Debt and Credit, Growth and Crisis
BdE - WB
Madrid, 18 June 2012

1. It provides a comprehensive story on the links between aggregate savings
(the savings “glut”), the scarcity of safe assets and the role of securitization in their production, interest rates, leverage and financial stability.
2. A relatively simple model :
A demand for safe assets by risk-averse investors (lenders)
- A supply of safe assets by risk-neutral intermediaries. Two cases: i) If low demand, intermediaries’ own collateral suffice to meet it ii) If high demand, intermediaries produce new “safe assets” securitization
3. Central results : i.
If risks are correctly assessed, securitisation contributes to financial stability (risk diversification pooling ) and is Pareto-improving (efficient risk allocation – tranching and originators retention ) .
ii.
If tail risks are neglected, securitisation may become a driver of financial instability through ex post 1) excessive leverage and 2) illiquidity

- A relatively simple model sheds light on the links between some key developments before and during the crisis in a credible way
- The shocks-transmission mechanisms (aggregate contagion of idiosyncratic risks through securitization and illiquidity) help understand the velocity and intensity with which the initial turbulences of August 2007 spread over the entire system
Some key pieces in the model are well grounded on empirical evidence :
 The role of securitization in producing high-quality assets
 The role of securitization holdings by leveraged intermediaries in amplifying the shocks

 The role of securitization in producing high-quality assets:
Global issuance of AAA-rated long-term fixed income assets (1990-2009)
Sovereign debt
Corporate bonds
As a percentage of total (right-hand scale)
7.000.000
Million dollar
Source: Dealogic
6.000.000
ABS (agencies included)
Other long-term debt
%
70
60
5.000.000
50
4.000.000
3.000.000
2.000.000
1.000.000
40
30
20
10
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
0
The rapid growth in global AAA-assets (from 20% of total assets in 1990 to 60% in
2003) was largely due to securitisation

 The high volume of securitization in the leveraged institutions’ balancesheets (key for the transmission of shocks in the model and in reality too):
Distribution of the holdings of GSE-backed securities
Source: Shin (2009)
Leveraged institutions (commercial banks, investment banks and hedge funds) were the main holders of ABS

 A “static” and “partial equilibrium” framework is used to explain some facts of “general equilibrium” (systemic) nature, thus missing some interesting dimensions, e.g.:
- In the model only one type of productive investment which exogenous wrt to how it is financed.
- In reality, most problematic ABS were linked to mortgages (RMBS and CMBS).
Some argue that the housing bubble was indeed fuelled by securitisation
- A conjecture: if securitisation favours the emergence of housing bubbles, then securitisation may not be that good in the first place, even under RE (e.g. in terms of financial stability or general welfare –e.g. Arce & López-Salido 2011)
- A (big) conjecture : can “too much” securitisation generate endogenous aggregate instability through its effects on the investment mix?

 The assumption that originators (think that) retain all the risk seems at odds with data ---too little “skin in the game”
Tranche retention by originators (% average share of retained deal volume)
Source: IMF GFSR
ABS
CDO
EU minimum retention (5%)
4
3
2
1
0
7
6
5
%
2002 2003 2004 2005
MBS
Weighted average
2006 2007 2008
- More realistic to assume two types of intermediaries: i) some with productive-investment opportunities that sell ABS; ii) some without such opportunities that buy ABS and not only their AAAtranches¡¡
- Also, relax the assumption of ex ante symmetric information would be interesting

 In the model, the positive link between securitisation and leverage depends on the volume of retained tranches.
 But, if retention is low (“O2D model”), that link weakens  in the limit, originators create and sell assets with no impact on the size of their balance-sheets.
 On the other hand, investors in ABS may well end up raising their leverage.
Bank Leverage Distribution of the outstanding stock of ABS
Germany
US
France
100
Spain
UK
Times
75
50
25
0
2000 2002 2004 2006 2008 2010
 (Net) originators seems less leveraged than (net) investors¡

 Is the paper’s liquidity contagion channel the most relevant??
An alternative based on asymmetric information would help us understand the collapse of the secondary market of European securitisations, whose performance has been remarkably good (i.e. a massive “lemons problem”)
Rating migrations: Spain, Europe and U.S
Aaa/AAA
Baa/BBB
U.S
Aa/AA
Bellow BBB
A/A Aaa/AAA
Baa/BBB
Europe
Aa/AA
Below BBB
A/A
100%
80%
60%
40%
20%
0%
100%
80%
60%
40%
20%
0%
2008 2009 2010 Jun-2011 2008 2009 2010 Jun-2011
- Asset complexity, lack of transparency and a minimum degree of standardization have exacerbated the asymmetric information, killing the EU secondary market

 Great paper, it helps understand some key links in the financial system that are crucial in the origin, the propagation and the depth of the crisis.
 Some assumptions and modelling choices are not fully convincing but the overall story is a credible one.