Ifo Viewpoint No. 111: Insecure Securities: The Collapse of the US Securitization Market
Munich, 19 January 2010
Once upon a time, stocks were risky and collateralized securities were safe. That time is over, as the breakdown of the American mortgage securitization market has shown.
For years, hundreds of billions of new mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) generated from them were sold to the world to compensate for the lack of savings in the United States and to finance American housing investment. Now virtually the entire market for new issues of such securities – all but 3% of the original market volume – has vanished.
To compensate for the disappearance of that market, and for the simultaneous disappearance of non-securitized bank lending to American homeowners, 95% of US mortgages today are channeled through the state institutions Fannie Mae, Freddie Mac, and Ginnie Mae. Just as there was a time when collateralized securities were safe, there was also a time when economies with such a high degree of state intervention were called socialist.
Most of these private securities were sold to oil-exporting countries and Europe, in particular Germany, Britain, the Benelux countries, Switzerland, and Ireland. China and Japan shied away from buying such paper.
As a result, European banks have suffered from massive write-offs on toxic American securities. According to the International Monetary Fund, more than 50% of the pre-crisis equity capital of Western Europe’s national banking systems, or $1.6 trillion, will have been destroyed by the end of 2010, with the lion’s share of losses being of US origin. Thus, the resource transfer from Europe to the US is similar in size to what the US has spent on the Iraq war ($750 billion) and the Afghanistan war ($300 billion) together.
Americans now claim caveat emptor: Europeans should have known how risky these securities were when they bought them. But even AAA-rated CDOs, which the US ratings agencies had called equivalent in safety to government bonds, are now only worth one-third of their nominal value. Europeans trusted a system that was untrustworthy.
Two years ago, Ben Bernanke, chairman of the US Federal Reserve, argued that foreigners were buying US securities because they trusted America’s financial supervisory system and wanted to participate in the dynamism of its economy. Now we know that this was propaganda intended to keep the foreign money flowing, so that US households could continue to finance their lifestyles. The propaganda was successful. Even in 2008, the US was able to attract net capital inflows of $808 billion. Preliminary statistics suggest that this figure has now fallen by half.
For years, the US had a so-called “return privilege.” It earned a rate of return on its own foreign assets that was nearly twice as high as the rate it paid foreigners on US assets. One hypothesis is that this reflected better choices by US investment bankers. Another is that US ratings agencies helped fool the world by giving triple-A ratings to their American clients, while aggressively downgrading foreign borrowers. This enabled US banks to profit by offering low rates of return to foreign lenders while forcing foreign borrowers to accept high interest rates.
Indeed, it is now clear that the ratings were ridiculously distorted. While, for example, a big US rating agency gave European companies, on average, only a triple-B rating in recent years, CDOs based on MBSs easily obtained their triple A-ratings. According to the IMF, 80 percent of the CDOs were in this category. And according to an NBER working paper by Efraim Benmelech and Jennifer Dlugosz, 70% of the CDOs received a triple-A rating even though the MBSs from which they were constructed were a negative selection of MBSs, with just a B+ rating, on average, which would have made them unmarketable. The authors therefore called the process of constructing the CDOs “alchemy”, the art of turning lead into gold.
The main problem with US mortgage-based securities is that they are non-recourse. A CDO is a claim against a chain of claims that ends at US homeowners. None of the financial institutions that structure CDOs is directly liable for the repayments they promise; nor are the banks and brokers that originate the mortgages or create MBSs based on them.
Only the homeowners are liable. However, the holder of a CDO or MBS would be unable to take these homeowners to court., because he would have to sue hundreds, if not thousands, of them simultaneously. And even if he succeeded, Above all, homeowners could simply return their house keys, as they, too, enjoy the protection of non-recourse. As home prices declined and one-third of US mortgage loans went under water – that is, the property’s market value sank below the amount of the loan – three million US homeowners lost their homes, unable to meet their payment obligations, making the CDOs and MBSs empty shells.
The problem was exacerbated by fraudulent, or at least dubious, evaluation practices. For example, homeowners signed cash-back contracts with builders to feign a higher home value and receive bigger loans, and brokers’ fees were added to mortgages and the reported values of homes. Low-income people who could not be expected ever to repay their loans were given so-called NINJA credits: “No income, no job, no assets.” Banks that combined MBSs to construct CDOs calculated default probabilities under the erroneous assumption of stochastic independence and added their fees to the securitization volume, defending the obvious risk of under-collateralization this implied with the argument of “value creation”, and so on and so on. Such reckless and irresponsible behavior abounded.
The US will have to reinvent its system of mortgage finance in order to escape the socialist trap into which it has fallen. A minimal reform would be to force banks to retain on their balance sheets a certain proportion of the securities that they issue. That way, they would share the pain if the securities are not serviced – and thus gain a powerful incentive to maintain tight mortgage-lending standards.
An even better solution would be to go the European way: get rid of non-recourse loans and develop a system of finance based on covered bonds, such as the German Pfandbriefe. If a Pfandbriefcovered bond is not serviced, one can take the issuing bank to court. If the bank goes bankrupt, the holder of the covered bond has a direct claim against the homeowner, who cannot escape payment by simply returning his house key. And if the homeowner goes bankrupt, the home can be sold to service the debt.
Since their creation in Prussia in 1769 under Frederick the Great, not a single Pfandbrief has defaulted. Unlike the financial junk pouring out of the US in recent years, covered bonds are a security that is worthy of the name.
Professor for Economics and Public Finance
President of the Ifo Institute
Published by Project Syndicate (www.project-syndicate.org), 23 December 2009; additionally printed in Business Day (Nigeria), The New Times (Ruanda), The Japan Times (Japan), The Korea Herold (Südkorea), Business World (Philippinen), The Sunday Times (Sri Lanka), Die Presse (Österreich), Vilaggazdasag (Ungarn), Journal De Negocios (Portugal), L’Agefi (Schweiz), Jordan Times (Jordanien).