Preventing another financial crisis: How to improve the securitization process

By Bengu Aytekin‡ “The art of simplicity is a puzzle of complexity.” Douglas Horton

The dream of acquiring an easy mortgage loan has vanished for the moment amid the recent financial crisis. Consumers with weak credit histories might be unable to get mortgage loans from the private market in the near future. Public loan guarantors Fannie Mae, Freddie Mac and Ginnie Mae – which before the crisis represented only about 50% of the securitization market – might stand for some time as the only conduits through which mortgages can be securitized and sold to investors. Making the market work again will require significant effort from those in both the public and private sectors to overcome the weaknesses in the system’s design.

In terms of the public sector, for example, this March the Federal Deposit Insurance Corporation (FDIC) stated that it would continue to guarantee securitized assets until September as it works to devise new standards for the market. “Markets remain the best mechanism for making decisions that involve risk,” FDIC Chairman Sheila C. Baird said, “but only if they operate under an institutional structure that requires all firms to bear the downside consequences of the risks they take.” Her proposal includes requiring institutions to retain at least five percent of that risk in an attempt to avoid a repeat of the imprudent behavior that helped trigger the 2008 credit crisis.

The 2008 credit crisis had its roots in price bubbles, which occur when price increases move out of line with macroeconomic fundamen­tals, like household income. The occurrence of price bubbles is mainly attributed to new financial instruments, which were perceived as successful innovations during good economic times, leading to more securitization of mortgages and other economic assets. Securitization involves pooling loans into transferable securities, such as in the much-criticized mortgage-backed securities market.  In this case, Bank of America and other financial institutions no longer held the mortgages they issued on their own balance sheets. Instead, they resold significant portions on the secondary market, reducing their own risks, freeing up capital for more mortgage lending, and more highly leveraging their own investments.

However, as the securitization market became more established, it grew more complex and opaque, making it increasingly difficult for investors to obtain a clear picture of the risks involved. These characteristics combined to create a price bubble for these securities. Other factors, such as freedom of the financial market to self-regulate, along with the banks’ overreliance on market dynamics and perceptions, led to less transparency and stability in the system. The securitization market turned out to be a poor mechanism to control the tendency of institutions and their investors to assume too much risk. In particular, the reigning views that markets are almost always self-correcting and that deregulation is the way to achieve more competitiveness led to regulatory gaps that were easily exploited.

One of the results of this belief was, for instance, that the ratings of the credit rating agencies were given too much weight. Hence, credit rating agencies also bear some responsibility for the crisis and its solution. Securitized products have traditionally been rated by credit rating agencies to ensure the quality of the assets backing them. However, rating agencies often mistakenly assigned inflated ratings to unproven backing assets. Investor confidence in the assessment of these rating agencies during the securitization process was so high that investors were even willing to buy securitized products based on subprime mortgages – the riskiest category of consumer loans – often without much hesitation.

Finally, banks’ business models have shifted away from the traditional model of financing that relied on deposits, to the new model based on more diversified sources of lending that rely on market-based sources such as mortgage bonds and securities. This shift has increased banks’ exposure to the instability of market dynamics and perceptions in the financial sector.

For the securitization system to work well again, several structural changes need to be made. For instance, the system’s transparency could be improved by adopting standardized disclosure packages for mortgage-backed securities and disclosing rating outcomes so that investors can better evaluate the track record of alternative suppliers of credit ratings.

Along with these measures, new regulatory arrangements – such as the strengthening of capital requirements and assuring reasonable leverage ratios – could help alleviate the problems associated with the new banking model and bring investor confidence back into the market.

The financial sector undertook tremendous innovations in the decade before the 2008 financial crisis, with securitized instruments as the centerpiece. However, the financial crisis demonstrated that current business models are unsustainable, and the financial system must be reformed accordingly. Otherwise, the current system’s failings will build up again while the world economy recovers. This build up will eventually lead to a new global financial crisis, keeping the dream of affordable mortgages unattainable.

Bengu Aytekin is an alumna of the Sanford School of Public Policy at Duke University (Master of International Development Policy program).

The History of Health Care Reform: Where We’ve Come From and Why It Matters