A fascinating paper is out from the Federal Reserve Board, examining the role of securitisation in the expansion of subprime credit (H/T Alea).
We’ll save you the suspense and tell you the paper’s conclusion straight away: Yes, securitisation did exacerbate subprime.
The authors assert that the process, including the assignment of credit ratings, provided incentives for securitising banks (underwriters) to purchase loans of poor credit quality in areas with fast-rising house prices. Increased demand from the secondary mortgage market for these types of loans then, according to the paper, facilitated easier credit in the primary mortgage market, and ’round and ’round subprime went. Sounds sensible.
But one thing in the paper in particular jumped out at us — the role of underwriters, who so far have escaped attention of the same scale being lobbed at the credit rating agencies. (Though many people think they shoulder as much of the blame — if not more — as the agencies).
Underwriters are important to securitisation deals. They structure and price securitised things like CDOs and pay themselves something like 1 to 1.5 per cent of the deal principal in return. But, like the shopping taking place among the rating agencies, we suspect there was also a degree of financial finesse occurring among underwriters.
In order for securitisation deals to receive decent credit ratings, they require some amount of overcollateralisation — which is the stuff that’s meant to protect higher tranches by absorbing the first losses — the equity tranche. The size of the equity tranche depends on the quality of the underlying collateral, lower quality deals typically require a bigger equity tranche, and vice versa.
And who funds that equity tranche?
The underwriters. So, assuming that fees don’t vary too much, underwriting banks are basically incentivised to structure deals so that they require the smallest equity tranche possible. That’s not a bad thing in itself — it’s basically structuring the deal as efficiently as possible — but we imagine it came in tandem with a decline in the amount of credit enhancement provided and the quality of the underlying collateral. At the very least, as the authors of the paper note, it seems that some underwriters were buying up loans in areas with fast-appreciating house prices but lower average credit quality, to keep funding cheap.
Not to worry though. If the underwriters did exacerbate the subprime crisis, they appear to have got their comeuppance (well, some of them anyway).
The two top underwriters* of subprime securitisation deals, according to the paper?
Bear Stearns and Lehman Bros.
* That’s according to number of deals. Making a list according to value of the securitisations will yield a somewhat different set of results.
Related links:
The role of CDOs in Merrill’s losses – FT Alphaville
Investment banks provided subprime lenders with critical funding – subPrimer
Wary of risk, bankers sold shaky mortgage debt – NYT