The use of mortgage-backed securities in international comparative perspective: lessons and insights.

• Author: Rusznak, Csaba

ABSTRACT

The secondary mortgage market in the United States has helped millions of people purchase homes over the past hall century. Following the burst of the real estate bubble and the credit crisis, it is important for American policymakers not to lose sight of the importance that the secondary mortgage market has played in increasing home ownership. The financial engineering in the form of securitization that led to the success of the secondary mortgage market needs to be preserved, although it should also be reworked so that the externalization of unappreciated risk is reduced and the possibility of a large-scale financial meltdown of the kind experienced in 2008-2009 is not experienced again. In this respect, American policymakers could use ideas from other countries, where synthetic securitization is the key financial tool that has helped the secondary mortgage market to develop. Synthetic securitization offers ways of reducing default risk by integrating financial derivatives such as credit default swaps into the instrument. Such an arrangement also offers the possibility of making securitization more transparent, consequently providing investors new ways of assessing risk and reducing their reliance on credit ratings agencies, and in turn hopefully reducing the concomitant systemic risk that the widespread use of these instruments has created.

TABLE OF CONTENTS I. INTRODUCTION II. BACKGROUND: THE MORTGAGE MARKET IN THE UNITED STATES A. Traditional Lending Institutions as the Early Key Players B. The Beginning of Government Involvement in the Mortgage Market C. Securitization and the Secondary Mortgage Market Take Off i) The Government Agencies' Involvement in Securitization ii) Private-Label Securitization D. The Role of the Credit Rating Agencies E. The Misalignment of Originator Incentives Inherent in Traditional Securitization III. SYNTHETIC SECURITIZATION: AN ALTERNATIVE METHOD OF WEALTH GENERATION A. How Synthetic Securitization Works B. The International Use of Synthetic Securitizations for Mortgage Financing i) Pfandbriefe and the History of the German Secondary Mortgage Market ii) Pfandbriefe and the Emerging Securitization Market in Germany C. Shortcomings of Synthetic Securitizations D. Rescuing Derivatives from Becoming the Bogey-Men of the Financial World IV. USING SYNTHETIC SECURITIZATION IN TRADITIONAL SECURITIZATION TRANSACTIONS TO PROMOTE TRANSPARENCY A. What is the Problem We Need to Address? B. Current Legislative and Regulatory Proposals--On the Right Track? C. Possible Alternatives i) Public Benchmarks for Securities Prices ii) Combining Synthetic and Traditional Securitization iii) Shortcomings of This Approach V. IMPLEMENTING THE PROPOSAL UNDER THE U.S. SECURITIES LAWS A. Regulation of Mortgage-Backed Securities Today B. Regulation of Mortgage-Backed Securities Going Forward VI. CONCLUSION I. INTRODUCTION

The subprime crisis in the United States delivered one of the largest shocks to the American financial system in decades. (1) Although the total impact of the crisis is not yet clear, the collapse of the subprime market ravaged international credit and equity markets, which in turn threatened the stability of economies around the world. (2) The reaction from the American public has generally been one of outrage. (3) They see the financial system as having failed ordinary people by cajoling them into mortgages they did not understand through predatory lending practices and enriching the financial elite at the expense of everyone else. (4) The American public is demanding greater government vigilance to ensure that a similar crisis does not happen in the future. (5) Congress and the Administration--their thumbs on the nation's pulse--have responded with promises of regulation and greater government oversight. (6)

At this point, we can only speculate as to the future content of legislation or regulation. Developments between now and whenever the U.S. government takes action will likely influence the contours of the response. Already, however, consensus is emerging between world leaders on what problems need to be fixed, and governments from around the globe are taking aim at certain targets. (7) These same governments are also showing prudence--calling for reasoned regulation, lest the rush to regulate end up hurting the financial markets. (8)

Chief among the complaints advanced by both the public and the American government is that the secondary mortgage market (where mortgage-backed securities were the engines of capital raising) failed in large part because it suffered from a fundamental misalignment of financial incentives. (9) Those selling the mortgages in the first place (originators), as well as those repackaging them in the form of mortgage-backed securities (arrangers), were able to avoid internalizing the default risk that these securities carried with them. (10) As a result, both the originators and the arrangers had little incentive to properly monitor the creditworthiness of individual borrowers as well as the mortgage-backed securities themselves. (11) In order to be effective, government regulation in response to the subprime crisis ought to include components which correct the incentives currently in place. Doing so would correct a structural problem in the secondary mortgage market and hopefully help avoid a similar crisis in the future.

