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How To Fix Securitization

Yesterday, I wrote approvingly of the administration's plan to force loan originators to hold onto some of the risks they create via the mortgage securitization process. But Paul Krugman, channeling Princeton colleague Hyun Song Shin, makes the good point that big banks did hold onto plenty of risk during the subprime crisis. In fact, most of their problems stemmed from this tactic. Here is Shin: reality, securitisation worked to concentrate risks in the banking sector. In a paper published this week (Shin 2009)), I argue that there was a simple reason for this. Banks wanted to increase their leverage – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself.

And Krugman's take:

Shin argues that financial firms actually used securitization to take on more risk, not to sell it to unknowing clients. This suggests that forcing firms to hold on to some of the securitized debt won’t make much if any difference.

So if keeping "skin in the game" isn't the ultimate solution, what is? A bit of good news, as Felix Salmon points out, is that the administration's white paper does see this sort of regulatory arbitrage as a risk. From the paper:

Risk-based regulatory capital requirements… should minimize opportunities for firms to use securitization to reduce their regulatory capital regulatory capital requirements without a commensurate reduction in risk.

Details on how this will actually be done are nonexistent in the paper and seem to have been put off until the end of the year when a report from a Treasury-led working group on financial regulation is due. Part of the solution, as hinted at in the paper I mentioned yesterday, could be limiting securitization by banks without big deposit bases. The researchers found that within the population of big banks, those with more deposits and liquid assets originated safer loans. (The thinking is that these banks tend to be more discriminating because they're not as reliant on securitization as a source of cash).

--Zubin Jelveh