‘The Discrete Charm of Securitization’: A Die-Hard Story
Can banks securitize NPLs? It was ages ago that the idea of securitization was first conceived in the minds of fund managers and trust holders. However, in its modern guise the packaging of a first CDO can be traced back to 1983, although the idea of a CDO is a bit older, i.e. 1980. It is contemporaneous with the advent of Reagan and Thatcher, and what has been dubbed neoliberalism in many circles. It changed the whole structure of Western Capitalism, and ended the social compact of Roosevelt. It caused an incredible increase in wealth and income distributions – although CEO paychecks inflated the wage bill and made it appear less dramatically twisted than it actually was - and winded the wings of financialization to such a dramatic scale that de-industrialization became the hallmark for at least two decades - true or not, that is. Nevertheless, one thing is certain: services grew by leaps and bounds, traditional industries shrank and financial markets became almost totally unfettered despite the SEC and all that.
Now, here is the situation: In a model with 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 story. Furthermore, as in the context of Arrow-Debreu regular economies, we obtain generic local uniqueness results. 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 equilibria translates into that of asset prices. Against this, the neoliberal argument, so to speak, is two-fold.
First, there is a conjecture harboring the possibility that private equity will diversify risk away. It argues that private owners may discretely transfer risk to counterparties – if markets tend to become ‘complete’, that is if the argument for market-clearing at infinity can be cast away - markets, who can manage or otherwise diversify away those risks they choose to forego, arguably becoming a lower cost substitute for traditional risk capital. The 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. If this mathematical argument can 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 all that of the 1985-2005 period.
Second, there was Lehman, and the crisis, and the secular stagnation, and all that, remember! We all understand that from a technical viewpoint many a financial system/ institution has entered the downturn of the credit cycle with heavily invested asset portfolios, overheated real estate markets, private equity/LBO and structured credit products entailing a number of L-geared risks: longer duration, lower credit quality, larger positions, leverages, less liquid assets. It is also clearly understood that, despite lots of examples cited above and that went at times right to the heart of existing literatures, people do not seem to have taken seriously myriad ways of advising against bearing potentially unbearable risks. Was it all about “fat tails”, i.e. non-linearity and non-Gaussianity, etc., or was it also about the macroeconomic framework, a framework that sheds its shadow to the finance world via monetary and credit channels? One, 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. The difficulty stems from two factors. First, there is insufficient data to determine meaningful probability distributions. Second, and perhaps more importantly, infrequency clouds hazard perception. Risk estimates become anchored on recent events. This leads to disaster myopia, whereby we ignore
low-frequency, remote events. 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. Two, the other problem is correlation within a portfolio; that is among the asset returns that form it. In this respect, using long-memory data sets has been of no avail, since such a practice only, perhaps, augments the parameter space since co-variation matrices can grow very large.
Then Li came up with a convincing idea, 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 PhD in actuarial science from Canada, ended up in Wall Street. The Gaussian copula he used allegedly allowed financial institutions to separate marginal distributions from their joint dependency. Not only correlation is contoured within the asset portfolio, let us say a CDO, but also it is possible to compute the default time of a company if the asset value falls below some threshold value. Gone all the risks, gone the incomplete market hypothesis which no longer matters, and back is the clinging association that markets can always provide the best solution. John Geanakoplos from Yale concisely put forward the theoretical and, hopefully, practical implication back in 1990: “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.”
Now, both arguments are incorrect. Securitization serves nothing in terms of mitigating market and portfolio correlation risks; a mere Gaussian copula cannot handle all the complexities of asset markets; private equity cannot pass for diversified publicly hold risk slices. Have we not yet learned – so painfully - that this kind of irrational exuberance and market fundamentalism only leads to financial and real crises? Securitization is a bad idea indeed, and it is extremely bad 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 – so many years after the crisis and obviously with hindsight - that asset-backed securities that banks are channeled to issue may go sour with such a high probability that the CBRT has better buy them right away from day one. 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 - give them security guarantees that go much beyond what a well-designed credit guarantee fund would entail, inducing them to extend credits at all costs? Let us see.
Clearly growth is predicated upon domestic spending of all sorts since exports are of no help. This means, primo, public spending, and we see the impact of that in the primary balance trends depicted in the relevant graph, and secondo triggered and prolonged loan growth; we see that in the graph as well. Public banks lead and private banks follow, reminiscent of the original intent of the Von Stackelberg-Zeuten game in the 1930s.
We have repeatedly claimed that impetuses and incentives of the sort observed in the last five years would suffice to carry GDP growth above three percent, and more likely above 3.5 percent easily. That would be still subpar growth. But now that the hit is almost complete, only near zero growth can be projected. We also claimed, back in 2017 for instance, that 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 – and warn out - mechanisms are being resorted to as if in a repeated game that will never end. In as much as we find the existence of risk-mitigating guarantee funds for SMEs, small exporters, and agricultural firms sound, theoretically and practically, helpful, we see securitized asset tranches bound to be plugged in the balance sheet of the central banks even before their issuance, a telling repetition of the post-2008 scenario globally speaking at a time when the world is revolving around a new attractor. The crisis in its first and narrow phase was over already in 2013 when the Fed signaled the end of asset purchases, and now the secular stagnation is over, or about to be. Is the situation so desperate the public is prematurely called in the game in a way that would astound all banking analysts and monetary economists?
Rough ride ahead…
There also is the possibility that given all sorts of moral hazard issues, a central bank-sponsored private bank credit securitization – obviously a CDO since eventually the process is repetitive and self-generating - will result; liquidity will also be an issue. If you provide TRY liquidity in excess of spot demand, there is a very good chance that this money will end up in FX 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 will ensue from its excess. Consider the current 49 percent FX deposit-to-M2 ratio of local residents. It has been trending up since the ‘stressful summer’ of 2013. Recently, after a normalization and back reversion episode, that ratio is heading south anew. Now, 50 percent is the key threshold for this key indicator, above which dollarization could not only accelerate but become persistent. We are just hovering around ‘the full dollarization ahead’ signpost.
Securitization through the Central Bank isn’t a good idea. It may be a dangerous idea that has ramifications and repercussions that could go much deeper than we may be ready to admit.