Securitization Reconsidered

Okay. Big news. Derivative Dribble explains securitization. Let's go back to the Bloomberg article:

"The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion. "

Okay. Claims about securitization:
1) bundles loans and mortgages into securities
2) more than $27 trillion of these securities have been sold since 2001
3) that makes these securities the largest U.S. export since 2000

So what? That hardly seems a bother other than the figure being quite large, but, then, good for the U.S.

So now banks outside the U.S. start doing this:
Result: $667 billion in losses: $260 billion or so outside of U.S.: about $400 billion in the U.S.

Okay. These securities lost this money? How?

"Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade."

Okay, here, I'm lost.

These securities fund:
A. Credit cards
B.Car purchases
C. Leveraged buyouts
D. Subprime mortgages

The "system"
A. Pools loans
B. Spreads risk
C. Makes borrowing cheaper

Voila: A Debt Culture
Does all lowering of interest rates lead to a Debt Culture?

There's $4.2 trillion in money market funds ( deposits paying interest )
Banks made money with the mm funds by funding subprime mortgages and cutting costs
The cutting costs sounds like a good thing, the subprime loans don't

"Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost."

The banks took in deposits, paid interest on the deposits to the depositors, and loaned the money out to borrowers at a higher rate of interest than they were paying depositors or charged fees. This example doesn't make that clear.

Now, after securitization:

"During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest."

How do the banks make money in this? If it's lending, do they get interest, fees, what?

"Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.

``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''

It is a fee business if there's no capital. That's why I asked how the banks make money on these securities. How does the bank originate a loan without capital?

"As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf. ``One of the things the United States exported overseas was a debt culture,'' Haley said."

So, because of these securities, consumer debt tripled in the U.S., and, since we seem to be rich, other nations did the same thing.

I've already gotten a headache, and we're just coming to CDO's.

"Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day."

Okay. CDO's use short term debt which is cheap but comes due fast.

"SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007"."

And:

"Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months."

And:

``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July"

Okay. Short term lending is the problem.

"Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since."

Only it's not. It looks here like lack of collateral.

We've come a long way. Derivative Dribble asked if I was fair to securitization in the first post I did? No, I wasn't. It looks like the culprits are:

A: Lack of capital
B. Poor loans

A poor loan is a poor loan.

Here's Derivative Dribble:

"So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee."

So remember where I said the banks are making money through fees? Banks are making money on these securities, mortgages through fees.

Of course, whether there is enough capital in a bank, or whether a loan or mortgage is sound, are completely separate questions. So until I hear otherwise from Derivative Dribble, it seems to me that, just like CDS's, the problems are lack of collateral and unwise loans, not the investments themselves.

Can people have been deluded?

See my post about coming up about PRDC's in Japan.