Centre for Computational Finance and Economic Agents
and Economics Department
Discussion: The Marketability of Bank Assets and Managerial Rents:
Implications for Financial Stability
Falko Fecht and Wolf Wagner
The Transmission of Credit Risk and Bank Stability
22 May 2008
Centre for Banking Studies
Cass Business School
106 Bunhill Row, London, EC1Y 8TZ (U.K.)
Sheri Markose
Director CCFEA
University of Essex
Main ingredients of the Fecht and Wagner (F&W)
Paper
• The main framework of paper is the ‘hold-up’ model of
bank managers based on asymmetric information
• Factors such as competitive loan market with ease of
switching between lenders by borrowers and the ease of
withdrawals by depositors (due to less than secure
provision of deposit insurance) – all mitigate bank
managerial extraction of monopoly rent in loan vs.
deposit rates
• F & W claim that their explanation goes beyond the
‘popular’ view (for lack of a precise provenance of this
straw man) that originate and distribute process of bank
loans resulted in reduced incentive by bank managers to
screen and monitor and hence led to asset quality
deterioration of assets retained on bank’s books
The operational word is retained
F&W claim the ‘popular’ model cannot explain “how banks have
become more risky since the selling of risks should have made banks
safer.”
• Assets with the least risk are easier to securitize as the
required coupon payments is less than what is
commensurate with the default risk on riskier tranches
In the ‘popular’ view, banks should find it too costly to
pass on high risk sub prime loans, hence end up
retaining them on their books
The question is how were banks able to willy nilly pass on
the subprime loans ? In other words what needs
explaining is how so much bad stuff got passed on. The
‘popular’ answer: Default risk on these loans and hence
costs to the bank for securitization in coupon payments
and credit enhancement were under estimated . Was
there excessive securitization ?
It is not clear as F& W claim that banks became less safe
as bad loans got passed on
Bank failure was negligible in this subprime crisis ( April 2
2007 New Century Financial files for bankruptcy; some 100
mortgage providers followed. Compare this with the so
called banking holocaust with 1000s of banks failing in the
1930s)
 Instead, massive losses of ABS were suffered by those to
whom it was passed on viz: hedge funds, investment
banks and institutional institutions
 For holders of MBS, write downs in excess of $300 bn
As of April 2008, credit rating agencies had downgraded
over $800 billion in highly-rated CDO and MBS, and more
downgrades are expected. ) Estimate of total MBS is $1
Trillion
Financial agents and Contagion
F & W model: banks optimally use deposit rate to mitigate
renegotiation problem and asset quality depends on
managerial effort
Returns c~ on the loan/project investment requiring $1 to
be a uniform distribution
With monitoring effort e= 1
Good state (cmax) and Bad (cmin) returns
Without monitoring effort e = 0 Δc >0 asset quality loss is
sustained through out ie.
Good state return = cmax - Δc
Bad state return = cmin - Δc
Unfortunately, as a result the density of a uniform
distribution is identical with and without monitoring
Ф (0,1) = 1/ (cmax- cmin)
Critical to the subprime crisis is the default probability on
loans/project were ex ante different.
Returns to agents
•
•
•
•
Investors get return βc~
( 0 ≤β < 1)
Depositors get return D
Equity/Managers get (1- β)c ~
F&W rely on exogenously given β return to
investors to proxy for the marketability of assets
and high β is meant to proxy the phenomena of
securitization ( does β = 1 mean that 100% of
bank loans are securitizited ?)
When do managers stop
monitoring ?
The loss on return from zero effort Δc > G where G
is the disutility or cost to manager for monitoring
To cut to the chase: F&W claim there is a critical β0
above which when the managers expected
incremental return falls below G, they cease to
expend effort (eq. 15)

c max
c max   c
(1   0 ) c  dc  G
Is the hold up framework of bank managers relevant to the
recent credit crisis ?
