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Securitization of mortgages & Crisis Comparison (1929, 2007, same same but different?)

October 11, 2009

I just finished writing my part of a paper for a class I’m currently taking (Capital Markets & Institutions) and quite like my segment on the securitization process and its effect on the increase of asymmetric information as well as a quick comparison with The Great Depression so I’m going to copy/paste it here. In case my prof. stumbles upon this, I’m Jean-Michel Savard-Lamontagne from your CMI class, this isn’t plagiarism.

Securitization

Advantages

From the viewpoint of the initial lender (bank), securitization means that the default risk associated with any given borrower is nullified past the short period during which the bank holds the loan. This means that the bank can profit from its lending operations through fees it charges for payment collection and having made the loan, yet it can externalize any risk of default. This also means that the bank doesn’t have to worry as much about asymmetric information since it is not the one who will hold the loan, which can result in lower costs in researching the creditworthiness of the applicant. Finally the process of securitization means that the mortgage assets of a bank are much more liquid since a large secondary market now exists for them where previously they would have had to sell the mortgage to another bank. The investors who end up holding these securities can also gain from this structure since they are able to hold large amounts of mortgage debt without having to run a bank’s operations. Most importantly, the investors can avoid the lemon problem by holding thousands of mortgages packaged into one: while some of the mortgages will likely default, theoretically, the group of mortgages as a whole should have a predictable default rate (here, having the least co-variance between the mortgages’ collateral value is best; holding 1000 mortgages from Ste-Foy, QC might not be good if that market crashes but holding 1000 mortgages spread over all provinces can be much less risky). Finally from the viewpoint of the potential debtor, that is individuals seeking a mortgage, the securitization of mortgages means that investors can invest in mortgages and hence increase the supply of money looking to invest in mortgages, something that can only be good for people looking to get a mortgage (lower rates and/or lower application standards).

Asymmetric Information

One of the major problems associated with subprime loans is the problem of asymmetric information and the adverse effects it has on the market for these loans. We have seen in class two major problems associated with asymmetric information: that of adverse selection, and that of moral hazard. Before we address these, let us observe that the structure of the market for securitized subprime loans is such that the long-term holder of the debt being securitized are, typically, several intermediaries separated from the debtor (debtor → bank → Freddie Mac or Fannie Mae → Investment bank → Investor). Thus, the investor has very little knowledge, if any, about the debtor, which is a self-evident cause of asymmetric information. This leads to adverse selection as the investor cannot differentiate between loans that are risky to an acceptable level (subprime, yes, but not bound to be delinquent) and those that are certain to default within a certain amount of time. Furthermore, the banks which provide the bulk of the loans packaged into these securities have an incentive to hold the better loans on their own books and resell those that are of lesser quality, doing exactly the opposite of that which would be desirable as a solution to that problem (presented as the first and fourth solutions in class notes, those of private production and sale of information and of financial intermediation). Another solution presented in class was government regulation, of which there is none in this market as it is not covered by SEC (or any other regulator) regulations. Even considering all of the risks and problems outlined above, investors are still easy to lure due to the concept of collateral: who cares if one debtor are prone to default when the collateral is worth more than the loan and can either be re-sold for profit by the investor or used as collateral for re-financing of the property? Obviously a crashing real estate market was not factored in when calculating risk. A last crucial aspect that arises from asymmetric information is related to moral hazard, especially from the debtor’s point of view: as soon as the market value of one’s home falls below the value of the mortgage of the house by an amount higher than one’s net worth, defaulting on the loan and declaring personal bankruptcy becomes a rational possibility, often better for the individual than not defaulting even when monthly payments can be made without problem.

The Driving Factor?

Considering the facts outlined above, we would conclude that the securitization of subprime loans itself is not the driving factor of the crisis but rather one of many. The securitization itself can have many benefits (see 1.) if used responsibly. However, its proliferation to absurd levels and the involvement of considerable amounts of non-qualified actors in the market (from Norwegian institutional investor to credit rating agencies doling out AAA ratings by the dozen) as well as its ability to bypass regulators’ radars means that the decade’s hip security will have to see its role in financial markets seriously re-evaluated. It is not, however, to be blamed for the crisis any more than kitchen knives are to be blamed for violence. The irrational real estate bubble in multiple developed countries, the inadequate regulatory environment (the AIG financial arm was regulated by an obscure agency, for example), the willingness of investors to drop billions of dollars in a market they were very unfamiliar with, the irrational American political will to incentivise home ownership and the structure of the modern financial corporation (from its management structure to its payouts structure[1]) are all within the realm of blame to differing degrees.


[1] “Management” by Dr. Henry Mintzberg, 2009

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First Post, Executive Pay; Moving to wordpress

October 11, 2009

I’m moving my blog to wordpress, re-posting the 2 posts I had on there

There probably won’t be anyone reading this first issue of my new blog considering its infancy and the fact that I haven’t quite told anyone about it just yet. I’m a business student at the Desautels Faculty of Management (McGill University) in Montreal majoring in Finance and have taken quite an interest over the past few years in international economics and diplomacy. My intent is to use this parcel of cyber-space to comment on current events relevant to the aforementioned fields and, hopefully, share the experience of a Finance student in the current economic and labour conditions.
I’d like to kick off this first post by considering an issue that is hard to address and important in financial industry at this moment: pay regulation. While, broadly speaking, I dislike the thought of government-regulated pay of financial executives, I still agree with Professor Hamilton’s comments on the need to re-establish the link between shareholders’ incentives and executives’:

One of the key questions for understanding the causes of our current problems is the following. Suppose that in 2005, the individuals who were putting together securities derived from subprime and alt-A mortgage loans could have known, with perfect foresight, events that were going to unfold in 2008. Would they have still done the same things they did in 2005? My concern is that, for many individuals, the answer might be “yes”, insofar as they were richly rewarded personally in 2005 for making exactly the decisions they did. It was other parties (namely you and me) who later down the road were forced to absorb the downside of their gambles. Capitalism functions well when individuals are rewarded for making socially productive decisions. It is a disaster when individuals are rewarded for making socially destructive decisions. For this reason, I am quite supportive of the broad idea of the above proposal.

One of the key questions for understanding the causes of our current problems is the following. Suppose that in 2005, the individuals who were putting together securities derived from subprime and alt-A mortgage loans could have known, with perfect foresight, events that were going to unfold in 2008. Would they have still done the same things they did in 2005? My concern is that, for many individuals, the answer might be “yes”, insofar as they were richly rewarded personally in 2005 for making exactly the decisions they did. It was other parties (namely you and me) who later down the road were forced to absorb the downside of their gambles. Capitalism functions well when individuals are rewarded for making socially productive decisions. It is a disaster when individuals are rewarded for making socially destructive decisions. For this reason, I am quite supportive of the broad idea of the above proposal.Specifically, top executives’ pay should skewed more towards either deferred pay over many years and/or linked to equity with longer requirements of minimum holding time before selling. This would provide an environment where firms can compete for the best minds by providing great incentives yet still align their firm’s long-term interests with those of their managers.

Hello world!

October 11, 2009

Welcome to WordPress.com. This is your first post. Edit or delete it and start blogging!