Posts filed under “Derivatives”
Did Securitization Lead to Riskier Corporate Lending?
February 04, 2013
There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.
Historically, banks kept on their books the loans they originated. However, over time they increasingly replaced this originate-to-hold model with the originate-to-distribute model, by syndicating the loans they originated or by selling them in the secondary loan market. The growth of securitization provided banks with yet another opportunity to expand the originate-to-distribute model of lending. The securitization of corporate loans grew spectacularly in the years leading up to the financial crisis. Prior to 2003, the annual volume of new collateralized loan obligations (CLOs) issued in the United States rarely surpassed $20 billion. Since then, this activity grew rapidly, eclipsing $180 billion in 2007.
Corporate loan securitization appealed to banks because it gave them an opportunity to sell loans off their balance sheets—particularly riskier loans, which have been traditionally more difficult to syndicate. By securitizing loans, banks could lower the risk on their balance sheets and free up capital for other business while continuing to earn origination fees. As with the securitization of other securities, the securitization of corporate loans, however, may lead to looser underwriting standards. For example, if banks anticipate that they won’t retain in their balance sheets the loans they originate, their incentives to screen loan applicants at origination will be reduced. Further, once a bank securitizes a loan, its incentives to monitor the borrower during the life of the loan will also be reduced.
To investigate whether securitization affected the riskiness of banks’ corporate lending, my paper with Bord compared the performance of corporate loans originated between 2004 and 2008 and securitized at the time of loan origination with other loans that banks originated but didn’t securitize. We found that the loans banks securitize are more than twice as likely to default or become nonaccrual in the three years after origination. While only 6 percent of the syndicated loans that banks don’t securitize default or become nonaccrual in those three years, 13 percent of the loans they do securitize wind up in default or nonaccrual. This difference in performance persists, even when we compared loans originated by the same bank and even when we compared loans that are “similar” and we controlled for loan- and borrower-specific variables that proxy for loan risk.
Our results suggest that banks use laxer standards to underwrite the loans they sell to CLOs. For example, we find that banks put less weight on the “hard” information on borrower risk when they set spreads on the loans sold to CLOs than on the loans they don’t securitize. We also find that banks retain less “skin in the game” when it comes to securitized loans, suggesting that they have less incentive to monitor these loans after origination. While on average banks retain 26 percent of each syndicated loan they originate but don’t securitize, they retain only 9 percent of each loan they do securitize. This difference in underwriting standards may help explain why banks’ securitized loans underperform unsecuritized loans.
Finally, we find evidence that all loan investors, including banks, expect that securitized loans will perform worse. Banks appear to do so because they charge significantly higher interest rates on these loans than on the loans they don’t securitize. Institutional investors, who together with the originating bank and CLOs acquire the loans that banks securitize, follow the loan originator and choose to acquire a smaller stake in securitized loans.
Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
João Santos is a vice president in the Research and Statistics Group of the Federal Reserve Bank of New York.
Is it possible that the Credit analysts who rated subprime junk as AAA at S&P are even more odious, more corrupt, more execrable than I previously imagined?
As this email from the government’s complaint (via Dealbook) shows us, yes!
[S&P analyst]: With apologies to David Byrne…here’s my version of “Burning Down the House“.
Housing market went softer
Strong market is now much weaker
Subprime is boi-ling o-ver
Bringing down the house
CDO biz — has a bother
Leveraged CDOs they were after
Going — all the way down, with
Hey you need a downgrade now
Huge delinquencies hit it now
Bringing down the house.
video after the jump
MERRILL LYNCH MBS TRUST SUES BANK OF AMERICA OVER MBS –> Trustee Lawsuits beginning –> This is an important development in MBS litigation. *U.S. BANK AS TRUSTEE SUES MERRILL LYNCH AND BofA – REPRESENTED BY QUINN EMANUEL (SAME LAYWERS AS FHFA AND MBIA)
Hat tip Manal Mehta
The unregulated multi-trillion dollar derivatives market exceeds global GDP and poses a clear danger to the global economy, Chris Whalen, Senior Managing Director at Tangent Capital Partners, and Barry Ritholtz, CEO at Fusion IQ, tell Bloomberg Law’s Lee Pacchia.
“The fix is very simple,” says Ritholtz, “repeal the Commodities Futures Modernization Act and suddenly this becomes like every other financial instrument.”
Whalen notes that the financial industry is reluctant to change the way derivatives are managed because they generate large returns at a time when banks are less profitable than before. “The super normal returns that they earn from derivatives subsidize the rest of the business,” he says.
One way or the other, Ritholtz and Whalen believe the financial industry needs to get used to the idea of making less money.
