The Over-Securitization of Debt

Marc Bautista, CFA   10 April 2008

What happens when the owner of risk is able to transfer such risk to a 3^rd party while retaining most of the benefits? In the case of the sub-prime mortgage securitization that eventually kicked-off the currentUS credit crisis, the result was an “accident” waiting for a place to happen. In this case, the loan originators had all the incentives to keep on lending, as long as all the cash flows arising from the loan could be liquefied via securitization. Securitization raises new money for even more loans, which, in turn, expands the cycle for even more securitization etc. However, there is a natural limit to how much of this can actually go on.  Once this limit was reached, it was just a matter of time before the whole process imploded.

Perhaps it is helpful to visualize what’s going on here. Say Company A has 1000 to lend to the public, say to Ann and Ben. If Ann borrowed 1000 to purchase a house in return for 11 annual payments of 100 to Company A, then the company has just transformed its asset of 1000 into an asset of 1100. However, since it will only have 100 every year for the coming 11 years, Company A has no more money to lend to Ben. Too bad for Ben, for he also wants to buy a house worth 1000. Under normal circumstances, what Company A can do is, borrow more money from other people, to be able to lend to Ben.

Alternatively, Company A knows it has assets of 100 every year for 11 years. It can package this cash flow as a security that can be bought, say at 1050. In this case, it receives 1050 now and pays out the 100 every year to the buyer of the security, where the 100 every year actually comes from Ann. Since Company A now has 1050, it can now lend 1000 to Ben, who now pays 100 every year for 11 years. At this point, Company A is still receiving 100 every year for 11 years (this time from Ben) and it now has an extra 50 which it counts as its fruit for its intermediation in the transactions.

Notice that in this simplistic example, the borrowing needs of Ann and Ben are satisfied, as they are able to buy a house. The buyer of the security is satisfied, since in return for 1050 it paid out, it will receive 1100 over the 11 year period. And finally, Company A is really satisfied, since it was able to do its intermediation and still remain profitable.

In a nutshell, all of this is straight-forward and perfectly all right. The problem is not in intermediation per se; it is in the potential misalignment of risks and benefits plus plain, old fashioned greed that push people to abuse the process.

How does the abuse happen. If Company A sees that none of the risk of loan defaults will fall its way, then it has all the incentives in the world to just keep on originating loans for eventual securitization, no matter how poor the creditworthiness of the borrowers, that it lines up. This sets up the condition for promoting asset bubbles in the housing market, wherein borrowers spot an opportunity to borrow money and buy a house with the expectation of eventually “flipping it”, that is selling the house down the road for a profit. Thus, the supplier of funds and the user of funds both have incentives to let the game run continuously.  However, there is still one more critical component lacking to let this game go “out of bounds,” and this comes in terms of the buyer’s support for the securitized paper.

With the misalignment of risks & benefits between loan originators, securitization buyers, and mortgage borrowers, it falls naturally on the buyers of the securitized paper to introduce market pressure to the transactions. Thus, if it sees that the quality of the underlying pool of mortgages underlying the security is deteriorating, then that fact should get reflected in the price. Poorer quality papers should get a lower price, which eventually will force the loan originator to mind the borrower base if he wants to be able to continually offload his loan portfolio via securitization. However, something intervened in this whole process which mucks up things: first, the “bad” stuff were bundled with the “good” stuff and secondly, a lot of these bundled stuff got rated at “top investment grade.”

At this point then, whether in good faith or perhaps tainted by ignorance or even fraud, that the “toxic” papers got eventually passed off as investment grade which, in turn, made the whole securitization process …spin out of control. In a period of low interest rates such as what happened in the US when the Fed kept benchmarks rates at 1% (some say for too long), the stage was then set for an asset bubble in the mortgage markets and the resultant over-securitization of debt. With the Fed eventually moving rates up and with mortgage rates belatedly following suit under the so-called "predatory practices" found in the Adjustable Rate Mortgages, the bubble was bound to burst as borrowers started to have problems paying their loans.  And now, the rest is history.

Marc Bautista, CFA is Head of Research at Metrobank and also the Chairman of the Advocacy Committee of CFA Philippines . He also teaches some of the core finance courses at the De La Salle MS Computational Finance Program. He runs the Fund Metrics Project at www.fundmetrics.com. He can be emailed at: marc.bautista@metrobank.com.ph (Article edited by Alexander Gilles, CFA)

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