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FR8SF
WEEKLY lETTER
July 4, 1986
Securitization and Banking;::;
Securitization is not a word that can be found in
the dictionary but is heard with increasing frequenCy in finanCial rnarkets. Securitization is the
process of turning an otherwise illiquid financial
asset into a marketable piece of paper. The
securitization of mortgages, automobile loans,
accounts receivable, credit card receivables and
a variety of other financial assets is a growing
practice in both
and international financial
markets.
u.s.
This Letter examines the causes of rapid growth
in securitization and evaluiltes the implications.
As we shall see, securitization increases the efficiency of financial markets but also brings a special type of risk and has important implications
for the structure of the banking system in particular.
Securitization
Securitization refers to the practice of creating
marketable debt instruments that are backed by
specifically designated assets. A mortgagebacked security, such as those guaranteed by the
GovernmentNational Mortgage Association
(GNMA) for example, is backed by specific
mortgages on specific parcels of real estate. The
payments of interest and principal to holders of
such securities are supported by the payments
on the underlying loans. (Indeed, in the case of
GNMA "pass-through" securities, the payments
on the underlying mortgages are simply passed
through to the holders of the GNMA securities.)
Although securitization of an asset is, in some
sense, tantamount to selling the asset, the original holder of the asset usually retains some
responsibilities related to the asset. For example,
the responsibility for servicing securitized loans
(that is, collecting interest and principal payments) may remain with the originator of the
loan. The issuer of a loan-backed security may
even guarantee interest and principal payment,
thereby retaining the responsibility to manage
default risk. In such a case, creation of a loanbacked security involves "transfer [of the loan]
with recourse." Unlike a true sale of a loan out
of portfolio, transactions with recourse relieve
the issuer (such as a bank) of the securitized
asset of interest rate risk (the risk that changes in
interest rates will affect the loan's value) but
leave him with credit risk (default risk).
Securitization and financial intermediation
To understand better the causes and implications of securitization, it is helpful to relate
securitization to the process of financial intermediation as it has traditionally been performed
by commercial banks and others. In general,
financial intermediaries facilitate the flow of
funds from savers to borrowers. They do this by
creating liability and asset instruments that
simultaneously satisfy the diverse needs of
lenders and borrowers, respectively.
Individual savers, for example, may wish to loan
out their funds in smaller denominations and for
shorter periods of time than borrowers may wish
to borrow. Among the services financial intermediaries provide is the matching of small
denomination savers with large denomination
borrowers ("denomination intermediation") and
making long-term loans to borrowers using
funds provided by the short-term deposits of
savers ("interest rate intermediation"). In addition, because financial intermediaries loan out
deposited funds in a diversified manner, savers
implicitly enjoy some reduction in the credit or
default risk to which they would otherwise be
exposed.
Securitization, in contrast, involves savers
directly in the process of lending to borrowers.
Although financial intermediaries may originate
the securitized assets (such as mortgage loans),
in the end, securitization creates a direct obligation between specific borrowers and specific
lenders and is more nearly like direct placement
of debt. The extent to which securitization
occurs depends, in part, on how economically
the goals of savers and borrowers can be
achieved in this manner rather than through
financial intermediaries.
With modern electronic transactions technology
and with the growth of certain specialized financial markets, it has become increasingly easy to
synthesize the services of the financial inter-
FRBSF
mediary in an "unbundled fashion," leading to
increased demand for securitized debt by savers.
Until recently, for example, it was difficult for
savers to avoid the interest rate risk associated
with making long-term loans directly.Today,
active financial futures and options markets permit individual savers to buy directly the desired
degree of protection from interest rate risk in
specialized markets. Similarly, mutual funds permit an individual saver to acquire relatively
small-denomination, diversified interest in debt
securities. Such developments make it possible
for savers and borrowers to satisfy their diverse
needs without employing a financial intermediary in the traditional sense.
Government protection and securitization
Various government policies also intentionally
or unintentionally encourage securitization. Certain securities backed by residential mortgages,
for example, are guaranteed against loss of principal or interest by the federal government.
These guarantees make such securities - notably those issued by GNMA - easier tomarket.
They also promote an active secondary market
for residential mortgages that helps mortgage
lenders adjust the composition of their asset
portfolios.
Securitization also is stimulated, perhaps
inadvertently, by the implicit and explicit pro·
tection of bank liabilities that results from the
reluctance of policymakers to let banks fail. This
encourages banks to sell guarantees or recourse
services for securitized assets. These guarantees
-in the form of Standby Letters of Credit (SLCs)
or Recourse Notes - are essentially liabilities of
the bank and may therefore be perceived by the
marketplace as enjoying some of the protection
explicitly afforded insured deposit liabilities. The "
result is that banks may be able to offer credible
guarantees more competitively thannoninsured
institutions. (Indeed, it was only very recently
that the Supreme Court ruled that SLCs are not
to be treated as insured liabilities.)
Deposit protection only encourages securitization in general, but when combined with other
regulatory policies, it also encourages insured
financial intermediaries to sell their own assets
with recourse. The reason is that, under current
regulation, removing the asset from their portfolios makes it easier for financial intermediaries
to comply with capital/asset ratios and, at the
same time, profitably increase their effective
degree of leverage.
