ramped up exposure against high risk constructions from other originators, because they “viewed retaining this risk as an attractive source of profit”.

Why would banks do this? Banks securitized loans to circumvent regulatory constraints, in particular capital requirements; the purpose was not to reduce their actual risk exposure. Banks were tremendously successful in gaming capital requirements. Eventually, they could finance crappy loans with leverage ratios of 30 or more. For each dollar they invested with their own “capital” (that is, shareholder money), banks used an additional 30 dollars of borrowed money for their gambles.

Now, imagine you could invest 30 dollars for each dollar you put up yourself and walk away if the investment losses exceed your initial dollar. How would you behave? You would go for the riskiest gambles. As long as the music keeps on playing, you could pay a stellar salary to yourself for the “economic value” you add, and you could disburse a nice dividend to your shareholders at the end of each year. When things go south, your losses are capped thanks to limited liability, and you should have already managed to put a nice retirement fund aside.

Given the perverted incentives of excessive debt, who would be so mad to lend money to a bank with a leverage ratio of 30 and a balance sheet stacked with exposure towards “subprime” loans? Well, each and every one of us. The government established deposit insurance long ago, which guarantees that the money we deposit at our banks is safe no matter what. By repeatedly bailing out failing banks in the past, the Treasury and the Federal Reserve also established a “too-big-to-fail” doctrine according to which medium to large sized banks have not only deposits, but all forms of debt implicitly insured.

Banks securitized mortgage loans to make regulators believe that they distributed the risk to investors. But in fact, securitization allowed banks to concentrate more risk on their balance sheet without a corresponding increases in their capital requirements. The conventional “unload-crappy-loans-to-unwitting-investors” narrative thus completely misses what securitization is all about.

Why marketplace loans get securitized

The power of the prevailing narrative prevents us from grasping most recent developments at the frontier of digital finance. Recently, investment banks have started to securitize marketplace loans. Many regard this exercise, which appears redundant within the conventional narrative, as a somehow inevitable step of a “maturing” industry. In general, explanations what actual economic value securitization adds to marketplace lending remain weak: Why would someone want to pay expensive investment bankers, lawyers and accountants to securitize something that is already “originated to distribute” without further ado? Why would anyone get expensive ratings from external agencies who miserably failed in the past to adequately assess the risk of securitized structures?

The evolution of marketplace lending exemplifies that securitization has not much to do with distributing risk to investors. The first generation “peer-to-peer” loans (a term that has been rightfully abandoned by the industry) were usually denominated in portions of $20 or less. With this small size, risk can already be distributed in any imaginable way. So why should financial institutions still be bothered to securitize peer-to-peer loans? The answer is simple: For the same reason they used securitization ten years ago, that is, to concentrate risks and to deceive regulators.

Once one abandons the “unload-crappy-loans-to-unwitting-investors” narrative, the securitization of marketplace loans suddenly makes a lot of sense. Government guaranteed funding is sitting ready on the balance sheets of banking institutions. Investing in higher risk marketplace loans that promise juicy returns is a very attractive prospect for this kind of funding. Unfortunately, directly investing government guaranteed funding in these loans could quickly motivate regulators to intervene and forcing banks to ramp up capital requirements.

However, by creating complex securitization structures – and supported by favorable assessments by rating agencies – banking institutions can disguise the risk. Doing so, they avoid higher capital requirements when investing in risky marketplace loans. What has just started with marketplace lending will eventually unfold the same way as the story of subprime mortgage loans did during the financial crisis of 2007-08.

And the Moral of this Story...

If we believe the intuitive narrative that distributing risks was the prime cause of the last financial crisis, then the only way forward is backward. We would have to force all financial institutions to operate a “take-and-hold” model, like they did during the industrial age when credit was immobile. But this is neither possible nor desirable.

If we debunk the flawed narrative, however, a different conclusion emerges. In today's regulatory framework, banking institutions use financial innovations to deceive regulators, concentrate risk, and abuse government guarantees. Behind this stands the rise of information technology: The delicate balance between government guarantees and banking regulation that worked so well in the industrial age has been unsettled by rapidly evolving financial innovation. Trying to fix the broken regulatory framework will do more harm than good. Only a paradigm shift in financial regulation will be able to restore a functioning financial system in the digital age.



financial crisismarketplace lendingpeer-to-peer lendingsecuritizationshadow bankingsubprime mortgage crisis
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Andrew, 2015-06-06 16:27:06

banks took heavy losses, government had to bail out the bank, who pays the government debt? Taxpayers. The narrative is still essentially the same. Except taxpayers didn't even know they were investors!

Marketplace Lending News Roundup – June 6, 2015 - Lend Academy, 2015-06-06 13:43:06

[…] How a Flawed Story Hides The Real Danger of Securitization from The End Of Banking – Interesting take on securitization and why it has really come to marketplace lending. […]

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