Securitization Working Group

April 24, 2010
Darrell Duffie and Kenneth Singleton, both of Stanford University, Organizers

Patrick Bolton, Columbia University and NBER; Xavier Freixas, Universitat Pompeu Fabra; and Joel Shapiro, Oxford University (UK)
The Credit Ratings Game

The collapse of so many AAA-rated structured finance products in 2007-8 has brought renewed attention to the causes of ratings failures and the conflicts of interest in the Credit Ratings Industry. Bolton, Freixas, and Shapiro provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of conflicts: 1) the CRA conflict of interest -- understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. These researchers show that when combined, this gives rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market efficiency, because competition facilitates ratings shopping by issuers. Second, CRAs are more prone to inflate ratings in boom times when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market efficiency because its role is to deceive trusting investors. The authors argue that regulatory intervention requiring 1) upfront payments for rating services (before CRAs propose a rating to the issuer), 2) mandatory disclosure of any rating produced by CRAs, and 3) oversight of ratings methodology could substantially mitigate ratings inflation and promote efficiency.

John Geanakoplos, Yale University
Solving the Present Crisis and Managing the Leverage Cycle

The present crisis is the bottom of a recurring problem that Geanakoplos calls the leverage cycle, in which leverage gradually rises too high then suddenly falls much too low. In normal times the government must manage the leverage cycle by monitoring and regulating leverage to keep it from getting too high. In the crisis stage, the government must stem the scary bad news that brought on the crisis, which often will entail coordinated write downs of principal; it must also restore sane leverage by going around the banks and lending at lower collateral rates (not lower interest rates); and, when necessary, it must inject optimistic capital into firms and markets than cannot be allowed to fail. For too long, economists and the Fed have focused on interest rates and ignored collateral, Geanakoplos writes.

Adam Ashcraft, Federal Reserve Bank of New York; Nicolae Garleanu, University of California, Berkeley and NBER; and Lasse Pedersen, New York University and NBER
Two Monetary Tools: Interest Rates and Haircuts

Ashcraft, Garleanu, and Pedersen study a production economy with multiple sectors financed by issuing securities to agents who face capital constraints. Binding capital constraints propagate business cycles, and a reduction of the interest rate can increase the required return of high haircut assets, since it can increase the shadow cost of capital for constrained agents. The required return can be lowered by easing funding constraints through lowering haircuts. To assess the power of the haircut tool, the researchers study the natural experiment of the introduction of the legacy Term Asset-Backed Securities Loan Facility (TALF). They estimate that the TALF program reduced required returns by more than 0.70 percent using a triple difference-in-differences regression. Further, unique survey evidence suggests the reduction in required returns could be more than 3 percent and provides broader evidence on the demand sensitivity to haircuts.

Andrew Kimball, Moody's

Ratings and the Demand for Structured Products

Kimball spoke at length about the process by which Moody's rates structured credit products, with a special focus on the important question of alternative approaches to the definition of "triple-A" for this class of debt instruments. Among the alternatives one might consider is the rating of structured credit products on the same expected-loss-to-rating mapping that is used for corporate and sovereign bonds. This same mapping is now being adopted by Moody's for municipal bonds. Given the new understanding of structured credit products obtained from the financial crisis performance of structured credit products backed by residential mortgages, using that uniform mapping would probably imply many fewer, if any, triple-A ratings in the future. Another approach is to rate structured credit products with an "SF" (structured finance) suffix, which is required in Europe anyway beginning later in 2010, and making it explicit through disclosure that a "triple-A-SF" is not equivalent in expected loss or volatility to a triple-A corporate rating. The meaning of triple-A-SF would probably be explained with the types of macro scenarios that a triple-A-SF could sustain without loss. Separate "volatility" ratings can augment the credit rating. After Kimball's prepared remarks, there was a substantial and wide ranging group discussion led by Kimball on the demand and supply for triple-A products, conflicts of interest in the ratings process, and the implications of competition among ratings agencies for market share. This discussion was connected to the presentation earlier in the day by Patrick Bolton.

Viral Acharya, New York University and NBER; Philipp Schnabl, New York University; and Gustavo Suarez, Federal Reserve Board
Securitization without Risk Transfer

Acharya, Schnabl, and Suarez analyze asset-backed commercial paper conduits, which played a central role in the early phase of the financial crisis of 2007-9. They document that commercial banks set up conduits to securitize assets worth $1.3 trillion while insuring the newly securitized assets using guarantees. The guarantees were structured to reduce bank capital requirements, while providing recourse to bank balance sheets for outside investors. Consistent with such recourse, the researchers find, during the first year of the crisis, asset-backed commercial paper issuance fell and spreads increased, especially for conduits with weaker guarantees, riskier banks, and lower quality assets. Furthermore, banks with more exposure to conduits had lower stock returns, and losses from conduits remained with banks rather than with outside investors. These results suggest that banks used this form of securitization to concentrate, rather than to disperse, financial risks in the banking sector while reducing their capital requirements.

Zhiguo He, University of Chicago; In Gu Khang, Northwestern University; and Arvind Krishnamurthy, Northwestern University and NBER
Balance Sheet Adjustments in the 2008 Crisis

He, Khang, and Krishnamurthy measure how securitized assets, including mortgage-backed securities and other asset-backed securities, have shifted across financial institutions over this crisis and how the availability of financing has accommodated such shifts. Sectors dependent on repo financing – in particular, the hedge fund and broker-dealer sector – have reduced asset holdings, while the commercial banking sector, which has had access to more stable funding sources, has increased asset holdings. The banking sector also increased its leverage dramatically over this crisis. These findings are important to understand the role played by the government during the crisis as well as to understand the factors determining asset prices and liquidity during the crisis.