Securitized banking fueled by myths

Four myths made securitized banking seem safe before the financial crisis, Eric S Rosengren, president of the Federal Reserve Bank of Boston, said in a speech at Boston University February 28.

Securitized banking is securitization financed mainly with repo loans.

This is not new, Rosengren said. For example, in the late 1980s many in Japan believed the myth that real estate prices could not fall. And in the late 1990s, many in the U.S. believed the myth that Internet company values could not fall.

From Rosengren’s speech, here are the myths:

Myth 1 – Diversification eliminated the risk of declines in residential real estate holdings

Despite the experience of Japan’s real estate in the 1990s, and substantial declines in real estate prices in many regions of the United States throughout history, many commentators argued that a significant, widespread housing-price decline in a country as large and varied as the United States had not happened historically and was very unlikely to occur.

Myth 2 – Triple-A mortgage securities carried little risk

Securitizations were structured so that any losses were first borne by lower-rated securities built from the pool of underlying mortgages. Given the structure, the assumption was that lower-valued securities would take all potential losses if borrowers defaulted.

Myth 3 – The “originate to distribute” model limited the balance-sheet risk of banks

Over the decade preceding the crisis, large commercial and investment banks had become increasingly involved in securitizing mortgage assets. They argued that this provided a steady stream of fee income but generated little risk for the bank. While they packaged mortgages, they were not retaining the risk in their own portfolio – instead, the risk was taken by those that purchased the mortgage securities, particularly the lower-rated mortgage
securities.

What was frequently ignored by many was the rapid growth of Triple-A mortgage securities holdings elsewhere within the banks, as well as in off balance sheet structures. …

In a sense, “originate to distribute” was, in practice, something more like “originate to hold, loosely, somewhat off to the side.”

Myth 4 – Investment banks were not subject to runs, because their liabilities were collateralized

It was assumed that because there was collateral backing up the (repo) loans, borrowers were protected and would not run. … However, the lenders in this market were other banks, money-market funds, and hedge funds. As questions about the value of the collateral became more prominent, and the solvency and liquidity of investment banks became a greater concern, many short-term lenders abandoned the market.