In the latest issue of FinReg21's Lombard Street e-Journal on financial regulation, regular Atlantic Business contributor and economist Arnold Kling has a very good piece arguing that mortgage securitization should be allowed to die, rather than fixed. He provides a fascinating perspective, having worked for Freddie Mac during the 1980s, when much of the securitization innovation was going on. His arguments are strong, and I find many of them quite compelling. Still, I ultimately see things differently.
Kling's piece is quite in-depth; I won't address the entire thing here. Instead, I hope to address just a few of the points he makes.
As mentioned, he begins by doing a splendid job of providing a historical picture of mortgage securitization. He describes the role it played in the 1980s at the government mortgage agencies Fannie Mae and Freddie Mac. He then goes on to explain the rise of private-label mortgage securitization, when banks began more commonly performing securitization of mortgages not backed by the government. Those, of course, are where so many of the mortgage-backed securities (MBS) we now refer to as "toxic" came from.
Private Label Vs. Agency MBS
Eventually, he gets around to why he believes that the mortgage securitization market should just be allowed to die. He sees the private label market as far more problematic than the agency (government-backed) market. He explains the disparity:
About ten years ago, a number of innovations emerged that substituted for an agency guarantee, allowing "private-label" securities to compete with those of the agencies. Borrower credit scores provided a simple, quantitative measure of the borrower's credit. Structured securities allowed credit risk to be reallocated, with subordinated holders taking most of the risk and senior holders only taking what was left over. The various tranches were evaluated by credit rating agencies, so that investors could treat AAA private-label securities as equivalent to agency securities (a practice which was formally ratified by bank regulators in a policy that took effect on January 1, 2002). For extra comfort, the holder of a security could purchase a credit default swap, which would pay off in the event that the security's principal repayment was jeopardized.
With all of these layers or protection, holders did not have to examine the underlying mortgages. In fact, it is not clear where that responsibility lay. With agency securitization, it was clearly the responsibility of Freddie Mac and Fannie Mae for managing, measuring, and bearing credit risk. However, with private-label securitization, those functions were diffused. The Wall Street firms that packaged securities had no experience with the risk management functions needed to ensure quality standards in mortgage origination. The credit rating agencies had most of the responsibility for credit risk measurement, but they bore none of the risk. In retrospect, the incentive to be overly generous in rating securities was far too high.
Let's think about an unsecured bond. You can buy credit default swaps (CDS) on those too, and they're also rated by the agencies. Who bears the risk on those bonds? Obviously investors do. Sure, the CDS might mitigate some of that risk, and they're rated. But investors still need to evaluate loss scenarios for the bonds they're purchasing for the full picture. I can't at all see how MBS is different -- the investors clearly should have the responsibility for understanding the risk.
Does Investor-Performed Risk Evaluation Make Securitization Worthless?
Of course, under the current system, investors don't have the ability to fully comprehend the risk of a MBS, because full data on the underlying mortgage pool is not provided. I've suggested that should change, and it would be one way to help the securitization market function more effectively. But Kling might respond like this, where he explains why securitization worked for government-backed mortgages:
The benefits of securitization come from the fact that investors do not have to go to the trouble and expense of examining the underlying mortgages. Investors know the types of mortgages and the interest rates on the mortgages in the pool, which is the information that they need to manage interest-rate risk. However, investors assume that they are entirely insulated from credit risk, because of the guarantee provided by Freddie Mac or Fannie Mae.
That may have been true in the 1980s, but I'd argue that technology has reduced that trouble and expense dramatically since then. Now it's very easy to create models to analyze loan-level data so that investors can manage credit risk themselves. Again, they must manage credit risk for all of their unsecured corporate debt, so why not have risk models for residential MBS as well?
Credit Risk Necessarily Kills Securitization?
Kling's credit risk worry leads him to assert:
Securitization worked because the holders of securities assumed that they were not bearing any credit risk. Securitization broke down when mortgage defaults reached a level where holders of securities were no longer confident that they were insulated from credit risk. For mortgage securitization to work again, the credit risk will have to be absorbed in a credible way by someone other than the holder of the securities.
In response to this conclusion, I would point to the securitization markets for assets other than mortgages. They still function, and are regaining their strength with each day that passes. Examples include prime auto loan and credit card securitization. Investors are still exposed to credit risk there, but are more comfortable with the collateral. The same can happen with mortgages, if certain reforms are taken.
