A new SEC rule in 2004 that, on paper, increased capital in five large broker-dealer banks -- Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley -- led to greater demand for lower credit quality subprime mortgage purchases. The evidence in deals from these investment banks in 2005 suggest they engaged in ‘ratings arbitrage’ to bring to the secondary market the lowest cost subprime loans that could earn an AAA investment rating, according to the Fed authors.
By Robert Stowe England
July 30, 2009
The securitization process – how loans are put together and assigned credit ratings – drove up the flow of credit in subprime residential mortgage-backed securities deals in harmful ways that increased the amount of funding for lower credit quality subprime mortgages while raising the risk in these deals.
That is the one of the key conclusions of a Federal Reserve Bank working paper authored by Taylor D. Nadauld, a doctoral candidate in the Department of Finance at The Ohio State University, and Shane M. Sherlund, senior economist in household and real estate finance for the Board of Governors of the Federal Reserve System.
Securitization is the process whereby mortgages are sold into the secondary market. Whole mortgages are sold to a deal maker who places them in a pool.
The dealer then issues mortgage-backed securities "backed" by the pool of mortgages and sells the mortgage bonds to investors. The mortgage-backed securities are divided into tranches based on different segments of the loan portfolio, usually with different credit quality characteristics and which pay differing rates of return for investors.
For more information on the process of securitization, go to this link: http://www.financialpolicy.org/fpfprimermbs.htm
The authors’ analysis of 1,267 subprime residential mortgage-backed securities (RMBS) deals originated between 1997 and 2007 was first drafted in May 2008 and was updated in April 2009.
Titled “The Role of the Securitization Process in the Expansion of Subprime Credit,” the 53-page working paper was posted for public discussion earlier this month (July) on the Fed’s Web site at http://www.federalreserve.gov/pubs/feds/2009/200928/200928pap.pdf.
The authors studied how the structure and ratings of subprime RMBS deals affected the incentives that drove the loan purchase decisions of investment banks that underwrite the deals. They also examined how the process of securitizing mortgages impacts the extension of credit by mortgage lenders.
In addition to the 1,267 deals, the authors also had data on 6.7 million loans that served as collateral for the deals. These data identified the underwriting characteristics of the loans, as well as the subsequent performance of these loans.
The analysis concluded with three key results.
First, mortgage pools concentrated in geographical areas with higher rates of home price appreciation were given AAA ratings on a larger share of the deal’s principal. Indeed, the authors found that a 5 percent increase in the average one-year rate of house price appreciation in a given deal correlated with a 1 percent to 3.5 percent increase in the share of a principal that received a AAA rating.
“This is an economically meaningful result because deals with a larger portion of the deal principal rated AAA can fund the purchase of the underlying loan collateral at a lower cost,” Nadauld and Sherlund wrote.
The second key result is that deal makers would seek to purchase the cheapest portfolio of loans – meaning loan pools with lower quality subprime mortgages – in the areas with the highest home price appreciation in order to provide a higher return.
For example, investment banks sought to buy higher loan-to-value mortgage pools from zip codes with the highest home price appreciation. Specifically, the authors found that the investment banks in the analysis purchased 5 percent more of the riskier loans than their competitors. Those loans had 5 percent higher loan-to-value ratios.
“We believe our evidence on the purchasing activity of the investment banks provides some evidence consistent with a theory of ‘ratings arbitrage,’” the authors write. “The loans purchased by investment banks which increase their relative demand for subprime loans defaulted at marginally higher rates.”
The authors argue that the empirical evidence that the secondary market activity can impact the availability of credit in the primary market can be found in the impact of a regulatory event in 2004, which led to a relative shift in the demand for subprime loans.
The third key result is that a 10 percent increase in the share of originated loans in 2005 being sold to the secondary market led to the origination of an additional 4 subprime loans per 100 units.
Five CSE Investment Banks
The “event” that the authors use to demonstrate a relative shift in the demand for subprime loans was a capital requirements rule change by the Securities and Exchange Commission in 2002 that went into effect in 2004 and which affected five large RMBS broker dealers.
The SEC rule change was the U.S. response to a Conglomerates Directive from the European Union that required that the affiliates of U.S. broker-dealers be subject to consolidated supervision by a U.S. regulatory authority. However, instead of increasing the capital requirements and safety and soundness of large U.S. broker dealers (each dubbed a Consolidated Supervised Entity or CSE), the rule change,relaxed capital requirements dramatically.
“In short, we argue that in 2004 the event endowed five of the five largest broker-dealers with additional capital which could be used to increase production of securitization deals,” Nadauld and Sherlund write.
The SEC rule affected Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley – the five CSEs that are a key focus of the Fed working paper. The rule change did not affect two other investment banks, Citigroup and JP Morgan Chase, because each was already under consolidated supervision by federal banking regulators.
The authors examined whether or not the increase in capital led the broker-dealers covered by the new rule to increase their demand for subprime loans. They found that the five CSE banks “did indeed increase their demand for subprime mortgages relative to competitor banks that did not experience a change in capital requirements.”
Looking at a basket of 2005 data from a number of sources, the authors found that 5.8 percent of all housing units were financed with higher priced loans (with at least 3 percentage points higher than standard rates), which the authors used as a proxy for subprime loans.
These subprime loans were sold 68.5 percent of the time into the secondary market. The five CSE banks increased their market-share in each ZIP code by an average of 61 percent from 2003 to 2005 – a dramatic indication of the impact of the additional capital on the availability of credit in the primary market, the authors contend.