Dec. 5 (Bloomberg Law)
One of the Main Indicators of Financial Danger Has Increased The failure to regulate the shadow banking system was one of the causes of the financial crisis. As we noted in 2009, the Bank for International Settlements – often described as a central bank for central banks (BIS) – slammed the Federal Reserve for failing…Read More
Fascinating quote from Nick Dunbar, author of The Devils Derivatives: “What would happen if VaR was taken out of bank regulation? Immediately, the intellectual crutch for highly-leveraged complex banks would disappear. Deprived of their fancy radar screens, regulators would have break up large banks that they could no longer pretend to understand, while increasing their…Read More
The amount of derivative exposure continues to dazzle and amaze (You can see the full report here: OCC’s Quarterly Report): Click to enlarge: Hat tip: Damien, an RIA in sunny San Diego.
Last week, I wrote about a few developments that should boost RMBS litigation recoveries, especially for bond insurers – Judge Crotty’s summary judgment decision in Syncora v. EMC (JPMorgan) and Syncora’s subsequent settlement with BofA, resolving all of the parties’ ongoing relationships. It appears I’m not the only one who has concluded that banks may need to reassess their potential payouts as a result of recent legal setbacks.
In this July 27 client alert, major financial services firm O’Melveny & Myers, which represents BofA in MBIA’s putback suit in New York, addressed the impact of Crotty’s Opinion [hat tip Manal Mehta from Sunesis Capital for passing this along]. While the alert is short and worth reading in its entirety, the gist of O’Melveny’s conclusion is as follows:
In light of a recent federal court ruling, banks may wish to reevaluate litigation risk from plaintiff insurers claiming injury from alleged breaches of representations and warranties regarding mortgage securitization notes that they insured…
Institutions facing such lawsuits may wish to re-evaluate their exposure, and possibly adjust reserves set aside to cover such risks, based on the type of plaintiff and the specific language of the securitization agreements at issue.
Hold the phone – so BofA’s own law firm in its putback litigation with MBIA is publishing an alert saying that banks may need to adjust their loss reserves associated with monoline putback litigation? This is essentially an admission that the firm sees the tide turning against the banks in these suits. Shouldn’t this have generated some serious pushback from O’Melveny’s powerful client?
Short answer: yes. According to Mehta, this alert was pulled from O’Melveny’s website shortly after publication, only to be re-posted today. We can only speculate as to why the alert was pulled and then re-published (without significant revision), but I can imagine that there were a few heated phone calls in between.
Regardless, now that we finally have a definitive decision from a respected court on the proper standard for mortgage putbacks, we have enough guidance to begin discussing RMBS litigation end games in earnest. Today, we’ll begin by looking at the bond insurer suits.
These, along with mortgage insurer suits, were some of the earliest filed pieces of RMBS litigation and have been prosecuted aggressively since the onset of the mortgage crisis by some of the most skilled and aggressive private legal teams in the business. And for good reason: the monolines issued what are known as “financial guaranty” policies, which included a guarantee that insurers would make policy payments if losses mounted; they could not deny claims or rescind coverage.
This means that bond insurers have already suffered massive, company-crippling losses as a result of insuring pools of misrepresented loans, and have been forced to pursue years of contentious litigation just to try to recover the funds they paid out. The good news for them, is that after 4+ years of litigation, they’re finally beginning to see the light at the end of the tunnel.
Monoline End Game Scenarios
As I mentioned at the top of this article, Syncora and Countrywide just reached a settlement of all their outstanding RMBS litigation and other issues, in which Syncora will receive a cash payment of $375 million and a return of certain of its preferred shares, surplus notes and other securities. It’s no coincidence that this settlement comes on the heels of several wins for the monolines in their suits against the major Wall St. banks. It demonstrates that the banks (or at least Bank of America), are beginning to realize that the bond insurers’ claims in these suits are potentially expensive and difficult to defeat. This settlement, in conjunction with BofA’s settlement with Assured Guaranty (AGO) back in April of 2011 and its proposed settlement of investor putback claims initiated in June 2011, show that BofA is making a concerted effort to put legacy Countrywide liabilities behind it.
This bolsters my long-held view that the most likely end game scenario for the monolines consists of party-by-party settlements with their various bank counterparties that address all of the outstanding legal issues between the parties. As I’ve discussed in the past, the last thing that an issuing bank wants is for one of these cases to go to trial and to see the parade of horribles that the monoline will trot out before the factfinder, showing clear breaches of underwriting guidelines time and time again. Not only would such a trial be long and embarrassing, but it would open up the banks to paying upwards of 75-80 cents on the dollar of losses to the insurers, rather than the 25-30 cents they might be able to pay in settlement.
Of course, the tougher questions surround the timing and the ultimate size of these potential settlements. If we could get our arms around the size of prior settlements, this might help give us a ballpark of the size of the settlements to come. In my prior article on the Assured Guaranty settlement (at item No. 4), I noted that based on BofA’s estimates, they were covering about 55% of AGO’s losses. The Syncora-Countrywide settlement is much more difficult to parse as the deal, according to Syncora’s press release was part of “an effort to terminate other relationships between the parties,” aside from simply the putback disputes. My guess is that the putback disputes constituted the bulk of the outstanding liabilities, but it’s difficult to assess the exact proportion, as well as the value of the other consideration received by Syncora.