Securitization could pose risks to Turkish banks

Dunya Executive - - ANALYSIS - Gunduz FINDIKCIOGLU Chief Economist

Why risk the possibility of a smooth transition in order to turn a precarious and temporary mechanism into a dangerously built-in risk recipe? We may be flirting with a dangerous idea with ramifications and repercussions that could go much deeper than we may be ready to admit. Fund managers and trust holders first conceived of the idea of securitization a long time ago. However, its modern guise is the collateralized debt obligation (CDO), which can be traced back to the mid-1980s, the era of Reagan and Thatcher.

Securitization changed the whole structure of Western capitalism and ended U.S. President Franklin Roosevelt’s social compact. It has caused an increase in the distribution of wealth and income – inflated by chief executives’ pay checks – and put wind under the wings of financialization to such an extent that de-industrialization became the hallmark of the past two decades in many Western nations. Service sectors grew in leaps and bounds, traditional industries shrank and the financial markets became almost totally unfettered despite the regulators’ best efforts.

In today’s model of linear real assets, budget constraints are homogeneous in prices ( jointly in asset and commodity prices) so prices can be defined up to a normalization. This is the usual Arrow-Debreu model, which descri- bes a competitive economy containing a finite number of consumers, commodities and production units. Furthermore, as in the context of Arrow-Debreu “regular economies”, we obtain results of generic local uniqueness.

In the case of nominal assets, however, there is a continuum of equilibrium allocations. In the absence of a well-defined monetary system, such indeterminacy may occur. One implication is that the indeterminacy of equilibriums translates into that of asset prices.

Neo-liberal arguments

Against this backdrop, the neoliberal argument is two-fold. First, there is the possibility that private equity will diversify risk away. Private owners may discretely transfer risk to counterparties – if markets tend to become “complete”, that is if the ar- gument for market-clearing at infinity can be cast away – markets that can manage or otherwise diversify away those risks they choose to forego, arguably becoming a lower-cost substitute for traditional risk capital.

This argument aims at discrediting any transfer to the public in the presence of constrained inefficiency to remedy one specific curse of incomplete asset markets. We know that with an incomplete span of assets, competitive markets do not function optimally even within the restricted subset of existing markets. Could this mathematical argument be so easily overturned? Indeed, if risk management can substitute for risk capital without requiring a transfer of ownership, then why go public at all? This first part goes against the whole literature of general equilibrium theory with incomplete markets, restricted participation and everything that happened between 1985 and 2005. Secondly, there was the global financial crisis of 2008 and sectorial stagnation. We all understand that from a technical viewpoint many financial systems and institutions entered the downturn of the credit cycle with heavily invested asset portfolios, overheated real-estate markets, private equity and leveraged buyouts and structured credit products entailing a number of risks, such as longer duration, lower credit quality, larger positions, leverages and less liquid assets. It is also clearly understood that people do not seem to have taken seriously myriad ways of advising against bearing potentially unbearable risks.

Was it all about “fat tails, or was it also about the macroeconomic framework that casts its shadow on the financial world through monetary and credit channels? Cyclical risks are low-frequency, high-impact events characterized by their negatively skewed and “fat-tailed” loss distributions. This means investors incurring such risk can expect mainly small positive events but are subject to a few cases of extreme loss. Consequently, they are difficult to understand.

Insufficient data

The difficulty stems from two factors. First, there is insufficient data to determine meaningful probability distributions. Secondly, and perhaps more importantly, infrequency clouds hazard perception. Risk estimates become anchored to recent events. This leads to disaster myopia, whereby low-frequency, remote events are ignored. Overemphasis on recent events can also produce disaster magnification immediately following an adverse event. These facts lead to risk mispricing and the pro-cyclical nature of risk appetite.

The other problem is correlation within a portfolio, among the asset returns that form it. In this respect, using long-memory data sets had been of no avail, since such a practice only augments the parameter space since co-variation matrices can grow very large.

