Securitization of real estate serves no purpose
Slate has the standard argument support securitization of real estate, namely that it helps diversify idiosyncratic risk:
This may make loans more expensive, but you're getting what you are paying for -- good credit decisions where the incentives are to lend out money when you expect it will be paid back.
Let's look at the other side, of how much cheaper loans benefit consumers. Prior to the mortgage securitization in the 1970s or so, homes in america were plentiful and cheap. There was no problem with there being insufficient capital in that area resulting in a shortage of housing stock. So what problem is being solved here? Cheaper loans did raise house prices and result in more outstanding debt that then had to be services. Good for the financial industry, good for existing homeowners, but not obviously good for society at large.
Say you have enough money to buy 100 houses. If all 100 of those houses are in Atlanta, you'll have a much easier time scouting the properties for potential purchase and managing them. But you'll also be exposed to a lot of Atlanta-specific risk. Something bad could happen in that particular metro area. But if you take those 100 houses and combine them with 100 houses in Chicago and 100 in Phoenix and 100 in Riverside County and 100 in Sacramento and 100 in Miami and 100 in Providence and 100 in Las Vegas and 100 in Houston and 100 in New York, then you have a pool of 1,000 houses that's much less volatile than the original 100.
The problem with that is that a pool of 1,000 houses is going to be very expensive. But if you slice that pool into 1,000 pieces, then each resulting security will be as cheap as one house, only with dramatically less volatility.
The purpose of banking is to make credit decisions by having private capital in first loss position against default. To ensure that that private capital remains in first loss position, any loan extended by an institution which has made a credit evaluation should stay on the books of that institution until the loan has matured.The alchemy is not that sophisticated, and while you can't "guarantee returns no matter the vacancy rate or the economic climate" you can truly reduce the average volatility without reducing the average return. It's basic diversification that works for the same reason that holding an S&P 500 index fund is probably a better idea than rolling the dice and buying a single S&P 500 stock at random.
This may make loans more expensive, but you're getting what you are paying for -- good credit decisions where the incentives are to lend out money when you expect it will be paid back.
Let's look at the other side, of how much cheaper loans benefit consumers. Prior to the mortgage securitization in the 1970s or so, homes in america were plentiful and cheap. There was no problem with there being insufficient capital in that area resulting in a shortage of housing stock. So what problem is being solved here? Cheaper loans did raise house prices and result in more outstanding debt that then had to be services. Good for the financial industry, good for existing homeowners, but not obviously good for society at large.
posted by winterspeak at
9:57 AM
7 Comments:
Agree with your post.
Additionally, I do not see any reason why Bank Certificate of Deposits should not be tradable and securitized. The loans stay on the books of the originating bank with the bank owners in the first loss position. But the end consumer can own a security comprising shares of hundreds of CD's. That way you get both the benefits of proper incentives but also allow a bit more diversification.
Aren't CDs FDIC insured?
If so, where's the risk?
Oh well, securaritzation is useful to hide the risk, so that they don't need to raise the adequate capital. Just reform the regulatory regime.
Given the role played by dodgy securitised mortgages in the recent crisis, it’s certainly tempting to say “ban securitisation”. However there is a good reason for thinking that securitised mortgages give us a more stable system than non-securitised ones, all else equal. It’s as follows.
Say a bank has a capital buffer of just 3% (the ridiculously small ratio recommended by Basel III). And say depositors make up the rest of the bank’s creditors, and their money is put into mortgages. Those mortgages only have to lose about 3% of their value and the bank is technically insolvent! Panic may set in, a la Northern Rock.
In contrast (and taking an extreme scenario) if the same bank securitises all its mortgages the moment they are granted, the bank’s liabilities would then consist only of shareholders. And shareholders are used to their shareholdings regularly losing and gaining value. So there is no panic if something goes a bit wrong with the bank.
Same goes for those owning the securitised mortgages: they have consciously taken a stake in some assets, and the nature of that stake is much the same as a shareholding: the “shareholders” expect to take a hit if the mortgages go wrong. Again: no reason to panic.
Mervyn King summed that point up when he said, ““And we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve”.
I.e. I suggest that what went wrong with securitisation recently was the nature of the mortgagers being securitised, not securitisation as such. Plus there's the fact that the criminals on Wall Street will sell bum steers if they possibly can.
Every body knows that we need more bigger step other than mere securitization but hey have some patience. Property sales is a big market.
Great explanation, "The purpose of banking is to make credit decisions by having private capital in first loss position against default. To ensure that that private capital remains in first loss position, any loan extended by an institution which has made a credit evaluation should stay on the books of that institution until the loan has matured.
This may make loans more expensive, but you're getting what you are paying for -- good credit decisions where the incentives are to lend out money when you expect it will be paid back."
The further convolutions are:
1) Whether money lent out by the Federal Reserve, and not collected by the bank from private depositors, substantially satisfies the label of 'private Capital'. I mean, the Fed has the printing press and can run unlimited banker welfare by throwing in more and more and more money to the banks to create mortgages. Securitization is the step 2 in the dilution of "To ensure that that private capital remains in first loss position, any loan extended by an institution which has made a credit evaluation should stay on the books of that institution until the loan has matured."
Indeed the current system is good neither for quality credit creation nor for society at large.
2) It should perhaps go a 1/2 step beyond "any loan extended by an institution which has made a credit evaluation should stay on the books of that institution until the loan has matured". If the loan goes bad, that is, it turns out that the borrower is unable to pay, the institution shld not be able to just confiscate the asset. I favor some sort of a "surrender value" model, ie if one serviced a 1/2 million loan for 5 years and then lost his nicely paying job, can't make payments any more, he should be able to surrender the house to the bank (if market price is lower than his loan still outstanding) and receive surrender value per a schedule published to him in advance. Something like: If you've kept up your payments for at least 3 years, then you can surrender the house at any time for the surrender value given by: (for example)
n/T of (all Principal payment made to date), where n is no of years you've made payments and T is the loan term. So towards the very end of the term, if you had to surrender, you wld get a 100% of all Principal paid, not adjusted for inflation or anything.
Something like 2) would make the bank co responsible against financing recklessly priced homes. Individual responsibility merely of the borrower is not a society or credit quality enhancing idea. It has been recognized in the abolition of debtors' prison and bankruptcy protection, but those have not been sufficient to inject lender's coresponsibility/coloseability in housing finance.
I do support FDIC protection to depositors. There needs to be some safe avenue for the man saving for retirement.
Securitization need not be a wriggle-out-of-risk-you-created concept. But it is a useful liquidity concept. Therefore, I wld agree with Winter that banks not be allowed to securitize the credit they created. But CDs being tradable is fine as a liquidity enhancing thing. The normal human being is not in business as a credit quality professional, the Bank is. So the former should be able to trade off his CD when he needs the cash. Yet the bank needs to stay put with the loan it created until the end of its term as Winter is saying.
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