Fragmentation nodes: a study in financial innovation, complexity, and systemic risk.

• Author: Judge, Kathryn

INTRODUCTION I. REGULATING SYSTEMIC RISK A. Traditional Approaches B. Systemic Risk and Its Regulation Today C. Policy Responses to the 2007-2009 Financial Crisis II. THE EMERGENCE OF FRAGMENTATION NODES A. Mortgage-Backed Securities 1. The early days 2. Private-label MBSs B. Toward More Complex Structures 1. Another type of innovation 2. Market forces 3. Subprime MBSs 4. CDOs and beyond C. A Changed Landscape 1. Understanding the complexity 2. The process of financial innovation 3. Other factors shaping these markets a. Regulation b. Agency costs III. FRAGMENTATION NODES AND SYSTEMIC RISK A. Information Loss 1. Fragmentation nodes and information loss 2. Inaccurate price signals and bubbles 3. Fragility 4. The unfolding of the 2007-2009 financial crisis B. Stickiness 1. Fragmentation nodes and stickiness 2. Stickiness in the financial crisis 3. Stickiness and systemic risk IV. POLICY IMPLICATIONS A. Looking Back B. Looking Ahead 1. Disclosure 2. Chain length a. Discourage serial fragmentation nodes b. Encourage simplifying alternatives c. Market forces C. Some Challenges 1. Recurrence 2. Identification 3. Response CONCLUSION INTRODUCTION

Two of the most pressing issues in financial regulation are systemic risk and the increasing complexity of the capital markets. (1) This Article sheds new light on each of these issues and the connection between them through a case study of a particular financial innovation that played a key role in the 2007-2009 financial crisis--the securitization of home loans.

This examination comes at a critical juncture for systemic risk and its regulation. Many of the key reforms adopted in the Dodd-Frank Wall Street Reform and Consumer Protection Act (2) and other policy responses to the 2007-2009 financial crisis seek to increase the stability of the financial system by imposing new costs and restrictions on banks and other large financial institutions. (3) While such regulations may increase the stability of the financial institutions regulated, they also increase the economic gains from financial innovations that shift financing activities out of regulated institutions and into the capital markets. Securitization is precisely such an innovation. Securitization entails the pooling of a group of cash-producing assets, like home loans, into a newly created entity against which multiple classes of securities are issued. The structures created--which this Article calls "fragmentation nodes"--are a critical feature of the shadow banking system through which the capital markets provide close substitutes for goods and services historically provided by banks. (4) As a result, the economic gains from innovations like securitization are likely to be even greater in the years ahead than they were in the years leading up to the financial crisis. It also means that the reforms adopted to produce a more stable financial system are unlikely to achieve that aim unless complemented by efforts to address the corresponding changes they are likely to induce in the capital markets.

Even if inadequately addressed in the policy reforms adopted thus far, this point is not novel. There is a significant and growing body of literature on the interplay between the traditional banking sector and the capital markets and ways that we might extend the types of regulations used to limit systemic risk in the traditional banking sector to the capital markets. (5) This Article goes further. It argues that the shadow banking system not only gives rise to sources of systemic risk akin to those that arise in the traditional banking sector, but that it also gives rise to new sources of systemic risk for which we have no precedent.

This Article's central claim is that specific sources of complexity inherent in fragmentation nodes--core features of the shadow banking system--impede transparency and flexibility in ways that increase systemic risk. More specifically, it identifies particular sources of complexity inherent in fragmentation nodes; it explains why, as a theoretical matter, those sources of complexity may give rise to systemic risk as fragmentation nodes backed by a particular asset type spread; and it draws on evidence suggesting that the theorized sources of systemic risk became manifest and contributed to the 2007-2009 financial crisis. By focusing on sources of complexity that are likely to be present in other financial innovations that shift financing activities out of banks and into the shadow banking system, this Article suggests that these dynamics are likely to arise again. It also enables policymakers and market participants to identify new financial innovations as potentially troubling even if, superficially, they can be distinguished from the securitization vehicles backed by home loans that were central to the 2007-2009 financial crisis.