Reforming Mortgage Securitization
I agree with Kling that most of the so-called reforms suggested thus far would be pretty useless, particularly the idea that mortgage originators need a measly 5% skin in the game. I have some other ideas, which were motivated by Kling saying:
A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one's responsibility. Some party must take on those functions in order to address idiosyncratic risk.
So why not instill some of those risk factors into regulatory requirements? For example, what if you required certain credit criteria for mortgages to be securitized, insuring that MBS pools were pristine? You could require loan-to-value ratios not to exceed 80% -- losses would then need to exceed 20% before even the credit enhancement was touched. You could require at least 24 months of seasoning -- meaning that a bank would have had to service a loan for two years before selling it to an investor, virtually eliminating fraud. You could require that only certain types of mortgages are securitized -- no option adjustable-rate mortgages or other shady products allowed. These are just a few of many suggestions which could also include proof of income verification, borrower credit history attributes, etc.
Securitization could be reformed to limit idiosyncratic risk. In fact, I would argue that this risk was already pretty limited in many prime residential MBS, which saw far fewer downgrades and losses than subprime MBS.
In recent years, many of these pristine mortgages have been purchased or guaranteed by the mortgage agencies like Fannie Mae or Freddie Mac. That should change, and banks should take over and securitize those mortgages to shrink the size of those agencies. Banks could continue to feel free to originate the shady mortgages -- at their own risk. They shouldn't just pass that junk onto investors through MBS.
Counterarguments To The Benefits Of Securitization
Finally, I wanted to address Kling's responses to contradict the argument that securitization is good because it allows capital markets to fund mortgages:
The first counter-argument I would make [AN1] is that the alleged efficiency of securitization has not been demonstrated in the market. Mortgage securities are the artificial creation of government, starting with GNMA and Freddie Mac.
I'm not certain here how he's defining efficiency, but securitization is certainly a more efficient way for investors to participate in mortgage securities than syndication. It's also generally more desirable for investors to have an interest in a diverse pool of real estate rather than own whole mortgages. A broader portfolio that includes diversified real estate holdings is desirable to many investors, and securitization is the most efficient way to achieve that end.
Just because the government created mortgage securities doesn't convince me that they're necessarily bad. Even I don't hate the government that much. As they say, even a broken clock is right twice a day. Besides, I would credit advances in technology more than the government in allowing securitization to flourish. In the 1960s we couldn't possibly pool hundreds of mortgages because we could not create databases to aggregate loans or software to model the deals.
Of course, there's also the issue that the government-sponsored entities Fannie and Freddie have traditionally scooped up the highest quality mortgages -- what appealed to investors first and foremost. Their guarantees also likely calmed investors who worried about purchasing a new kind of security. As a result, the government agencies, rather than the banks, would naturally have an easier time getting the ball rolling. After getting their feet wet, investors became more comfortable and began moving into private label deals. Despite the recent track record of private label MBS, other private label asset-backed securities markets have served investors well.
The second-counter-argument is that adding efficiency to mortgage securitization serves to divert capital from other uses, and it is not necessarily the case that this capital diversion is best for society.
Indeed, why should capital markets invest in the mortgage market? I'd begin by asserting that, in a free market, they should be able to invest in whatever they like. I don't particularly care whether investor's capital diversion is best for society, and neither should any other free market advocate.
But let's say we should care about what's best for society -- even then I think securitization has a place. Securitization allows banks to sell giant pools of mortgages. When they get that funding, they can create new loans. Some of those new loans might be mortgages, but others could be for small business -- clearly positive end for society. By providing banks an easy way to obtain more funding, they don't have to have their capital tied up for 30 years in mortgages and can fund elsewhere. That, I think, is necessarily good for society, because it allows banks to perform more diverse lending.
Let me be clear: not all securitization is good. But on that same token: not all securitization is bad. I think it's highly desirable to have robust capital markets where investors can decide what kinds of assets they want to invest in and do so efficiently. It's also ideal for banks to be able to sell assets easily so to obtain more capital for new loans. Clearly, something went wrong over the past decade with mortgage securitization due to a host of reasons from too easy credit to investors passing the buck on prudent risk mitigation. But these were symptoms of an unhealthy market, not of securitization.