Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Role of Bank Credit Enhancements in Securitization

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Role of Bank Credit Enhancements in Securitization

Article excerpt

I. INTRODUCTION

Does the advance of securitization--a key element in the evolution from banking to "shadow banking" (Pozsar et al. 2010) (1)--signal the decline of traditional banking? Not necessarily, for banks play a vital role in the securitization process at a number of stages, including the provision of credit enhancements. (2) Credit enhancements are protection, in the form of financial support, to cover losses on securitized assets in adverse conditions (Standard and Poor's 2008). They are in effect the "magic elixir" that enables bankers to convert pools of even poorly rated loans or mortgages into highly rated securities. Some enhancements, such as standby letters of credit, are very much in the spirit of traditional banking and are thus far from the world of shadow banking.

This article looks at enhancements provided by banks in the securitization market. We start with a set of new facts on the evolution of enhancement volume provided by U.S. bank holding companies (BHCs). We highlight the importance of bank-provided enhancements in the securitization market by comparing their market share with that of financial guaranties sold by insurance companies, one of the main sellers of credit protection in the securitization market. Contrary to the notion that banks were being eclipsed by other institutions in the shadow banking system, we find that banks have held their own against insurance firms in the enhancement business. In fact, insurers are forthright about the competition they face from banks:

Our financial guaranty insurance and reinsurance businesses also compete with other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided, in most cases, by banks, derivative products companies, and other financial institutions or governmental agencies, some of which have greater financial resources than we do, may not be facing the same market perceptions regarding their stability that we are facing and/or have been assigned the highest credit ratings awarded by one or more of the major rating agencies (Radian Groups 2007, form 10-K, p. 46).

Given the steady presence of bank-provided enhancements in the securitization market, we next study exactly what role enhancements play in banks' securitization process. The level of credit enhancements necessary to achieve a given rating is determined by a fairly mechanical procedure that reflects the rater's estimated loss function on the underlying collateral in the securitization (Ashcraft and Schuermann 2008). If estimated losses are high, then--all else equal--more enhancements are called for to achieve a given rating. Those mechanics suggest a negative relationship between the level of enhancements on a deal and the performance of securitized assets. Note that in this scenario, enhancements serve as a buffer against observable risk (as embodied in the estimated loss function).

We are interested in the idea that enhancements might also be used to solve part of the asymmetric information problems that may plague the securitization process. If banks are better informed than outside investors about the quality of the assets they are securitizing, as they almost certainly are, banks that are securitizing higher-quality assets may use enhancements as a signal of their quality. In other words, by their willingness to keep "skin in the game" to retain some risk, banks can signal their faith in the quality of their assets. Such signaling implies a positive relationship between the level of enhancements and the performance of securitized assets, just the opposite of the buffer explanation. Obviously, enhancements could, and probably do, serve both as a buffer against observable risk and a signal against unobservable (to outsiders) quality. However, since the buffer role is almost self-evidently true, we are interested in whether we can detect any evidence for the role of securitization enhancements as a signal. …

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