In addition to contributing to the conversation about systemic risk generally, this Article also draws upon and contributes to two more narrow bodies of work. One of these bodies consists of the numerous accounts of the processes through which the securitization of home loans contributed to the 2007-2009 financial crisis, (6) and the other body focuses on the interactions among financial innovation, complexity, and systemic risk more generally. (7) Premised on the commonly held assumption that the 2007-2009 financial crisis was the result of myriad causes, this Article seeks to complement rather than displace these alternative accounts. (8) Its contributions arise largely from its methodology. By approaching these issues through a case study of how the complexity that resulted as a particular financial innovation arose, evolved, spread, and became a significant source of systemic risk, it provides valuable new insights into the processes through which financial innovations become so complex, and it elucidates the challenges and opportunities facing regulators charged with reducing systemic risk.

The case study begins with a brief history of the evolution and proliferation of mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) backed by MBSs. (9) MBSs and CDOs are created through securitization transactions in which assets (mortgages and MBSs, respectively) are bundled together into a newly created entity against which securities are issued. This account draws attention to the fact that these complex transaction structures are the product of a series of incremental innovations that accumulated over time. The incremental nature of this process is critical to understanding how these transactions became so complex and why that complexity was not subject to greater regulatory or market scrutiny prior to the 2007-2009 financial crisis.

The case study introduces the term "fragmentation node" for the nexus of contractual and other arrangements put into place each time an MBS or CDO is consummated. This term draws attention to the way such transactions permanently transform the relationship between investor and investment, making it easier to conceptualize the ways that the spread of MBSs and CDOs fundamentally altered the landscape of the capital markets. The descriptive account also examines the attributes of fragmentation nodes that make them complex. Four specific sources of complexity are highlighted: (1) fragmentation, (2) the creation of contingent and dynamic economic interests in the underlying assets, (3) a latent competitive tendency among different classes of investors, and (4) the lengthening of the chain separating an investor from the assets ultimately underlying its investment. Identifying these specific sources of complexity is critical to the analysis that follows. While the term "complexity" appears often in descriptions of modern finance, it has been used accurately but loosely to describe a wide array of phenomena. Defining the complexity at issue more narrowly enables this Article to examine with greater precision the effects of that complexity.

The Article builds upon its descriptive foundation by examining how the identified sources of complexity contribute to two distinct sources of systemic risk--information loss and "stickiness." Its approach to each merges theory about why the identified sources of complexity may be expected to give rise to the phenomenon, and why each phenomenon, in turn, may be expected to increase systemic risk, with evidence from the 2007-2009 financial crisis. More specifically, the Article shows how the spread of fragmentation nodes led to a pervasive loss of information about the quality of the underlying home loans and the value of MBS and CDO securities backed by them. This loss of information likely contributed to the bubbles that preceded the 2007-2009 financial crisis, and it set the stage for the paralyzing uncertainty which was central to the unfolding of the crisis. Similarly, coordination problems arising from the fragmentation and repackaging of economic interests in home loans made it exceptionally difficult to modify the terms of those loans, making the original terms of the loans more "sticky" than they would have been otherwise. The resultant stickiness in the original terms of the underlying loans increased the likelihood of foreclosure. The excess foreclosures that resulted caused home prices to fall further, setting off a feedback loop of rising defaults, more foreclosures, and further price declines. While these phenomena have been noted in other accounts of the crisis, this Article is the first to show how each arises from specific sources of complexity inherent in the packaging of home loans into fragmentation nodes.

The Article concludes by considering the type of policies that are likely to be effective in reducing these sources of systemic risk. Once we recognize the systemic consequences of the highlighted sources of complexity, we can appreciate why it may be appropriate, and perhaps even necessary, for regulators to target that complexity directly. Prior to...