This Note attempts to weigh in on the kind of regulation that might be effective at avoiding future crises. First, the Note will consider the prevalent method of financing in the U.S. secondary mortgage market today--traditional asset-backed securitization. (12) In particular, the Note will examine the implications of traditional asset-backed securitization with regard to credit default risk externalization. Second, the Note will consider an alternative form of mortgage financing used in other countries around the world, especially Germany: synthetic securitization. (13) The Note will compare the two methods and attempt to delineate their respective strengths and weaknesses. Most importantly, the Note will explain how synthetic securitization differs from traditional securitization in terms of allocating default risk. Finally, the Note will propose a solution that unites elements of the traditional asset-backed securitization model with elements of the synthetic securitization model. The key insight of the Note will be that synthetic securitization's use of credit default swaps has the potential to make assessing credit risk more transparent and market-based, rather than relying on credit rating agencies to issue ratings opinions that are often subject to easy manipulation. Hopefully, such an arrangement will respond constructively to the critics of the current system, while preserving the capital markets' ability to raise money for mortgage financing.

The purpose of this Note, therefore, is hot primarily to discuss one single method of securitization in great detail, nor is it to argue that one method of securitization should prevail over another. Rather, this Note argues that the different types of securitization methods should be amalgamated in order to overcome the shortcomings that hamper traditional securitization when used individually. In this sense, the Note seeks to understand how already existing financial tools can be used together in order to create stronger, more transparent, and ultimately, more valuable investment vehicles.

Discussing complex financial instruments is necessary in a Note such as this; however, care has been taken to avoid making the text inaccessible to non-financial readers. This Note intends to contribute to a policy discussion in broad terms, not to explore the intricacies of certain financial products in excruciating detail.

2. BACKGROUND: THE MORTGAGE MARKET IN THE UNITED STATES

   1. Traditional Lending Institutions as the Early Key Players

      The financing of American mortgages has undergone a radical transformation in the past seven decades. (14) Before the 1940s, banks originated the majority of mortgages to individuals desiring to purchase a home. (15) The money for the mortgage came directly from deposits held by the bank. (16) Banks thus had an incentive to make sure that borrowers were sufficiently creditworthy; in case of a borrower default, the bank would directly surfer a loss. (17) As a result, banks were generally prudent in their lending practices, with the concomitant result that fewer people were able to afford home ownership. (18) Typically, banks were conservative in the amount of money they lent on a particular mortgage relative to the amount that the property itself was worth. (19) This is known as the loan-to-value ratio. (20) Generally, banks before the 1940s did not loan more than 50% of the property's value. (21) Banks typically kept their loan-to-value ratios low so that they could be assured of some return if the mortgage became delinquent and the bank had to repossess the property. (22) By way of comparison, non-bank mortgage originators often made subprime loans in the past few years with loan-to-value ratios well in excess of 100%. (23)

   2. The Beginning of Government Involvement in the Mortgage Market

      The Great Depression and subsequent collapse of housing prices introduced new forces and actors into the American mortgage market. The mid-1930s saw close to 10% of American homes go into foreclosure and mortgage lending decrease significantly because financial institutions were both unwilling, and in some cases unable, to lend money to prospective homeowners. (24) It was at this point that the federal government entered the mortgage market through the Home Owner's Loan Corporation, which used government money raised through selling government bonds to buy defaulting mortgages from banks, rearrange their terms, and finally reinstate them. (25) For the first time long-term, fixed rate, and amortizing mortgages came into being, making it easier and less risky for...