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Many of the new alternatives for borrowers and investors came, directly or indirectly, from what is sometimes called the shadow banking system SBS. However, they offer a more complex array of products than just simple loans, and they are often subject to less intensive regulation. As part of the move from bank financing to the SBS, one way that financial markets changed dramatically from the mids through the onset of the financial crisis in was in the rise of structured finance. Securitization is the issuance of bonds backed by the payments on a pool of assets. It allows banks and other lenders to origi- nate assets without the need to hold them on their balance sheets for an extended period of time. The initial securitizations involved pools of home mortgages, with the bonds issued called mortgage-backed securities MBS.
MBS were soon followed by so-called asset-backed securities ABS , which were bonds backed by the payments on pools of loans such as automobile and credit card loans. In the last twenty years, the types of assets that were part of securitizations expanded to include large corporate loans and mortgages as well as more obscure assets there was a securitization backed by the royalties on recordings by David Bowie. There have also been securitizations that are backed by the payments on pools of securitized bonds from different deals collateralized debt obligations, or CDOs. Instead of making a loan and holding it on its balance sheet until maturity, a lender could make originate a loan, then immediately sell it.
The ability of lenders to use the OTD model is frequently cited as one of the factors that contributed to the financial crisis. One argument goes as follows Diamond and Rajan, A glut of foreign savings with a desire for safe securities led to an increase in demand for bonds such as highly rated MBS and ABS securities. The demand for these securities gave banks an incentive to create them by originating and selling loans. Problems crept into valuations, but rising home prices covered up these problems and allowed lenders to keep originating and selling new loans. When home prices started falling, losses became apparent.
Since many holders of MBS, including banks and derivative conduits such as structured investment vehicles SIVs 3, were either leveraged Adrian and Shin, or held longer-term assets along with short-term liabilities Brunnermeier, ; Diamond and Rajan, , the home price declines led to questions about the institutions viability. This, in turn, might have sparked a run on these institutions Gorton and Metrick, Hidden in this line of thinking is why, as noted above, mispricing crept into valuations. In other words, why did the problems that followed once housing prices started to fall seem to surprise so many market participants? I explore why several tendencies of investors, and the ability of intermediaries to take advantage of these tendencies, may have made seemingly surprising deviations of prices from fundamentals more likely.
The SBS facilitated innovations such as the advances in securitization, but many of the innovations shifted the responsibility for screening and monitoring borrowers from lenders to investors in securitized bonds. ROSEN Traditionally, much intermediated finance was done by banks. The bank, because it kept the loan on its balance sheet, would have an incentive to screen potential borrowers to make sure they were creditworthy and to monitor the loan to maximize the chance it got repaid. Many of the new products facilitated by the SBS shifted some of this responsibility from banks to investors. This introduced two possible problems. First, investors were at least one step further removed from the actual lending decisions, making their ability to screen and monitor more difficult.
Second, many of the investors in securities made available by the SBS were, in fact, agents for other investors, leading to potential incentive problems. I discuss how these two potential problems, especially following a long period of stability and growth in the financial system, can make a crisis more likely. Why would the financially sophisticated investors that participate in structured finance markets be willing to purchase extremely complicated securities? The strong performance of structured finance in general gave three incentives for investors to purchase structured securities such as securitized bonds. First, behavioral finance has identified a number of circumstances where overconfidence affected investor decision making see, e.
The high returns on structured securities in the run-up to the crisis may have led investors to believe the securities were better than they actually were. Second, the credit ratings on these securities had proved reliable in the recent past see, e. It may have been rational for busy investors to rely on the recent track record of the securities and the rating agencies rather than to care- fully examine each security they planned to purchase. Finally, many of these investors were investing for others such as mutual fund managers acting on behalf of their fund investors , and this gave them an incentive to reach for yield and to follow the herd see, e. The factors that attracted investors to structured securities such as MBS could also explain some of the evolution of the securitization market over time.
As noted above, securitizations became more complex over time. This is consistent with the intermediaries involved in issuing structure securities taking advantage of overconfidence and rational inattention, since overconfident investors are likely to believe they can evaluate the more complicated securities and inattentive investors are unlikely to notice as securities become gradually more complicated as long as credit rating agencies continue to give them strong ratings. The pattern in the years leading up to the crisis was that investors successfully invested in new securities, often ones promising them extra returns. The successful investments led to new investments and an increased reliance on simple guideposts. The investors were pushed toward similar but riskier investments by issuers or advisors. Finally, there was a reckoning as many of the risky securities saw a sharp decline in value.
