Term Paper on "Securitization and Bank Liquidity"

Term Paper 17 pages (4798 words) Sources: 15 Style: Harvard

[EXCERPT] . . . .

Securitization and Bank Liquidity

The objective of this work is to examine securitization and how it is currently used in the banking industry with a focus on real estate and the current problems banks are facing recently regarding mortgages and how that banks lend easy money to anyone and then are unable to recover the money. This work seeks to examine what the future holds for mortgage markets and banks.

Securitization: A process of creating new financial instruments by pooling the cash flows from a number of similar assets such as mortgages or credit card accounts, and putting them into a separate entity often with some explicit guarantee or extra collateral. (Loutskina, 2004; 7)

Liquidity: According to the Federal Deposit Insurance Corporation (FDIC), liquidity is "the ability to fund future asset growth and/or pay liabilities in a timely manner, at a reasonable cost." (2007)

Market liquidity: Refers to the speed and ease with which an asset can be sold at a price close to its fair value and with low transaction costs, is a property of assets or financial instruments and of the markets in which they are traded. (Buiter, 2008; 1)

Funding liquidity: Is provided by the authorities at the discount window (on demand against suitable collateral) and, in extreme circumstances, through lender of last resort (LoLR) facilities. Market liquidity is provided by the authorities through open market operations (OMOs), both repos, reverses repos and outright purchases/sales, and, when markets become illiquid, by the authorities acting as market maker of last resort (MMLR), buying normally liquid but temporarily illiquid instruments at punitive prices and discounts. (Buiter, 2008; 1)

INTRODUCTION

Some researchers hold that securitization has "greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk." (the Economist, 2008) According to an article published in 'The Economist' magazine entitled: "Fear and Loathing, and a Hint of Hope" the volume of outstanding securitized loans had by 2006 reached the sum of $28 trillion and in 2007, the volume of securitized loans that were outstanding totals "three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold." (the Economist, 2008) the following chart illustrates the 'securitized loans outstanding as stated by the Federal Reserve and NERA Economic Consulting as cited in 'The Economist'.

Securitized Loans Outstanding

Source: 'The Economist'

The Economist' report states that during this time "banks cooked up a simmering alphabet soup..." which included ingredients of 'collateralized-debt obligations (CDOs) "which repackage asset-backed securities, and collateralized-loan obligations (CLOs) which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets." (2008) the prospect for the 'CDO-squareds' which are 'resliced and repackaged CDOs' is not good because they are unpopular and their value has fallen during the housing industry mortgage crisis. 'The Economist' states prospects for SIVs being "bleaker still' because the SIVs "borrow short-term to invest in long-dated assets and investors will no longer tolerate such mismatches in vehicles shielded from standard banking." (the Economist, 2008) Funding sources for SIVs have disappeared which means: "...banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion of subprime-related write-downs, over a third of which has come at three banks" which are those of (1) Citigroup; (2) Merrill Lynch; and (3) UBS. (the Economist, 2008)it is stated in the research report of 'The Economist' that the subprime crisis has brought to the light four flaws that are "very deep...in the practice of securitization: (1) by cutting the link between those who scrutinize borrowers and those who take the hit when they default, securitization has fostered a lack of accountability; (2) the second flaw is the sheer lack of understanding of some instruments; (3) some securities were poorly structured, often because their risks were not fully understood; and (4) the market's over-reliance on rating as a short cut to assessing risk. (the Economist, 2008)

The FDIC states of the methods utilized by banks in their strategies for funding are comprised by a "mixture of borrowing, brokered deposits, and securitization activities, and, as such, banks with substantial credit card holdings might exhibit a relatively high volatile liability dependency ratio. The advent of credit card securitizations dramatically expanded funding avenues for credit card portfolios." (FDIC, 2007) the Market Oracle presentation entitled: "Judgment Day for Wall Street" published in the Stock-Markets/Credit Crisis 2008 segment of March 31, 2008 states as follows:

