An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets
Figure 1: Asset-Backed Securities Issuance (Quarterly Data, 2000:Q1 - 2010:Q2)
Figure 1 is a 6 panel chart showing time series data of several types of ABS issuance. All figures begin in 2000 and run through the present. They have quarterly frequency. The upper left panel shows Non-Agency MBS Issuance. The long run mean (LRM) is about 130 billion dollars per quarter and issuance drops off significantly beginning in 2007 and continuing until the present. The top right panel displays Agency MBS Issuance. The LRM is about 300 billion dollars per quarter and issuance hovers around the average. The middle left panel shows Credit Card ABS Issuance and has a LRM of 15.5 billion dollars per quarter, there is a large drop off in 2008, which returns to normal and then drops off again in 2009. The middle right panel is Auto ABS Issuance. Its LRM is about 19 billion dollars per year, and has a large drop off in 2008 which then returns to somewhat below the average. The bottom left panel is Student Loan ABS Issuance. This has a drop off in 2008 which then returns to just below the average. Finally, the bottom right panel describes CMBS Issuance. Like the chart for Non-Agency MBS Issuance, this chart has a large drop off after beginning at the end of 2007 which continues until present day.
Figure 2: Financial Institution (FI) Funding of Loan Portfolios and Securitization
Figure 2 provides a graphical representation of the industry supply curve for a given loan market segment (e.g., the "prime conforming mortgage" loan market). On the vertical axis of the figure is the interest rate for the loan extended to the household (increasing from 0 as one moves up the figure). On the horizontal axis is the probability that a borrower will not default, q, in the loan market segment, which ranges from 0 to 1 (moving from left to right). Borrowers with higher probabilities of not defaulting (i.e., those closer to 1 in the right corner of the figure) have the lowest credit risks. The marginal cost of bearing borrower credit risks declines as q increases, so the lowest rate that a lender is willing to accept falls as the probability of not defaulting on a loan rises.
The purple line FI(r,q) (solid and dashed, stretching from the top left corner to the bottom right corner of the figure, concave to the upper right corner) represents the locus of zero economic profit combinations of loan rates (r) and credit risks (q) from using liabilities (including insured deposits and FHLB advances) to fund loans using the "originate-and-hold" strategy. At any given interest rate, the FI is willing to use its liabilities to fund all loans with credit risk equal to, or less than, the credit risks represented by this line (denoted as the set of all points to the right of FI(r,q), indicated by the purple cross-hatches).
The red line S(r,q) (solid and dashed, arcing parallel to the purple line but lower on the figure) is the locus of zero economic profit combinations of loan rates and credit risks if the FI uses the "swap-and-hold" strategy. In this case, the FI is willing to fund all ABS with credit risks equal to, or less than, the credit risks represented by this line (indicated by the red cross-hatches). As portrayed in figure 1, the asset-backed securities yield a liquidity benefit to the FI--measured by the vertical distance between FI(r,q) and S(r,q). If the guarantee offered by a securitizer is credible among market participants, then the securities backed by the whole loans are easily transacted and can be sold to retail investors. The FI would prefer to use its liabilities to fund asset-backed securities, all things equal, rather than loans.
The loans that an FI will keep in portfolio are all those with credit risks that are equal to, or less than, those to the right of the blue dashed line CP(r,q) (arcing parallel to the purple line, but higher on the figure), indicated by blue cross-hatches. Changes in an institution's underwriting standards (i.e., the quality of loans that are "cherry picked") are represented by movements of CP(r,q).
In the course of maximizing profits, a loan securitizer must offset the loan originators' first-mover advantage (the "cherry picking") to earn a target rate of return and to not be stuck with "lemons." Thus, the securitizer generally sets a higher credit risk standard than does the loan originator. This higher standard does not necessarily ensure that the securitizer's average credit risk is lower than the originator's average credit risk on the loans because the originator can pool the "lemons" (loans that have a higher credit risk than allowed under the securitizer's underwriting standards) and the "cherries" (loans that are very low-risk and are not sold to the securitizer). In Figure 2, the credit standard of the securitizer is given by the green line SU(r,q) (dashed, arcing from the bottom left corner to the middle of the top edge, concave to the upper left corner, intersecting the S(r,q) and FI(r,q) curves, but falling short of meeting the CP(r,q) curve). The securitizer will only purchase, securitize, or rate, loans with credit risks equal to, or less than, those represented by this line. That is, only loans to the right of SU(r,q) (indicated by green cross-hatches) are securitized. SU(r,q) slopes upward because the originator is more likely to "cherry pick" loans when loan rates are higher, which provides an incentive to the securitizer to tighten its underwriting standards.
Changes in underwriting standards by the securitizer, other than those due to changes in loan rates, are represented by shifts of SU(r,q). (The curve shifts to the right when the underwriting standard is tightened.) Such changes are, of course, linked to the FI's underwriting standards, as well as to any exogenous events that change the securitizer's target rate of return on its equity. As the originator removes more low-risk loans from the flow of loans into the pools of collateral backing a securitization, the securitizer has to tighten its lending standards to guard against adverse selection when taking loans out of the remaining pool of loans. These actions reduce the gap between the green and blue lines.