Growth of securitization
Securitization is thus one manifestation of how
financial innovation - driven by technological
and other changes - is moving some parts of
financing activity away from financial intermediaries. Even venerable securitized instruments
such as "pass-throughs" backed by residential
mortgages grew 40 percent between 1983 and
1985 versus only 20 percent and 17 percent,
respectively, for mortgages and commercial and
industrial loans (C&I) held in the portfolios of
financial intermediaries. The growth trend is
even more pronounced for the newer assetbacked securities such as collateralized mortgage obligations (CMOs), and securitized automobile loans, commercial mortgages and credit
card receivables. Public offerings of securities
backed by automobile loans, for example,
reached approximately $1.5 billion in the first
half of 1986 - twice the volume in all of 1985,
and CMOs (a more compl icated variant of the
mortgage pass-through) grew by over .3'00 percent between 1983 and 1985.
It is interesting to note that the vast majority of
this securitization activity involves assets that are
directly or indirectly guaranteed by government
agencies or depository institutions. This is consistent with the notion discussed above that
securitization to some extent is "subsidized" by
government policies or is the result of tighter
capital requirements on banks.
Such is not universally the case, however.
Recently, over$l billion in bonds backed by
commercial mortgages were privately sold with
a guarantee issued by an insurance company. In
addition, Standard and Poor's recently introduced a system of rating the credit quality of
commercial mortgage-backed bonds.Thus, the
existence of direct or indirect government guarantees is an important but not exclusive contributor to the trend toward more securitization.
Pros and cons
Whether or not a particular class of assets is
securitized depends upon whether a sufficiently
large and homogeneous population of assets
exists. Only when the market can "understand"
those assets can they be securitized economicallyand then sold.
Although many assets are potentially securitizable, the virtues of continued rapid growth in
securitization are actively debated. One of the
benefits of securitization clearly is that it permits
more economical transfer of loanable funds from
savers to borrowers. If this were not so, then it
would not be competitive with the other major
means of bringing borrowers and lenders
together, namely, direCt placement of general
debt obligations and financial intermediation.
For securitization to exist and grow so rapidly, it
must offer lenders higher rates of return and borrowers lower costs of borrowing, everything else
being equal, than the alternatives.
Because securitization of assets requires relatively homogeneous - and therefore standardizable - assets, some also believe securitization
enhances competition in the underlying assets.
For example, the standardization of residential
mortgage loan features that is stimulated by
securitization presumably makes it easier for
mortgage borrowers to compare the mortgage
loan instruments available to them. The result,
some claim, is that the standardization also
enhances competition among mortgage lenders.
Others, however, see such standardization as
working to the detriment of at least some market
participants with needs not met by the standardized securitizable asset.
A more important criticism is that securitization,
by separating the origination and servicing of the
asset from its ownership, may create an incentive to perform slipshod analysis of the asset
when it is first originated or acquired. The originator of a loan that will be securitized (without
recourse), for example, has less incentive to perform a careful credit evaluation than the originator who holds the loan in portfolio. Although the
development of appropriate standardization or
rating procedures can help avoid this problem,
this potential for "adverse selection" must be
recognized by market participants, and is a
source of risk attending the trend toward securitization.
Securitization and banking
The "unbundling" of intermediation services
also has implications for the structure of financial markets. In particular, the role and clientele
of commercial banks is likely to change as
securitization progresses. Increasingly, bank
assets will consist of loans to borrowers who are
unable to issue their own liabilities economically, whose creditworthiness is difficult for the
marketplace to assess, or whose liabilities are
sufficiently "nonstandard" as to be difficult to
securitize. In general, these are likely to be individuals and smaller corporations and businesses.
The ability of banks to participate in providing
components of the "unbundled" intermediation
services will depend upon a number of factors.
Because loan origination requires familiarity
with local market conditions and companies,
and loan servicingrequires continued contact
with borrowers, banks are likely to retain a comparative advantage over most other organizations in those functions. Their ability to provide
guarantee or recourse services competitively,
however, flows in part from the combination of
government guarantees and capital regulation as
currently implemented. Similarly, their ability to
provide interest rate risk management for borrowers and lenders will depend upon howecoc
nomically these services can be provided by
banks versus their competitors in the brokerage
and underwriting industries, which also depends
on the extent of regulation.
In conclusion, the trend toward securitization is
a natural consequence of markets evolving to
provide fundamental financial services in the
most economical manner. Although the pace of
its development is contingent on an expanded
,scale of certain financial markets and the pace
of financial innovation, securitization will continue to have an important impact on the relative role of traditional financial intermediaries in
our economy.
Randallj.Pozdena
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
LargeCommercial Banks
Loans, Leases and Investments' 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Amount
Outstanding
6/11/86
200,264
181,789
51,880
66,707
39,128
5,638
10,752
7,724
204,964
52,091
48,174
16,545
136,329
Change from 6/12/85
Dollar
Percent!
Change
from
6/4/86
-
903
853
- 563
173
32
22
20
69
-2,273
-2,004
11,954
- 153
115
-
46,632
-
35,721
19,577
124
-2,059
-
-
-
8,285
7,941
394
3,396
4,805
258
369
713
7,362
5,153
17,092
2,725
514
4.3
4.5
0.7
5.3
13.9
4.7
3.3
10.1
3.7
10.9
54.9
19.7
- 0.3
2,422
5.4
162
-
Period ended
Period ended
6/2/86
5/19/86
2,624
1,295
Reserve Position, All Reporting Banks
Excess Reserves (+ )jDeficiency (-)
Borrowings
Net free reserves (+ )jNet borrowed( -)
127
18
109
28
41
13
, Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
2
-
6.8
6.2
@FedFRASER