In the first days after the Fed's history-breaking Bear Stearns bailout, a parade of Wall Street pundits preached the theory that..."The worst of the crisis is behind us...The dollar has hit rock bottom..., and "The great investor flight to hard commodities is over. Markets that had been surging fell. Markets that had been falling surged. Investors cheered. And everyone who wanted to believe believed. But nothing changed. All across America, home prices were still falling, home sales were still plunging, and consumers continued to suffer withdrawal pains from the greatest debt addiction of all time. That's why we learned last week that consumer confidence is in a free-fall, consumer spending has just taken a huge blow, J.C. Penney sales are swooning, and retail stocks are getting hammered. That's why Wall Street firms such as Lehman Brothers are rumored to be on the brink of collapse, while commercial or savings banks -- like Fremont in California with $7 billion in deposits -- are known to be near failure." (Market Oracle, 2008)

I. INTERNATIONAL MONETARY FUND

On April 2, 2008, Bloomberg's Shamin Adam reports that the International Monetary Fund (IMF) "cut its forecast for global growth this year and said there's a 25% chance of a world recession, citing the worst financial crisis in the U.S. since the Great Depression." (2008) it is stated by Adam that the world economy is expected to experience a 3.7% expansion during 2008. In a March 4, 2008 Board of Governors for the Federal Reserve System, Vice Chairman, Donald L. Kohn, on the 'Condition of the U.S. Banking System before the Committee on Banking, Housing and Urban Affairs, and the U.S. Senate states that the Federal Reserve is not the "primary federal supervisor for the majority of commercial bank assets..." nevertheless, the Federal Reserve plays a key role as the 'umbrella supervisor' for most of the assets of commercial banks. (Kohn, 2008)

II. The FEDERAL RESERVE & the TESTIMONY of KOHN (2008)

The Federal Reserve is also...the primary federal supervision of state-member banks, sharing supervisory responsibilities with state supervisory agencies." (Kohn, 2008) Presently more than 870 state member banks hold assets totaling more than $1.5 trillion which represents approximately twelve percent of all commercial banks by number and approximately fourteen percent of all commercial bank assets. (Kohn, 2008; paraphrased) the Federal Reserve holds responsibility for consumer protection in the financial services sector which includes but is not limited to: "...writing and interpreting regulations to carry out many of the major consumer protection laws; reviewing bank compliance with regulations; investigation complaints from the public about compliance with consumer protection laws, and conducting community development activities." (Kohn, 2008; 1) Kohn addresses the "condition of banking supervised by the Federal Reserve and states that "bank holding companies (BHCs) experienced substantial deterioration in asset quality and earnings, largely attributable to the effects of the slowing residential housing market on the quality of mortgage and construction loans. The sharp rise in subprime delinquencies, moreover, adversely affected the securitization market and placed strains on the liquidity and capital of some of the largest BHCs as these institutions brought off-balance sheet exposures onto their books. Many of these institutions also recognized significant valuation write-downs on assets affected by this market volatility." (Kohn, 2008; 1)

Kohn states that when the "sizable write-downs and substantially higher provision s for loan losses are combined the result was a weaker profit for the banking holds companies in 2007 third quarter with overall losses stated at over $8 billion in the fourth quarter based on the preliminary data of the regulatory report." As the quality of mortgage loans weakened, "nonperforming assets also increased notably..." (Kohn, 2008) State member bank, according to Kohn "...entered the recent financial disturbance in sound condition, reporting strong earnings through the first half of 2007, and maintaining high capital rations." (2008) However, the state member banks did show an impact in terms of their profitability in the last half of 2007 "as state member banks increased loan loss provisions, reducing the aggregate return on average assets from 1.4% for the full year 2006 to 1.1% for 2007." (Kohn, 2008)

Kohn states in his testimony that the largest challenges to the U.S. banking system has been residential mortgage lending practices as the banking industry has been significantly affected by the "sharp increases in sub-prime mortgage loan delinquencies and foreclosures over the past year..." (Kohn, 2008) Furthermore, an emerging area of difficulty has been the home equity lending in that "as… READ MORE

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