05 December 2010

Securitisation – Fast Way to Create Debt

Money creation and profit generation as described in our earlier post “Compound Interest and Loan Growth” may be a good and sure way for getting rich, but things really need to get sped up for making banking more than just a boring business. I don’t know if the one who brought securitisation into banking thought exactly this, but what securitisation turned out to be is a fast way of making profits via technically enabling to create almost unlimited amounts of debt without creating money, and this almost without any time lags. Until music is playing, everyone gets its part of the profits: lender is compensated by cash for the purchase of the loan and by fees, servicer is compensated with fees based on the volume of loans serviced, rating agencies earn fees for assigning ratings to the various securities issued by SPV (Special Purpose Vehicle, also denoted as SPE – Special Purpose Entity), underwriter collects fees for administering the issuance of the securities to investors etc. etc. That’s why securitisation grew from a non-existent industry in 1970 to a multi-trillion-dollar business now. So much for introduction, let’s now go to the mechanics of this debt-making-machine.

The following example is of course very much simplified. In reality, a bank that wants to benefit from securitisation has to make sure that the SPV fulfils all the criteria necessary for keeping it off balance sheet. There are many more participants in the securitisation process, and commissions, fees and other costs related to the creation of suitable securitisation structures. We also assume only one bank and one SPV, although in reality there are and need to be several of them for making the process possible. It’s not our aim to explain the technical details of securitisation, but to illustrate its fundamental flaw from systemic perspective. If you need some more background information about securitisation, I’d recommend you to begin with the respective Wikipedia article, and/or read e.g. the statement of Cameron L. Cowan that he made in 5 November 2003 on a Hearing on Protecting Homeowners (although the statement about the decrease of systemic risk is not a valid statement as we shall see, and the pointed out benefits for the investors are questionable), or the statement of Sheila C.Bair in 17 April 2007 about Possible Responses to Rising Mortgage Foreclosures.

As starting point, we take the bank’s balance sheet as it was presented in Figure 5 of the post “Compound Interest and Loan Growth”, and clean it a bit:

In this example, the bank’s reserve ratio (cash and reserves with central bank divided by deposits) is 10% and capital ratio (capital divided by total assets) 9.5%. Let’s say, the bank aims to improve its liquidity up to 15%. It also wants to earn some more commission income by granting more loans and charging more fees, while not causing its capital ratio to fall. For achieving these goals, the bank decides to sell a part of its loans, let’s say 5,000.00 of them. A SPV is being set up. First, the SPV “borrows” these loans from the bank as a result of which it owes to the bank 5,000.00, but owns the loans to the public in the same amount. Figure 2-a and Figure 2-b depict the SPV’s and bank’s financial positions respectively.

Now the SPV issues its securities to investors. These securities are collateralised by the purchased loans that in turn are “sliced and diced”, as a result of which investors with different risk preferences can buy securities that (seemingly) perfectly match their needs and wishes. Using the money received from investors, SPV repays its debt to the bank. The resulting SPV’s balance sheet and the respective bank’s balance sheet are depicted in Figures 2-c and 2-d respectively. Note that in the bank’s balance sheet the deposits have declined from 10,000.00 to 5,000.00. This is because investors also deposit their money in the bank and now, after purchasing securities from SPV, have just 5,000.00 less in bank deposits. For meeting the targeted reserve ratio (15%), the bank now needs lower reserves in central bank (750 units of money that is 15% of 5,000.00). So there is free cash in the amount of 250.00.

The free cash can be used for granting new loans. Remembering how fractional reserve system works, it’s possible to easily calculate the maximum amount of newly issued loans: 250.00/15% which is approximately 1,666.67. When adding this amount to the existing loans in bank’s balance sheet, we arrive to the following numbers:

When analysing the Figure above, we can see that the bank has achieved its goals: its reserve ratio is now 15%, it has granted new loans and collected  more commission fees (which for presentation clarity are not shown in our numbers), and it has even improved its capital ratio from 9.5% to 13.6%.

Let’s say the bank likes this originate-to-distribute model. Why to risk and finance long-term assets (such as mortgage loans) with short term liabilities (deposits) if it’s possible to get cash back immediately, grant new loans and earn from different kinds of fees? Suppose the bank will not sell everything to SPV, but just the loans granted in previous step, i.e. in the amount of 1,666.67. The resulting SPV’s and bank’s balance sheets are depicted in Figures 4-a and 4-b respectively.

What is interesting in here, is that the bank (without taking into account additionally earned commission fees from newly granted loans) is after this step exactly in the same situation as it was after the previous step (see Figure 2-d above). The total loans outstanding (both, in bank’s balance sheet plus in SPV’s balance sheet) have increased from the amount of 10,052.43 at the beginning of the example to the amount of 11,719.09. Deposits at the same time have not increased. Instead, a part of people’s assets is in the form of securities issued by the SPV. That’s not all, by far. The bank can technically “spin” the money in this way endlessly or in practice until there is any demand for new loans and/or securities issued by SPV.

Good, but imagine what happens if loans start to default (which they will do because sooner or later the interests payable for the loans will exceed the amount of available deposits) and investors will not receive their expected cash flows? No one will any more like the securities issued by SPV and backed by the loans. Everyone starts selling. Prices go down. Riches are destroyed, card houses collapse.

The question remains: are the benefits of securitisation really so significant that they justify this simple but fatal flaw in the securitisation framework?

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