Yasuyuki Fuchita is senior managing director at the Nomura Institute of Capital Markets Research in Tokyo. He is coeditor, with Robert Litan, of Pooling Money (Brookings, 2008) and New Financial Instruments and Institutions (Brookings, 2007).Richard J. Herring is the Jacob Safra Professor of International Banking and professor of finance at the Wharton School, University of Pennsylvania, where he is also codirector of the Wharton Financial Institutions Center.Robert E. Litan is a senior fellow in Economic Studies at the Brookings Institution and vice president for research and policy at the Kauffman Foundation. Among his books is Good Capitalism, Bad Capitalism, and the Economics of Growth Prosperity (Yale, 2007), written with William J. Baumol and Carl J. Schramm.

PRUDENT LENDING RESTORED

Securitization after the Mortgage Meltdown

BROOKINGS INSTITUTION PRESS

Copyright © 2009 THE BROOKINGS INSTITUTION
All right reserved.
ISBN: 978-0-8157-0336-5

Contents

Preface...................................................................................................................................................vii1 The Future of Securitization: An Introduction Yasuyuki Fuchita, Richard J. Herring, and Robert E. Litan................................................12 Financial Turmoil and Central Bank Responses in the United States, United Kingdom, European Union, and Japan Robert A. Eisenbeis.......................113 Structuring for Leverage: CPDOs, SIVs, and ARSs Joseph R. Mason........................................................................................794 The Future of Securitization Günter Franke and Jan P. Krahnen.....................................................................................1055 Legal and Economic Issues in Litigation Arising from the 2007–08 Credit Crisis Jennifer E. Bethel, Allen Ferrell, and Gang Hu.....................1636 Mortgage Payment Insurance and the Future of the Housing Finance System Jack Guttentag and Igor Roitburg...............................................2377 The Development and Future of Securitization in Asia Eiichi Sekine, Kei Kodachi, and Tetsuya Kamiyama..................................................251Contributors..............................................................................................................................................305Index.....................................................................................................................................................307

Chapter One

YASUYUKI FUCHITA RICHARD J. HERRING ROBERT E. LITAN

The Future of Securitization: An Introduction

Since its development over a period of more than three decades, the securitization of loans—the process by which many individual loans (initially mortgages and since then many other types of loans as well) are packaged together in trusts and used as collateral for securities—has been hailed as one of the more important and socially useful financial innovations of recent times. The securitization process has allowed Wall Street to more efficiently finance Main Street, bringing capital from securities markets to loan originators, relieving them of the need to finance and maintain loans on their balance sheets. Further, by effectively splitting the ownership of loans into many smaller units—through the sale of securities—the process was thought to diversify credit risk more widely across national and, indeed, global capital markets rather than concentrate that risk on the balance sheets of the institutions that originated the loans.

However, the meltdown since late 2006 of the subprime mortgage market, coupled with the severe recession that has since followed, has caused many to reconsider what they may have believed about the securitization process. Al though there is little basis for questioning the lower cost of credit that securitization affords for prime quality borrowers, there is now widespread skepticism of the net benefits of the more complex securitized structures that facilitated the explosion of subprime mortgage credit in the United States during the last three years of the 2002–06 economic expansion. Moreover, it is now broadly accepted that the securitization process did not disperse credit risk as broadly as was once thought but instead may have simply shifted it, in concentrated forms, across a limited number of financial entities, some of which are systemically important.

What, then, is the future of securitization? And what can be done to ensure that in the future securitization continues to deliver benefits—cheaper loans and more liquidity in lending markets—without causing harm? The chapters in this volume seek to answer those questions.

The authors come at the issues from a variety of perspectives. In chapter 2, Robert A. Eisenbeis sets the stage for the later chapters by analyzing the causes of the subprime mortgage crisis, concentrating on what he argues was excessively lax monetary policy. Joseph R. Mason describes in chapter 3 how the creation of an alphabet soup of complex securities and structures—constant proportion debt obligations (CPDOs), structured investment vehicles (SIVs), and auction rate securities (ARSs)—played a key role in facilitating the rapid growth and eventual implosion of the subprime mortgage market. In chapter 4, Günter Franke and Jan P. Krahnen examine the flaws in the policy framework and the misalignment of incentives that they believe allowed the securitization process to run off the rails and suggest changes to put it back on a constructive track. In chapter 5, Jennifer E. Bethel, Allen Ferrell, and Gang Hu take up the legal and economic issues from the litigation that has arisen and is likely to arise in the future from the 2007–08 credit crisis. Jack Guttentag and Igor Roitburg offer in chapter 6 a specific proposal for improving the alignment of incentives in mortgage markets. In chapter 7, Eiichi Sekine, Kei Kodachi, and Tetsuya Kamiyama conclude this volume with a penetrating comparison of securitization in Asia, especially in Japan, and that in the United States. Ironically, the fact that securitization has grown more slowly in Asia and has simpler structures that are easier to value has so far better insulated Asian economies from the financial problems recently experienced in the United States, if not from the subsequent recession. A brief summary of the contents of each of these chapters follows below.

Eisenbeis begins in chapter 2 by providing a timeline of the key events that characterized the financial crisis in the United States and subsequently elsewhere, through October 2008 (the time of the conference on which in this volume is based). Eisenbeis places heavy emphasis on the low interest rate environment since 2002 as a major contributing cause of the crisis. Policy actions in several parts of the world made that possible: loose monetary policy in both the United States and Japan and the willingness of central banks in countries such as China to purchase U.S. Treasury securities even in the face of large U.S. federal budget and trade deficits. Eisenbeis is also critical of financial institutions for their laxity in originating subprime mortgages and of the credit rating agencies for their failure to analyze the securities secured by these mortgages with sufficient rigor.

In discussing the sequence of events that led up to the crisis and its aftermath, Eisenbeis highlights the different responses by central banks and finance ministries in various developed economies. At first, the reactions were uncoordinated: the European Central Bank injected massive amounts of liquidity into European banks, while the Federal Reserve cut rates and expanded its liquidity facilities to cover primary dealers of U.S. Treasury securities. The Fed followed with its term auction facilities for banks, while the FDIC expanded its insurance coverage of bank deposits and extended coverage to some long-term debt. Only when those actions seemed insufficient to stem the crisis did central banks begin to coordinate their rate cuts and liquidity facilities, in a massive and unprecedented fashion. Throughout the crisis period, the different responses by various central banks permitted different interest rates to prevail in the affected countries, despite the fact that all were confronting similar crisis...