Tuesday, February 19, 2008

Lax banks blamed for defaults

(Gillian Tett in the FT) 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, an academic study has found.

Defaults on US subprime loans that have been repackaged and sold to non-bank investors have been 20 per cent higher than those kept on the books of lenders in the traditional manner, the study found.

Tracking more than 2m US subprime mortgage loans issued between 2001 and 2006, the study suggests banks and credit rating agencies have under-estimated the risk on securitised loans.

The study, which was compiled by academics at London Business School, the University of Chicago and other institutions, marks one of the first wide-ranging attempts to measure the link between mortgage defaults and securitisation, or the process of turning loans into bonds. It will be closely watched by the financial industry as it comes as politicians and regulators consider whether they need to impose tighter control on securitisation, amid allegations that a boom in the practice has contributed to the current credit problems.

The study’s authors stress they are not calling for a ban on the idea of turning loans into bonds, saying “we believe that securitisation is an important innovation and has several merits”.

However, they argue that securitisation appears to have triggered a decline 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 concept of securitisation has existed for more than two decades, but it has grown dramatically on both sides of the Atlantic in the past five years, creating a lucrative source of business for investment banks.

However, in recent months many securitisation markets have in effect ground to a halt as mainstream investors have lost confidence in the sector, partly because of its opacity and the perceived lack of lender accountability.

This crisis of confidence has prompted the Financial Stability Forum - a committee of central bankers and supervisors - to start a debate about possible measures to impose greater oversight on the industry in the future, and inject greater transparency and lender responsibility.

The investment banking industry is fighting to prevent regulatory intervention by creating its own reform measures.

Did Securitization Lead to Lax Screening? Evidence from Subprime Loans 2001-2006

BENJAMIN J KEYS, TANMOY K. MUKHERJEE, AMIT SERU, VIKRANT VIG

Theories of financial intermediation suggest that securitization, the act of converting illiquid loans into liquid securities, could reduce the incentives of financial intermediaries to screen borrowers. We empirically examine this question using a unique dataset on securitized subprime mortgage loan contracts in the United States. We exploit a specific rule of thumb in the lending market to generate an instrument for ease of securitization and compare the composition and performance of lenders' portfolios around the ad-hoc threshold. Conditional on being securitized, the portfolio that is more likely to be securitized defaults by around 20% more than a similar risk profile group with a lower probability of securitization. Crucially, these two portfolios have similar observable risk characteristics and loan terms. We use variation across lenders (banks vs. independents), state foreclosure laws, and the timing of passage of anti-predatory laws to rule out alternative explanations. Our results suggest that securitization does adversely affect the screening incentives of lenders.

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