The new argument against securitization

I’ll give you just one argument in favor of securitization, it’s called Basel II.People respond to incentives.
Securitization cuts risk capital requirements and therefore borrowing costs.
If there is no market for securitized paper, expect borrowing costs to rise sharply, it makes little sense for banks to hold that paper on the balance sheet at current spreads levels.This is why there is some “dislocation” in the market as the pundits say.The wholesale price is a long way from the retail one.

I have been asking this question for a while with no answer: how big is the problem?. Supposing you could find someone who services the loan who also has authority to renegotiate it — contrary to Krugman’s claim that “…there’s nobody to deal with.” which I find very odd — how big is the problem? How much would it cost (forget about who pays quite yet) to bring monthly payments to a level where “enough” people wouldn’t default? If the “teaser” rate is 2% and the current market is 7% that’s a 5% spread. There’s a finite number and there is also a finite number of potential defaultee. How big is the shortfall on a monthly basis?

Given that the percentage of loans that are in default is still small and given that this risk was factored into the way the loans were repackaged why is there even a panic? Obviously the cause lies elsewhere.

I think it is best to look at how highly leveraged the hedge funds and buyout firms are. They even brag about how much money they control compared to their capital. If some owns a subprime portfolio and, say, 6% of the loans are in default then the value of the fund should drop by less than 6% (some of the capital will be recovered). This is not a very big risk. On the other hand if you have borrowed 90% of the value of a deal to fund a takeover or buyout and the asset drops 10% in price you are wiped out.

Even if the asset drop 2-3% you will most likely get a margin call. If you can’t cover it you will be sold out. If too many people get caught trying to exit at the same time they all get stuck in the doorway.

This is what happened in 1929 and to prevent a recurrence the SEC put into effect margin and trading rules. The hedge fund and allied industries have been explicitly exempted from these requirements. The result is the classic crash.

Stop looking at the subprime market and focus instead on the financial speculators. It is likely that they will be bailed out by the government. Rich people don’t lose money. The US has even sent in the marines to protect the interests of American investors, so some loan guarantees or other measures will be much easier to implement.

How can such a brilliant economist know virtually nothing about banking or business in general? Krugman implies the government should not bail out hedge funds and investment banks because it will create a moral hazard. What about the role played by borrowers who purchased homes they obviously couldn’t afford? Doesn’t this “workout† plan suggested by Krugman create the same moral hazard on the individual level?

Secondly, Krugman states that “there’s nobody to deal with.† Who does he think is servicing the loans? If a work out is the best option for the banks, then they will certainly offer this option to the homeowner. If the bank can make more money with a foreclosure then the bank will exercise this option. In this market (falling real estate prices and high loan to value ratios) in most cases the bank will offer to a work out but in my opinion many homeowners will realize that they owe more than the home is worth and they will simply walk away from the home. This scenario played out in the Los Angeles real estate market in the early 1990s.

Finally, what does Krugman think will happen if a few hundred thousands borrowers lose their homes to foreclosure? They will exchange their $3000 a month mortgage payment for the $1500 a month rent payment they should have opted for before they bought the house they couldn’t afford.

This is not a “market failure† by any stretch of the imagination. Did the market lower borrowing rates to their lowest level in 40 years after September 11th? Did the market keep those rates that low for several years? I seem to remember it was the Federal Reserve who did that and the market responded the way any market will respond to cheap money, the market make a lot of bad loans.

Why is it the de facto position of Krugman that the government should step in and help whenever people make bad decisions? Did the lenders engage in shady practices in some cases? Yes, they did and if they broke the law they should be prosecuted. Should the taxpayers insulate everyone from bad financial decisions? I don’t think so.

Echoing a comment above, I’m shocked at how Krugman manages to blow this. Well, ok, maybe “shocked” isn’t the right term, his credibility with me was already low when he burned off the rest of it during the CNOOC deal.

But I’m still surprised at how little of the detail he understands. Sub-prime delinquency has increased drastically in period-to-period % terms, but from an unnaturally low base. What has driven the current crisis is the extreme effective leverage applied by some of the ABS buyers. You can make a AAA tranche out of sub-prime paper, but only by putting it in a last-loss position vis-a-vis a first-loss “equity” tranche. Buy that equity tranche and you’ve already applied leverage. Buy it on deep margin and you’ve got a lever big enough to shift the Moon. And the slightest bump wipes you out. This has very little to do with work-out difficulties (and work-outs often don’t, um, work out anyway) or less info on the part of new-style lenders (they have less info, to be sure, but it shows in pricing differentials; I regularly see us undercut by credit unions that know their customers well). It has to do with the risk that must exist if you’re getting outsized returns, even if you don’t see it.

