Why banks had so much skin in the game

One of the great surprises of the financial crisis of 2007-2008 was that commercial and investment banks held one-fourth of the mortgage-backed securities they’d supposedly sold to investors.

This surprise shot a big hole in the pre-crisis theory that securitization would make banks safer because instead of holding onto the loans they made, they would pool them and sell securities backed by those pools to investors, in effect transfering the loan risk to investors.

It also shot a big hole in the post-crisis theory that banks didn’t care if they made lousy home loans because they sold the risk to investors. How to explain that banks held many of the securities themselves, if banks knew the loans were bound to fail?

An August 2011 study by three finance professors says banks held on to the highest rated mortgage-backed securities to convince clients that the securities were good investments, so clients would buy some, too.

Here’s how economist Tyler Cowen, professor at George Mason University in Washington, D.C., summarizes the study in his blog the Marginal Revolution:

In other words, it was not “too big to fail moral hazard” and it also was not venal corporate incentives.  It was possibly some regulatory arbitrage but also just plain, flat stupidity and complacency.

The study, “Why did U.S. banks invest in highly-rated securitization tranches?” was authored by Isil Erel and René M. Stulz of Ohio State University and Taylor D. Nadauld of Brigham Young University. According to the report, Stulz “has been and is involved in compensated activities, including expert testimony, on behalf of large financial institutions related to the securities studied in this paper.”

  The authors said they examined and discarded or could not prove the following explanations:

– Banks weren’t worried about the risk because they knew they were so big the federal government couldn’t let them fail.

– Banks could hold the securities with lower regulatory capital than if they held the underlying loans. In other words, holding onto mortgage-backed securities was a ploy to reduce banks’ capital requirements.

– Bankers were paid to structure deals and didn’t care who got stuck with the bad securities.

– Bankers thought these securities were good investments.

– Banks that are too big to fail have a lower cost of funds than other banks, because the market doesn’t expect them to fail, so investing in risky assets didn’t raise their borrowing costs much.

The study did not consider whether banks held onto the securities to use them as collateral for repo loans.

From the study:

So-called toxic assets held by U.S. financial institutions were at the heart of the recent financial crisis. A mainstream view of the role of these assets is that their loss in value led financial institutions to have low capital, which forced them to raise more capital, to cut back on making loans, and to engage in fire sales (see Brunnermeier (2009)). The most visible and controversial policy initiative of the U.S. Treasury to deal with the crisis, TARP, started as an attempt to fund the purchase of toxic assets from banks.

Though a vigorous debate has been taking place on why banks held these assets, to our knowledge, there is no systematic investigation of the various theories that have been advanced to explain these holdings. In this paper, we estimate bank holdings of assets that became toxic and investigate which of the various theories advanced to explain these holdings are consistent with the empirical evidence. …

Before the crisis, it was widely believed that the originate-to-distribute model would make banks safer and reduce systemic risk (e.g., Greenspan (2004)). However, a substantial fraction of securities issued through securitizations did not leave the banking system and eventually became the banks’ most notorious toxic assets.

In trying to understand why the subprime losses were followed by a long-lasting financial crisis while stock market losses from the crash of 1987 that were of roughly similar magnitude were not, economists have argued that the key difference between the subprime crisis and the stock market crash is that the subprime crisis led to large bank losses through the securities that they retained from securitizations while the crash of 1987 did not lead to significant bank losses.

Although the securities clearly were a drain on banks during the financial crisis, they were minor holdings when compared to total assets, the report says:

The median holdings of highly-rated tranches normalized by total assets are less than 0.2 percent. Obviously, for the typical bank, these holdings were not material. The mean across banks was about 1.3 percent in 2006. Again, average holdings of highly-rated tranches across banks were not threatening. Banks with large trading portfolios (more than $1 billion of trading assets and trading assets representing more than 10 percent of total assets) had higher holdings, as the average for these banks represented about 5 percent of assets as of 2006.