Thursday, December 23, 2010

SOW - Russell Bradshaw

This article mainly relates to the following terms of reference for the Son of Wallis Challenge:

3. Given securitisation was at the centre of the GFC, what role should it play in renewed competition?

4. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?

The paper will aim to show that de-regulation, originally designed to stimulate competition merely led to mis-pricing of credit resulting in sub-optimal lending practices and massive risk transfers. The crux of the argument is that credit risk can’t be qualitatively “transformed” (as assumed within the market based competition for lending), instead it just gets absorbed or “transferred”. Securitisation is the means of masking underlying fundamental credit risk and for facilitating massive risk transfers to unsuspecting counterparties.

Intermediation and risk in banking
One of the major functions of a bank is its role of intermediation, whereby the requisite demands of lenders and borrowers are brought together for mutual benefit. This intermediation can be split in to two key functions for banks. The first is maturity transformation, whereby banks borrow money in the short-term (e.g. instantly available deposits) and lend out over the long-term (e.g. a 20-year mortgage). This places a bank in the unfortunate position of being vulnerable to a liquidity squeeze whereby lenders could withdraw deposits quicker than a bank could liberate its assets. In return for handling this transformation (borrowing short and lending long), banks are rewarded through extracting a profit, provided that this trust is honoured.

The second role is deemed to be one of risk transformation. In this capacity, a bank undertakes to control or mitigate the different levels of risk that it holds as assets (e.g. loans). This takes the role of the bank trying to protect itself from the potential abuse of trust by borrowers. By choosing the word “transformation“ one is led to believe that banks can perform tangible changes to the extent of risk that they are exposed to, however a better choice of word would be risk mitigation. The table below shows the various strategies that banks undertake for risk mitigation:

Risk management strategy (after Buckle & Thompson p.66)
Underlying risk management strategy
Screening for bad loans
Risk avoidance
Pooling risks (large number of loans)
Dilution / absorption of risk
Diversifying risk (supply to different types of borrower)
Containment / absorption of risk across the loan book
Holding sufficient capital
Containment / absorption of risk over time

As we can see, it is clear that risk in its pure and aggregate sense is not strictly acquired by banks and then mystically detoxified into a safer level. To believe otherwise, is to assume that banks can “spread risk and somehow magically evaporate it in the vast complexity of the financial galaxy” (Perez 2009). Banks receive the right to profit from appropriately containing or avoiding risk, not because of their ability to convert the risk to a less hazardous state. Therefore risk is not qualitatively transformed in the way that maturity has been changed. Instead banks either avoid the risk in the first place or absorb the stochastic nature of default / delinquency through the appropriate dilution of risk in their loan pool or by holding a sufficient cushion of capital to smooth losses over time. If presented with the prospects of weaker quality loan issuance, the institution’s only choices would be to demand a higher risk premium (commensurate with the default risk) or decline to originate (therefore avoid) the loan.

The rise of Securitisation
The previous description of banking intermediation is often referred to as the “originate and hold” model (O&H) as banks would not trade or sell-on the loans that they had initiated. Recent deregulation of the banking sector has led to the feasibility of trading loans on a secondary market, also known as the “originate and distribute model” (O&D). This has led to a fragmentation of the loan process into the following key steps:

Loan origination
Credit risk assessment
Secondary market funding (e.g. Asset Backed Securities)

This market structure has resulted in increasing proportions of loans becoming packaged up and traded as securities. The objective was to reduce banking costs for customers by promoting greater competition and liquidity. Tasks that would normally be the integrated responsibility of banks would become dissected, with one of the most critical aspects, the pricing of risk and the supervision of borrower behaviour, placed within the hands of the market.

However, none of the “perceived benefits” offered to justify O&D (lower entry barriers, increased competition, increased liquidity etc.) actually addresses the fundamental issues of adverse selection and moral hazard brought about by the abdication of loan responsibility. Ultimately, with credit risk assessment becoming separated from credit risk responsibility it takes an extreme stretch of the imagination to believe that this approach would lead to anything other than a decline in the quality of loan evaluation:

“Lack of screening incentive created by the separation of origination from the ultimate bearer of the default risk has been a contributing factor to the current mortgage crisis.” Fritz-Morgenthal (2008)

What begins as a belief that risk can be tamed through the wonder of the market was to be proved wholeheartedly incorrect. Evidence collected and published on the cusp of the crisis in 2008 demonstrated that there were already warning signs of adverse selection and moral hazard occurring in this practice. Berndt & Gupta (2008) demonstrate that securitised loans severely underperformed:

“We find that borrowers with an active secondary market for their loans underperform their peers by about 9% per year in terms of annual, risk-adjusted abnormal returns, over a three year period subsequent to the initial sale of their loans.” Berndt & Gupta (2008)

The very structure of securitisation is facilitating the exploitation of the asymmetric information concerns that have dogged banking for centuries. Firstly borrowers themselves may be making inferior loan judgements. Observed rises in equity release loans, credit card loans and car loans may instead just be providing artificially stimulated consumption demand, rather than genuine economic investment.

Secondly, the accusations that loan originating firms tended to ignore potentially worrying borrower circumstances is not unfounded. This is particularly pertinent given that in many circumstances banks earn on a fee basis, and therefore have no incentive to weigh up aspects relating to the long term repayment structure. Under these conditions then, the phenomenal growth in debt witnessed these last 20 years may not be all fully attributable to genuine economic investment and instead could be the symptom of poorly judged credit issuing.

Transferring poor quality risk
The evidence provided by Berndt & Gupta leads to the highly portentous conclusion that loan quality is compromised under secondary market handling. The empirical findings give credence to the following risk management model:

The crux of the model is that the aggregate quantity and quality of credit issuance within a market is inversely related (Warburton p47, p49). Rationing of credit is believed to result in an overall improved status of portfolio quality, whereas an increase of total credit issuance is connected with worsening quality. As stated above, an O&H approach is prevented from risk transfer practices, therefore the expansion and contraction of credit issuance is limited by the direct participants’ ability to absorb risk. However, in an O&D environment, rising quantity of credit issuance is feasible by accepting (potentially mis-priced) declines of credit quality, assisted on the part of the issuer through the practice of risk transfer.

The turning over of banking functions to a seemingly competitive market has at best yielded superficial hopes of improved customer choice but, more importantly, has masked a more serious issue of the mis-selling of credit and gargantuan risk transfer to the public purse:

“The virtual elimination of the credit quality spread, in all its dimensions, ought to be regarded as a source of fear and trembling, not a celebration of capital market efficiency.” (Warburton p.174)

To accept that securitisation (even under promised conditions of increased supervision / sanitisation) is necessary for modern banking is to implicitly condone the continued growth of debt levels of potentially deteriorating quality. Not only are they a risk in themselves to banking stability but it is clear that they pose a more substantial systemic risk to the nation by providing the means for even further debt expansion as well as the obfuscation of risk ownership and exposure levels.

Writing in 1999, Peter Warburton stated that:

“The highly developed consumer credit and securitised loan markets of the USA provide an acid test of credit quality developments throughout the Western world.” (p.175)

And so far, it seems that they have failed that test. The pursuit of competition through de-regulation has done little more than let the speculation genie out of the bottle. But this is no pantomime, as the consequences of this policy action could be felt for many years to come.

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