As sort_of_knowledgable puts it above, “If the servicer can renegotiate the loan he didn’t really sell it because he has control over it.”

So, to the extent that securitization creates multiple independent legal claims to the income stream, and to the extent that these claims complicate renegotiation, the real issue concerning possibility of market failure has to do with re-assembly (you might call it unsecuritization) of all legal claims to the income stream from a mortgage.

Here’s a cross-post of my comment over at voxbaby.blogspot.com (specifically, at this post):

The securitization of pieces of mortgages surely increases the transactions costs of workouts. One view of this fact is that we’re stuck with it. Another view is that it creates an opening for further innovation—namely, firms specializing in re-assembling troubled mortgages.

It seems to me that re-assembly is a necessary part of workouts, as well as outcomes like your

In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender.

If the mortgage hasn’t been fully assembled, there would surely be title/lien problems with this otherwise-sensible approach.

So one way to reconcile your dispute of Krugman’s market failure claim, I think, is that there are market failures only if there is some reason to think that the re-assembly market has a failure.

If there is a failure, then the issue isn’t just your point about higher TC “in the event of default”. Rather, the event of default is the event of a (most likely unforeseen) market failure. On the other hand, if re-assembly can be done competitively without market failures, then what we really have is a situation in which the higher transaction costs “in the event of default” can actually be reduced via further financial innovation.

Could markets in re-assembly be competitive? Well, obviously there are already secondary markets in these securities–that’s how we got to this point. The key question is not whether these markets exist, or even whether there are short-term liquidity problems like those that have hit the markets recently. Rather, the key question is whether there is some distinct failure related specifically to the re-assembly of all chunks of a mortgage.

To be sure, there are some conceivable hitches. For example, holdup problems could arise if a holder of the last non-re-assembled chunk of a mortgage figures out its status. Obviously being the last holder conveys bargaining power, and this could cause inefficient delay.

(As usual the efficiency problem isn’t the case of the last holder that uses bargaining power, but rather jockeying on the part of multiple agents to achieve that bargaining power.)

To the extent that auctions or hiding any given loan’s re-assembly status can avoid such holdup problems, it seems likely that such a market could avoid serious failures.

Suppose that market failures turn out to exist in re-assembly and be severe enough to cause non-existence of the market. I’m skeptical that this would happen, but let’s say it did.

Perhaps the most reasonable government policy (leaving aside Dean Baker’s) intervention might then be to have Fannie Mae do the re-assembly and then re-sell the fully titled mortgage security on open financial markets. There would, by hypothesis, be high costs for Fannie Mae in re-assembly. But surely we could expect the demand side of such markets to be competitive. The sort of workouts that Krugman proposes or re-sales that you mention would then be feasible via direct negotiations between residents and their new creditors.

Obviously this isn’t my field of expertise, so I’m curious as to your thoughts.

jck,
I suggest (assuming that you have a mortgage) that you try and contact your mortgage lender and renogotiate anything. I remember when rates were falling, I tried to negotiate a lower (but higher than current) rate on my existing loan. I just got blank stares when I suggested that they might prefer to keep my loan at 6% (I was paying slightly more than 7)…so I just refied to 5 at a different institution.

Now of course, non payment may focus them…but as servicers only where exactly is the incentive?

Krugman is right for the wrong reasons. It’s not that “there’s no one to deal with,” but that the negotiating parties will likely never get together.

Consider the old-time banking situation of holding a mortgage on your bank’s balance sheet. If the borrower got in trouble, you could look at the situation, grant a 30-day forbearance, etc., and get the loan current, maybe.

In the securitized world, the mortgage has been sold to a bankruptcy-remote entity different from the original lender. It’s been packaged into a pool of thousands (or tens of thousands) of mortgages. It’s sold to Wall Street investors, frequently not to just one buyer. So when one or a hundred of the borrowers are delinquent or in default, and there are dozens of MBS holders, you can see the difficulty in getting everyone together for any type of work-out on the mortgages.

The other, probably bigger problem, is that the terms of the SPE trust are explicit as to what the servicer must do once a borrower is 30, 60, 90 days overdue. No exceptions — no old time “It’s a Wonderful Life” banking.

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