Why do banks securitize loans?

1
Why do banks securitize loans?

• More efficiently use expensive capital
• Regulatory capital arbitrage
• SPV with credit enhancement versus retaining the
  loans in the portfolio
• 1/10 capital requirement
• Credit enhancement liquidity enhancement?
• Securitization without risk transfer?
• Spanish system
• Performance of banks that set up bigger SPVs

2
Securitization methods

• Pass through securitizations (no credit
  enhancement, no layering)
• CDOs (magic of diversification? whats the idea
  behind tranching ABS?)
• ABCP conduits (securitization without risk
  transfer?)

3
Whats wrong with tranching?

• Default correlations are ignored
• Example A mortgage pool with 2 loans each with a
  face value of 1 and default probability of 10.
  Two investors each invest 1, one buys the senior
  tranche the other one buys the junior tranche.
• If defaults are uncorrelated, default probability
  of the senior tranche 1.
• If defaults are perfectly correlated, default
  probability of the senior tranche 10.

4
Securitization and bank incentives

• Securitization reduces banks incentive to
  properly screen and monitor their borrowers
• However, this cannot explain the large losses
  banks took during the crisis
• 39 of securitized loans were sitting on banks
  balance sheets as of June 2008

5
The role of rating agencies

• 44 of Moodys revenues in 2006 came from rating
  structured finance products
• 27 out of 30 AAA-rated CDOs underwritten by
  Merrill were downgraded to junk within a year
• Illusion of comparability of corporate bond (1
  AAA) and CDO ratings (60 AAA)
• Barely enough to obtain a AAA rating

6
Agency problems at rating agencies?

• One analyst expressed concern that her firms
  model did not capture half of the deals risk,
  but that it could be structured by cows and we
  would rate it
• An analytical manager in the same rating agency
  Lets hope we are all wealthy and retired by the
  time this house of cards falters.

7
Or is it ignorance?

• CEO of First Pacific Advisors on the phone with
  an associate at Fitch
• FPC What are the key drivers of your rating
  model?
• Fitch FICO scores and home price appreciation
  of low single digit or mid single digit, as home
  price appreciation has been for the last 50
  years.
• FPC What if home price appreciation was flat
  for an extended period of time?
• Fitch Our model would start to break down.
• FPC What if home prices decline 1 to 2 for an
  extended period of time?
• Fitch The models would break down completely.
• FPC With 2 depreciation, how far up the
  ratings scale would it harm?
• Fitch It might go as high as the AA or AAA
  tranches.