Then Li came up with a convincing idea: a sort of a Black-Scholes equivalent device that all investment houses could easily use and hedge against portfolio correlation risks. Li, a Chinese exchange student originally, who went on to pick up a doctorate in actuarial science from Canada, had ended up in Wall Street. The Gaussian copula he used allegedly allowed financial institutions to separate marginal distributions from their joint dependency.

Not only is correlation contoured within the asset portfolio, such as a collateralized debt obligation, but also it is also possible to calculate when a company will default, if the asset value falls below some threshold value. Gone are all the risks and the incomplete market hypothesis, which no longer matter, and back is the association that markets can always provide the best solution.

“The automatic association of the existence of competitive markets with some kind of intuitive notion of efficiency in the mindset of practicing economists has now no theoretical validity whatsoever,” said the American economist John Geanakoplos in 1990.

Securitization doesn’t mitigate risk

Both arguments are incorrect. Securitization serves nothing in terms of mitigating market and portfolio correlation risks, a normal distribution cannot handle all the complexities of asset markets and private equity cannot pass for diversified publicly hold risk slices. Have we not yet learned that this kind of irrational exuberance and market fundamentalism only lead to financial and real crises?

Securitization is a bad idea, especially if you are pre-set to pack up all eventualities in anticipation and market-securitized credit chunks to a central bank. This argument amounts to accepting that asset-backed securities that banks are channeled to issue may go sour with such a high probability that the Turkish Central Bank had better buy them right away from day one on.

This is not only wrong on all counts, but it has a signaling effect that is self-defeating. Are we so desperate to strongly incentivize banks and wrongly at that to give them security guarantees that go far beyond what a well-designed Credit Guarantee Fund would entail and then induce them to extend credit at all costs?

Spending-driven growth

Clearly, growth is predicated upon domestic spending of all sorts since exports are of no help. This means firstly public spending, and we see the impact of that in the primary balance trends depicted in the graph, and secondly triggered and prolonged loan growth, also seen in the graph. Public banks lead and private banks follow.

I have often claimed that impetuses and incentives of the sort observed in the last quarters would suffice to carry GDP growth above 3 percent and more likely above 3.5 percent easily.

I also claimed, based on base effects, that the initial momentum provided by accelerated public spending-cum-bank lending would suffice for achieving that end.

However, these successfully used mechanisms are being resorted to as if in an endless game. In as much as I find the existence of risk-mitigating guarantee funds for small and medium-sized enterprise exporters and agricultural firms theoretically sound and practically helpful, I see securitized asset tranches bound to be plugged in central banks’ balance sheets even before their issuance; a telling repetition of post-2008 scenario globally speaking at a time when the world is revolving around a new attractor.

The crisis in its first and nar- row phase was already over by 2013 when the U.S. Federal Reserve signaled the end of asset purchases, and now the sectorial stagnation is almost ended. Is the situation so desperate that the public is prematurely called in the game in a way that would astound all banking analysts and monetary economists?

There also is the possibility that, given all sorts of moral hazards a central bank-sponsored private bank credit securitization would entail, liquidity will also be an issue. Obviously it would be a collateralized debt obligation, since eventually the process is repetitive and self-generating, otherwise why resort to it in the first place?

Lira liquidity

If lira liquidity is provided in excess of spot demand, there is a good chance that this money will end up in foreign currency demand, in either the short or long end of the curve. Liquidity is a short-term issue by nature, and many short-lived monetary phenomena ensue from excess liquidity.

Consider the foreign currency deposit-to-M2 ratio of local residents in the graph. The ratio has been going up since the summer of 2013, a time of nationwide civil unrest and economic chaos in Turkey. Recently, after a period of normalization and reversion, that ratio went up again. The key threshold for this indicator is 50 percent, above which dollarization could not only accelerate but become persistent.

There is still room to move in terms of public spending because the public debt stock is low and because foreign trade and the current account deficit are rising slowly. We can now see ahead two or three quarters with confidence. Why risk the possibility of a smooth transition in order to turn a precarious and temporary mechanism into a dangerously built-in risk recipe? We may be flirting with a dangerous idea with ramifications and repercussions that could go much deeper than we may be ready to admit.

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