This investor-intermediary risk cycle fits not only the most recent crisis, but a number of prior examples such as the Asian currency crises in the late s. Thus, the current crisis may have been more extreme than prior incidents, but a number of the factors that led to it were also present in previous incidents. The remainder of the chapter is organized as follows. The next section gives some background on the U. financial system and its evolution. There is a particular focus on lending and the role of the SBS. In Section 2, I discuss why investors would buy securities that do not have a positive expected return.
After that, I explore whether the run-up to the crisis was fundamentally different from anything in the past. Finally, Section 4 offers some concluding comments. Background This section gives some background on how the evolution of financial institutions and markets in the United States set the stage for the financial crisis. I start with a basic comparison of intermediated versus market- based financing and then discuss the specifics for the United States. Understanding the rise of the SBS means understanding both the financial system structure and the incentives of the participants in the financial system. The structure and incentives in arose in part because of choices made in the last major crisis in the s. The traditional role of banks is transforming deposits into loans. Depositors and other bank liability holders generally value liquidity, so most bank liabilities are short term.
Borrowers, on the other hand, often want longer-term loans. This mismatch between the desired maturities of savers and borrowers leaves a role for financial intermediaries such as banks. Banks are able to manage balance sheets with many assets and liabilities of different maturities. This allows them to transform short- term liabilities into long-term loans and small deposits into large loans. A value added from having banks do asset transformation is that they are set up to screen potential borrowers and then to monitor the borrowers they eventually lend to. ROSEN In contrast to the traditional role of banks, the traditional role of other financial market participants such as investment banks and securities dealers is to help the sale of securities in markets.
In this role, investment banks and securities dealers serve as brokers, holding securities for at most a short time period as part of the sale or underwriting process. In their traditional roles, investment banks and securities dealers help facilitate market-based finance. Market-based finance can have lower overhead costs than intermediated finance and can give borrowers access to a wider pool of potential investors. Countries differ in the relative importance of bank-oriented and market-based finance. The United States has historically had a strong market-based finance sector. This is largely a function of laws and regulations that helped strengthen an independent investment banking sector.
The most important law that affected the structure of the financial sec- tor in the United States in the period leading up to the financial crisis is the Glass-Steagall Act in Glass-Steagall, a response to the financial crisis that led into the Great Depression in the s, effectively separated commercial banking from investment banking. While the separation between commercial and investment banks was not complete, for the most part, each type of firm completed in its own type of market. The separation of commercial and investment banking in the United States also resulted in investment banks that, in the s, were not struc- tured to compete with banks in the loan market. Realizing this, investment banks worked at innovations that would allow them to compete with banks.
In the s, investment banks got many large firms to replace loans with commercial paper CP. To make CP attractive to investors, the borrowers typically had a backup guarantee of repayment, which often came from banks. Investment banks liked CP because it generated fees for them, and investors liked it because it was a high-quality liquid security, but these features were not the only reasons for its success. One big difference between the CP and loans is that a bank loan is reflected on the balance sheet of the bank. Banks are subject to capital requirements and reserve requirements.
Both of these require- ments impose costs on banks that can be avoided—or arbitraged—if a firm funds in the CP market rather than by using a bank loan. Later, investment banks pioneered high-yield bonds. Typically, the only firms that could issue public debt bonds were those with an investment- grade rating BBB or better from the credit rating agencies. But starting in the s, investment banks were able to market high-yield, or noninvest- ment grade, debt. High-yield bonds served as a substitute for bank loans. Again, regulatory arbitrage may have been one of the factors that contrib- uted to the start of the high-yield bond market. One characteristic of both the CP market and the high-yield bond market is that intermediated debt bank loans was replaced by market-based nonintermediated debt. The private securitization market, which started in , but did not expand rapidly until the late s, was a different sort of innovation than CP and high-yield debt because securitization is a form of intermediation.
In addition, participants include both traditional banks and investment banks. Securitization was one of the first activities where investment banks competed with commercial banks as intermediaries. The first securitizations in the United States preceded the private secu- ritization market. Starting in , banks and other lenders put together pools of home mortgages that were then guaranteed by the government agency known as Government National Mortgage Association GNMA, also known as Ginnie Mae. The broad structure of these securitizations, except for the GNMA guarantee, was similar to most of the deals that followed.
