Has Securitization Increased Risk to the Financial System?

Article excerpt


The burgeoning volume of securitizations has generated concerns over risks to the financial system in the form of excessive credit creation, reduced incentives to closely monitor loan assets, enhanced danger from the illusion of liquidity, and handicaps to the efficient implementation of monetary policy. These concerns are misplaced. To the extent securitization increases risk, the problem lies in a failure to achieve in practice what is sought in theory, that is, in a failure to shift the burden of defaults on securitized assets from financial institutions to investors in the manner assumed in accounting and regulatory treatments.

Securitization--the formation of pools of mortgages, bank loans, credit-card debts, and other financial assets into securities that are sold to investors--has become very popular very fast. The volume of assets securitized is estimated to be over $3 trillion. [1] The variety of receivables securitized climbed from three in 1985 to twenty-three by 1996. [2] Liabilities of asset-backed security issuers (special-purpose entities established to hold assets and issue debt obligations) grew at a compound annual rate of forty-six percent from 1982 to 1999, and the non-mortgage segment of those issues grew at a compound annual rate of fifty-five percent according to the Federal Reserve's flow-of-funds accounts.

Lenders find securitization a less expensive method of funding than alternatives such as issuing commercial paper or borrowing from banks. They can also enhance liquidity and lower interest-rate risk. [3] Other institutions arbitrage returns on bonds or loans with relatively high yields through securitizations. [4] Commercial banks employ securitizations to support a higher volume of lending activity with a given amount of capital by moving loan assets off their books for regulatory and accounting purposes. The resulting securities are attractive to investors because they offer higher rates of return than other marketable securities with similar credit ratings, even as credit enhancements qualify the top-rated tranches of securitizations for AAA ratings.

It is important for analysts, investors and government officials to determine whether there are significant risks to the stability of the financial system as a consequence of the surging volume of these special securities. A leading role in this inquiry has been taken by Henry Kaufman, who concludes that securitization is one in a combination of factors that does entail significant risks. [5]

Kaufman argues that securitizations promote excessive credit creation, promote an illusion of liquidity, and diminish the role of depository institutions. [6] A related concern is that securitizations result in less careful monitoring of underlying loan assets. This paper begins with a critical review of these concerns, which we find to be less worrisome than Kaufman does. We conclude, however, by identifying other sources of increased risk. Also, we find that while, by and large, securitizations are a source of stability rather than instability to the financial system, they may entail increased risks in ways that may not be widely understood.

Data Not Definitive

We acknowledge at the outset that our conclusions cannot be tested thoroughly with available data. While that data suggest the risks of securitization are minimal, [7] recent years have been good ones in the financial markets. Therefore, we cannot conclude that the creditworthiness of these instruments has been rigorously tested, particularly the creditworthiness of many of the more recent issues.

When and if credit market conditions provide a more severe test, however, it will not be enough to ask whether there were losses related to poorly performing securitizations. Rather we should ask whether those losses were more severe than the losses that would have been incurred in the absence of securitizations. …