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| Vikrant Vig, Assistant Professor of Finance, London Business School |
The Financial Times reports today that US banks have been quietly borrowing massive amounts of money from the Federal Reserve in recent weeks by using a new measure the Fed introduced two months ago to help ease the credit crunch. In related news, a study published on Monday, shows that banks relaxed standards in respect of loans that could be repackaged and sold onward as bonds.
The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.
US officials say the trend shows that financial authorities have become far more adept at channelling liquidity into the banking system to alleviate financial stress, after failing to calm money markets last year.
The FT says that the move has sparked unease among some analysts about the stress developing in opaque corners of the US banking system and the banks’ growing reliance on indirect forms of government support.
The Wall Street Journal says today that US and European banks, already reeling from persistent losses on mortgage investments, are facing a new hit as the global financial crisis spreads to deteriorating corporate debt.
The Journal says that Credit Suisse, Switzerland's second-largest bank in stock-market value, valued its leveraged-finance portfolio of loans and bonds at a 6.3% discount as of Dec. 31. That suggests the loans and bonds have an average value of 93.7 cents on the dollar. Meanwhile, two corporate-loan credit-derivative indexes have fallen sharply in the past two weeks, indicating negative sentiment and falling demand.
If the trend holds, analysts and investors are bracing for as much as $15 billion in leveraged-loan-related write-downs at commercial and investment banks in the first quarter, further depleting capital levels already sapped by the mortgage mess. Estimates of the markdowns range from 2% to 10%.
In another report today, the Wall Street Journal that there are growing signs that Lehman Brothers, the New York investment bank, is sitting on a big pile of commercial real-estate loans, and that market is deteriorating, potentially causing bigger-than-expected write-downs.
In recent weeks, credit markets have worsened, and Lehman believes it is now facing a write-down in the $1.3 billion range, according to people familiar with the matter. That has risen from a recent estimate of $800 million to $1 billion, and from a $830 million write-down in the fourth quarter.
Study says securitization linked to lax screening standards
Approximately 60% of outstanding U.S. mortgage debt is traded in mortgage-backed securities (MBS), making the U.S. secondary mortgage market the largest fixed-income market in the world.
A study published on Monday found that the rate of default on mortgage loans has risen in recent years because banks have become more lax about screening loans when they turn these into bonds.
Defaults on US subprime loans that have been repackaged and sold onward to non-bank investors have been 20% higher than those kept on the books of lenders in the traditional manner, the study found.
The research tracked more than 2 million US subprime mortgage loans issued between 2001 and 2006, the study suggests banks and credit rating agencies have under-estimated the risk on securitized loans.
The study, which was produced by researchers at London Business School (LBS), the University of Chicago and other institutions, does not oppose the securitisation of loans and says: “we believe that securitization is an important innovation and has several merits”.
However, it is argued that securitization appears to have triggered a fall in lending standards, because when loans are turned into bonds and sold on, the losses from defaults are felt by bond holders, rather than just banks.
Vikrant Vig, Assistant Professor of Finance at LBS and an author of the study, said: “The empirical results are really neat. We find strong evidence suggesting the securitisation destroys screening incentives of banks”.
The study says that an 80% increase in securitization volume is on average associated with about a 20% increase in defaults. These defaults are being driven by characteristics of the loan or the borrower that are unobservable to both the researchers and the securities market. That we find any effect on default behaviour in one portfolio compared to another with virtually identical risk profiles, demographic characteristics, and loan terms suggests that the ease of securitization may have a direct impact on incentives elsewhere in the subprime housing market, as well as in other securitized markets.
Prof. Vig says that the "benefits of securitization are limited by information loss, and in particular the costs we document in the paper. More generally, what types of credit products should be securitized? Our conjecture is that the answer depends crucially on the information structure of the particular loans. Loans with more “hard” information are likely to benefit from securitization as compared to loans that involve “soft” information. A careful investigation of this question is a promising area for future research."