The lenders sold their loans to intermediaries sponsored by com- mercial and investment banks see Rosen, , for a fuller description of the securitization process. For legal reasons, the loans were owned by so-called special purpose vehicles SPV; sometimes these are called special purpose entities rather than by the sponsoring institution. An SPV would collect some loans into a pool, and then issue MBS. The bondholders were repaid based on the payments on the loans in the pool. The initial GNMA securitizations passed through all payments less fees. Each bond would share the same coupon rate and other features, and importantly, each would have a similar claim on all payments.
MBS are structured so that interest payments on the mortgages are at least sufficient to cover the interest payments due on the bonds plus the fees of the intermediaries. Principal payments either scheduled payments or prepayments on the mortgages are used to pay down the principal on the bonds. The role of GNMA was to guarantee principal repayment. This leaves bondholders exposed to interest rate risk and the risk that the mortgage loans would be repaid early. As with the GNMA, the GSEs guaranteed payments on the mortgages in the pool backing its MBS. The private securitization market started in when Bank of America issued an MBS without guarantees from Ginnie Mae or the GSEs. The market did not grow appreciably, however, until a law was passed in that allowed regulated financial institutions such as banks to own MBS.
Then, in , the ABS market started with securities backed by computer leases and automobile loans. Private-label MBS those without guarantees from Ginnie Mae or the GSEs and ABS have a basic structure much like the GNMA-guaranteed MBS, but with some important differ- ences. The firm putting together a private-label MBS or ABS deal sets up an SPV to purchase a pool of securities, then issues bonds with payments that are based on the payments on the loans in the underlying pool. However, since private-label MBS and ABS do not have government or GSE guarantees, they are structured with built in protections, something I discuss below. The private-label MBS and ABS markets grew rapidly in the following years, as figure 2.
Securitization changes what banks do from screening, monitoring, and funding loans to originating loans after an initial screening, then selling the loans. This new process, known as the OTD model, can lead to an agency problem as it reduces the incentives of banks to carefully screen and monitor the loans they are planning to sell e. This is why most of the early securitizations involved large pools of small, somewhat homogenous loans such as mortgages and automobile loans. So, reducing the incentives to monitor was not a big issue. In addition, the banks that sold loans into a pool were able to give aggregate statistics on the loan pool, giving investors in the MBS a good idea of the overall default and prepayment characteristics of the pool. In addition to any contractual prohibitions against fraud, the desire to be able to sell future loans gave banks an incentive to report the information they learned from screening the loans. Another feature common in private-label MBS and ABS is tranching.
Starting in , the securities offered in a securitization were split into different classes, or tranches. Many investors were willing to sacrifice some return for very safe, predictable payment streams while others were willing to accept more risk to get high yields. Bonds issued in a tranched deal gen- erally differed in payment priority, and therefore risk. For example, a deal could have two classes of bonds, senior and junior. The interest payments on the underlying assets would be used to pay interest on both classes of bonds. Principal payments, whether scheduled or prepayments, would first be used to repay the principal of the senior bonds. Once these bonds were repaid, principal payments would be used to repay the junior bonds. Thus, the senior notes would have a shorter and more predictable maturity and be safer since initial principal losses would be borne by the junior bonds.
Many securitizations had a large number of tranches, leading to complicated payment dynamics if a large number of the underlying loans defaulted. Most private-label MBS and ABS also use overcollateralization and excess spread to provide a default buffer for all bondholders. ROSEN refers to the difference between the principal balance on the loans in the pool and the principal balance on the outstanding MBS or ABS; excess spread is the difference between the interest payments coming in loan payments minus any fees and the weighted average payments going to bondholders. They are related in that excess spread can be used to build up overcollateralization. The first use of excess spread is to cover default losses. If any excess spread is left, it can be used to build up a cushion against future losses.
As noted above, the tranche structure of a securitization can be extremely complicated as the payment and default risk are split up in different ways. A higher level of sub- ordination means that there would have to be a larger share of defaults before the bond suffered a principal loss. One objective of tranching is to get one or more class of bonds that are rated AAA by a credit rating agency. The intermediaries involved in issuing these bonds henceforth, the issuers often wanted to issue as large a percent of the bonds with a AAA rating as they could. There was a complicated dance between issuers and the credit rating agencies about the level of subordination of the AAA bonds. One of the ways in which the credit rating agencies were accused of working with issuers during the boom was in structuring the tranches in a securitization so that the issuer had an attractive set of bonds to sell Kane, As the securitization market expanded and demand for securitized bonds increased, issuers started to include different types of assets in the pools backing the securitizations.
