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Securitized Banking

The Originate and Distribute Model of Banking

Beginning in the 1990s the banking system underwent significant but largely unregistered transformations, none of which bear resemblance to either traditional banking or traditional, competitive markets.  One of the narratives surrounding these transformations is the birth of the so-called originate and distribute model (ODM) of banking.   According to this theory, instead of retaining their loans, banks began selling (i.e. "distributing") their loans to third party investors.  The ODM model of banking is depicted in Figure 34.

As Acharya and Richardson (2009) note:

Securitization alters the original idea of banking:  banks are now intermediaries between investors (rather than just depositors) and borrowers.  (199)

Consider the following example.  A bank pays $100,000 for a mortgage valued at $115,000.  The bank profits by selling the mortgage at any price above $100,000, while the investor should end up making a profit by purchasing the mortgage at any price below $115,000.  In effect, the bank trades expected future income for income in the present.

The value of future money relative to money in the present is measured by the interest rate.  The interest rate can be regarded as the cost of postponing gratification in the present.  In other words, it reflects a preference for present consumption over future consumption, which means that the former has a higher price.  The interest rate is in theory intended to compensate for the

Figure 34.  Originate and Distribute Model of Banking.

value depreciation of the principal of the loan.  The general depreciation that occurs solely as a result of time, is calculated as a discount rate.[1]  In theory, both parties to the transaction benefit.

Large banks, of course, do not sell individual loans, but rather a portfolio of loans, bundled together.  A mortgage backed security (MBS) is one example.  The selling of assets, (i.e. loans) provides the bank with profit (i.e. equity), enabling it to borrow more money and make more loans.  This system, referred to as the shadow banking system (to be discussed below), is the principle means by which the regular banking system has been funded for the past 30 years. (Gorton 2010).   

The ODM revised

The originate-and-distribute model, however, is somewhat misleading.  Banks didn't sell all of their loans.  Some of them were sold, and others were retained.  In addition, many of the loans that were sold ended up in the hands of other banks, effecting a relative concentration of public debt in the financial sector.  In short, debt was not distributed but stock-piled.

Figure 35.  Ratio of Loan Sold to Loans Kept.

The ratio of loan sales to loans outstanding began to rise in the 1990s, but never exceeded 30 percent.  Figure 35 is a time series depicting the ratio of secondary market loan sales to commercial and industrial loans outstanding.  The data are provided by Gorton (2010:  42).
Moreover, the securities markets were heavily concentrated.  As Fligstein and Goldstein report,

Contrary to view that there were too many players to control any facet of the market, by the end of the boom, 5 firms controlled at least 40% of the market (and in some cases closer to 90%) (2010:  8; my emphasis).[2]

Numerous studies corroborate these findings.  Acharya and Richardson (2009) note that about 30 percent of the world's AAA-rated asset backed securities were on the bank's balance sheets, and another 20 percent were on their off-balance-sheet-entities (SIVs).  In total, about half of the securities were kept by the banks rather than sold to other investors (Friedman 2009:  145).

This indicates that the market was not characterized by perfect competition, but was instead dominated by a few big players; and second, banks were themselves the primary investors of asset backed securities.  What then, explains the inordinate growth of securitization?  For an individual bank, it is often more profitable for banks to sell loans than to keep them, but en masse, the banks were in large part simply securitizing and selling the loans to each other.  One convincing explanation is provided by Acharya and Richardson (2009):  the banks securitized loans in order to circumvent capital requirements.

Securitized Banking, or, the "Shadow Banking System"

The need for low-risk (secure), short-term lending between giant financial institutions gave rise to what is called the shadow banking system, also known as the parallel banking system.  The pillar of the shadow banking system is the repo.  In the shadow banking system (aka securitized banking), banks both sell loans and retain loans.  Banks also move their assets off the books to what are variously called off-balance sheet vehicles, special instrument vehicles (SIVs) special purpose vehicles (SPV), or special purpose entities (SPE).  The SPV is, for all intents and purposes, a part of the bank, but legally it is a regarded as a separate entity.

The process of securitization can be broken down into a few steps, depicted in Figure 36.  First, the bank pools the cash flows from its assets and sells them to the SPV.  Second, the SPV divides up the pooled assets into tranches, or slices, creating asset backed securities of varying risk.  A collateralized debt obligation (CDO) is a type of ABS that is divided into tranches (a French word meaning "slice") of varying risk.  So-called "structured finance CDOs" create securities from other securities, pooling together tranches of equal rating (e.g. AAA, Alt-A, etc) into a new security.  Examples of collateral used in CDOs include residential mortgages, student loans, auto loans, and credit card debt.  Central to the subprime crisis was the devaluation of residential mortgage backed securities (RMBSs).

Figure 36.  Securitized Banking.

In a CDO, securities in the senior (AAA) tranche receive lower returns in exchange for a lower risk.  Losses are born first by the lowest tranches.  CDO issuance more than tripled between 2004 and 2006 (Jarsulic 2010:  27).  In addition, there were CDO-squared and CDO-cubed bonds, which pooled CDO's of varying risk (Friedman 2009; Crotty 2009).

Securitization was the primary channel of funding for mortgages during the bubble.  Whereas in 1989 47.2 percent of all mortgage originations were securitized, by 2007 approximately 75 percent were securitized (Jarsulic 2010).   Among subprime mortgages, between 2001 and 2006 the percentage securitized had risen from 60 percent to 80 percent.

It should be emphasized that securitization was a means to increase leverage.  Securitizing enabled the banks to borrow more money, both by a) moving its assets off of its balance sheets and b) by holding reduced risk-weighted ABSs.  Once the bank sells the securities to its SPV, it can then move all of those assets off its books.  A bank with $100M in assets, consisting of $90M in loans financed by $10M in equity, for example, can move (if it can find the investors) $40M of the $90M to the SPV.   The capital ratio has just gone from 10 ($100/$10) to 5 ($50/$10).  It can thereby get around its capital requirements and borrow more money.    Using SIVs thus enabled banks to exploit a loophole in the Basel I rules and allowed them to dramatically reduce their capital reserves.  This gets around the capital requirement regulations, but how does the bank convince the lenders to lend it money?  The banks issued the ABSs as collateral for the money they borrowed to buy and/or originate more loans, which they could in turn securitize into more ABSs.

Moreover, there was a strong incentive to securitize generated by the Basel I rules, which assigned a lower risk weight to all securities issued by GSE's (e.g. Fannie and Freddie) and to all ABSs receiving a AAA or AA-rating.   According to Friedman (2009):  "SIV purchases were paid for with money borrowed from money-market funds, and 95 percent of a money-market fund's investments have to be in double-A or triple-A securities"; he also adds that "of the $1.323 trillion in [MBSs] held by banks and thrifts in 2008, 93 percent were either rated triple-A or were issued by a GSE" (145).

[1]  Three, roughly approximate, methods of discounting the value of a present commodity over time are:
1.  (1+d)^ -TIME
2. exp(-d*time)
3. (1+d*dt)^(-time/dt), or (1+d*dt)^(-time),
where d is the rate of discount and dt is the derivative of time.   The discount rate presupposes that the future is worth less than the present.  Some argue that this attitude towards time, contributes to environmental degradation and resource depletion, among other social ills (cf. Deb 2009).      
[2]  Available at:  http://sociology.berkeley.edu/profiles/fligstein/pdf/The%20Anatomy%20of%20the%20Mortgage%20Securitization%20Crisis5.pdf