The loan rate r1 (a point on the loan rate axis, determined by the intersection of the effective industry supply curve (explained shortly) and the industry demand curve D(r,q) (not shown) is indicated by a dashed black horizontal line, beginning a bit more than halfway up the loan rate axis, and intersecting the FI(r,q) and SU(r,q) curves before terminating in the CP(r,q) curve. The intersection of r1 with FI(r,q) yields q0, a corresponding point on the credit risk axis, represented by a dashed black vertical line extending down from the intersection to the credit risk axis). Loan originators (FIs) only want to sell loans with credit risks between 0 and q2 (the point on the credit risk axis corresponding to the meeting of r1 and CP(r,q), and indicated by another dashed black vertical line extending down from the intersection to the credit risk axis) because they are engaging in "cherry picking" vis-a-vis the securitizers. Moreover, because of this cherry picking activity, the loan securitizer wants to avoid "lemons" and only wants to guarantee loans with credit risks between q1 (the point on the credit risk axis corresponding to the meeting of r1 and FI(r,q), and indicated by a third dashed black vertical line extending down from the intersection to the credit risk axis) and 1 to create marketable securities. High quality loans originated by an FI (i.e., loans with credit risks lower than q2 and thus to the right of q2) are placed in the FI's own investment portfolio. Therefore, the effective industry supply curve for loan credit risks of a given product type is represented by the solid segments of the purple, FI(r,q), and red, S(r,q), lines. (In other words, FI(r,q) is solid everywhere except in the securitized region, between q1 and q, while S(r,q) is dashed everywhere, except between q1 and q2; the solid portions of FI(r,q) and S(r,q) give the effective industry supply curve.)
Figure 3: Financial Institution (FI) Funding with Uninsured Deposits
Figure 3 is the same as Figure 2, except that FI(r,q) has a kink; rather than extending completely from the bottom right corner to the top left corner as before, it stops a bit more than halfway across the page, at a point labeled qmin (qmin is equivalent in positioning to q0 in Figure 2; it is the value of q where FI(r,q) intersects with r1). qmin is between q=0 and q1.
Figure 4: Equilibrium Loan Rates Without Retail Investors
Figure 4 (Top Panel) is the same as Figure 2, except that the industry demand curve D1(r,q) is shown as an orange line, stretching from the bottom left corner to the top right corner, concave to the bottom left corner of the figure. D1(r,q) intersects the effective supply curve portion of FI(r,q) at (r1, q0).
Figure 4: Equilibrium Loan Rates Without Retail Investors
Figure 4 (Bottom Panel) is the same as Figure 4 (Top Panel), except that a new loan rate r2 (lower than r1) is now used. This loan rate is sufficiently low enough that the points q0 and q1 described in Figure 2 have converged and become one, effectively eliminating the "not securitized zone" formerly between points q0 and q1. This new merged point is labeled q1. The industry demand curve D2(r,q) has been shifted down substantially so that it intersects the part of the effective supply curve formed by S(r,q) at the point (r2,q1).
Figure 5 (Top Panel): Equilibrium Loan Rates With Retail Investors in Financial Institutions (FIs)
Figure 5 (Top Panel) is of the same form as Figure 4 (Top Panel). There are two main differences. First, the FI(r,q) curve is kinked and has a vertical line at qmin like Figure 3. This leads the demand curve D2(r,q) to intersect the effective supply curve portion of FI(r,q) at a rate higher than r1, in this case labeled rR. This causes what formally would have been labeled q2 (the value of q where r1 meets with CP(r,q)) to be shifted toward q=0, decreasing the size of the securitized zone.
Figure 5 (Bottom Panel): Equilibrium Loan Rates With Retail Investors in Financial Institutions (FIs)
Figure 5 (Bottom Panel) is identical to Figure 4 (Bottom Panel) except that the FI(r,q) is again kinked at q=qmin like in Figure 3. This yields the same results as Figure 4 (Bottom Panel).
Figure 6 (Top Panel): Equilibrium Loan Rates with Deposit Insurance and Retail Funding of Securitization
Figure 6 (Top Panel) is the same as Figure 4 (Top Panel), except that a kink is introduced to the S(r,q) curve. Rather than extend from the bottom right corner toward the top left as before, the curve goes up vertically in the middle of the securitized zone at q=qmin. This results in a smaller securitized zone, with attendant changes to the various quantity values.
Figure 6 (Bottom Panel): Equilibrium Loan Rates with Deposit Insurance and Retail Funding of Securitization
Figure 6 (Bottom Panel) is the same as Figure 6 (Top Panel), except that the shifted-down demand curve D2(r,q) is utilized - leading to a larger securitized zone than in Figure 6 (Top Panel), but a smaller one than Figure 4 (Bottom Panel).
Figure 7 (Top Panel): Graphical Description of the Financial Crisis
Figure 7 (Top Panel) demonstrates how a rightward shift in the upward thrust of the kink of the S(r,q) curve, as shown in Figure 6 (Bottom Panel), could eliminate the securitized region.
Figure 7 (Bottom Panel): Graphical Description of the Financial Crisis
Figure 7 (Bottom Panel) illustrates how outward (away-from-the-center) shifts in the FI(r,q), CP(r,q) and SU(r,q) curves (using Figure 4 (Bottom Panel) as a base) can expand the securitized zone.