• F&W go on to say the β also proxies for market
value of bank asset and as bank managers do
not monitor for β0 < β < β^^, bank default
probability increases and when β > β^^,banks
will have zero default probability and perfect
stability !!
• How can high β > β0 market value for bank
assets get determined with uniform asset quality
deterioration as managers cease to monitor?
• Curiously no model of securitization ie. what
proportion of assets does a bank securitize? Is
there an optimal level of securitization?
Optimal securitization ratio (minimising capital injections/
maximising capital accumulation):
Simon Wolfe (2000)
Asset accumulation process with securitization: α = %
of Asset securitzed; C(α ) : Cost of Securitization;
(1-γ) : Default Rate on Assets
At 1   (1   ) At   At  r A At  M t  C ( ) At
C ( )   R C   2 R C
capital injection/accumulation:
Mt  (1  )At  (At  Lt )  (1 )At  Et
if M > 0 capital injection is
needed ;  : capital adequacy ratio
Figure I.5 Capital accumulation and α analysis I (T=5) (linear Cost)
With linear costs note that as a higher
and higher % of assets
are securitized, a bank can keep
improving its capital accumulation :
The Money Pump model of
Securitization
Costs of MBS
C ( )   RC   2 RC , RC is Coupon Rate on MBS.
Citibank Report 2007
Sub-prime: Exploding ARM
Capital Accumulation
ra = 15% and rd = 3% (for BB-) ; ra= 11%; rd=3% (BB) ; ra= 7.5% , rd= 3% (BBB);
ra = 5% rd = 3% (AA)
Sub-prime Market
MBS on Loan on Real Estate:Source FDIC
WASHINGTON
NEW CENTURY
2001.3
0.497971656
0.255255547
2001.6
0.427332242
0.236253407
2001.9
0.393723897
0.205321179
2001.12
0.302951192
0.180109436
2002.3
0.232911549
0.17544783
2002.6
0.198129305
0.218473105
2002.9
0.170938075
0.192971619
2002.12
0.155603184
0.157524953
2003.3
0.110635337
0.130638446
2003.6
0.071946644
0.109395568
2003.9
0.076294759
0.126652608
2003.12
0.052989651
0.122883974
2004.3
0.037408302
0.112385321
2004.6
0.038606
0.127830593
2004.9
0.035673732
0.134108553
Concluding Remarks
• F&W model is ambiguous about what they mean by β, market value
of ABS
• Higher and higher values for ABS when asset quality is deteriorating
is possible only if these assets are wrongly rated
• ‘Hold up’ theory vs. popular theory of mispricing risk and reg. arb
(Ambrose et. al (2003)
• If costs of securitization are made to reflect default rates of 11% 15% (which grew to 33%) on sub prime loans, banks could not have
passed them on as costs too exorbitant and close to zero advantage
re. capital growth
• If banks had to retain sub prime loans – they may not have
generated them and the rate of securitization would have been
modest rather than upto 50% of assets seen in early 2000
• ABS a substitute for bank equity; once that channel was defunct as
ABS market values fell, pain suffered by banks is that of having to
recapitalize
• Pain suffered from contagion closer to $1 Trillion and possibly more
Some References
• Wolfe, Simon (2000), “Structural effects of asset-backed
securitization”, The European Journal of Finance 6, pp353-369
• Sheri Markose, Yang Dong and Bewaji Oluwasegun , “An MultiAgent Model of RMBS, Credit Risk Transfer in Banks and Financial
Stability: Implications for the Subprime Crisis”, Mimeo,
Centre for Computational Finance and Economic Agents (CCFEA),
University of Essex ,UK
• Altman, Edward; Sreedhar T. Bharath, and Anthony Saunders
(2004), “Credit Rating and the BIS Capital , Adequacy Reform
Agenda” Forthcoming: Journal of Banking and Finance.
• Ambrose, Brent W., LaCour-Little, Michael & Sanders, Anthony B.
(2003), “Does Regulatory Capital Arbitrage or Asymmetric
Information Drive Securitization?”, Journal of Financial Services
Research,