Collateralized loan obligations CLOs are securities that are backed by the payments on a pool of commercial loans. CLOs differ from earlier ABS in part because the loans in the pool are large. Absent securitization, banks typically monitor even performing commercial loans. The need to monitor increases the agency problems with these loans, but market participants believed that the structure of the securitizations and reputational issues were enough to get the lenders to monitor them. CLOs were followed by CDOs. The pool of assets backing CDO bonds varied, but in the mids often included bonds from other securitiza- tions and commercial loans including commercial real estate loans. There were also CDOs that included bonds from other CDOs these were often referred to as CDO-squared. Most CDOs were very difficult to value because of their complexity. The expansion of securitization rested on three pillars.
One pillar was regulatory arbitrage see, e. As noted earlier, there are regu- latory costs for keeping a loan on a bank balance sheet. In addition, under the risk-based capital guidelines, banks that want to hold the exposure to a certain class of loans can reduce their risk-weighted assets by holding securitized bonds rather than whole loans. The second pillar that facilitated the expansion of securitization was valuation. Technological advances made it easier to analyze large amounts of data in an attempt to price MBS and ABS bonds. Related to this was the willingness of credit rating agencies to rate the bonds. Together, these made investors comfortable purchasing what were often very complex securities. It is this second pillar that has crumbled during the recent crisis. As the rapid decline in value of some MBS and ABS bonds during the crisis shows, there were significant problems in the valuations and ratings.
In the next section, I return to the question of why investors would purchase bonds that were difficult to price. The third pillar is the ability to distribute risk inherent in securitization. Tranching allows issuers to divide the risk in the underlying assets in an almost unlimited way. They can design bonds with a broad variety of payment and risk characteristics. In theory, this allows investors to buy bonds with the characteristics that most appeal to them. Of course, as noted below, banks ended up holding much of the risk from structured securities Shin, Underlying the move to securitization, in particular, and the SBS, in general, was an attempt by financial firms to capture business from their rivals. Investment banks attempted to break down the Glass-Steagall bar- riers by innovating around them with products such as CP, high-yield bonds, and securitization.
At the same time, banks were attempting to get into the underwriting field, formerly the province of investment banks. While some of these innovations offered potential improvements such as securitization allowing risks to be divided , innovation was also aimed at regulatory arbitrage. In , in an effort to level the playing field between banks and investment banks and, coincidentally, reduce incentives for regulatory arbitrage , the United States implemented the Gramm-Leach- Bliley Act. Gramm-Leach-Bliley allowed commercial and investment banking in the same financial firm. This meant that the largest financial firms had both lending and investment banking arms, changing their incentives to innovate Boot and Thakor, The evolution of the financial industry and the rise of the SBS may have been motivated by efforts of industry players to capture revenue, but it drastically changed how firms profited from financial intermediation.
As the lending process moved away from bank loans to either market- based alternatives such as CP or intermediation-based alternatives such as securitization, revenues for banks moved from interest-based to fee-based. ROSEN This only accelerated once commercial and investment banks could merge. The move to fee-based earnings reduced the incentives for banks to worry about the long run, and in particular, to worry about the risk of the loans or securities they were selling. This risk was shifted to the buyers. As long as there was someone to buy them, the banks had an incentive to sell them. This leaves the issue of what motivated the purchasers. Many of the structured finance securities described in the last section were quite popular in the period leading up to the financial crisis.
Between and , the value of mortgages that were issued to subprime borrowers and were then securitized more than tripled fig. This reflected a general increase in the share of MBS that were issued without a government or GSE guarantee fig. When housing prices started to fall in and , it was the most recent vintage of securities those issued closest to the crisis that did the worst Demyanyk and Van Hemert, Why did investors continue flocking into these markets until sometime in ? One possibility is that the investors were right ex ante, but the crisis was just extremely bad luck. This hypothesis cannot be rejected, but given what is known today about the quality of some of the assets in structured securities, bad luck does not seem to be a complete explanation. In this section, I consider some alternative hypotheses. ABS and MBS typically had higher yields than corporate bonds with equivalent ratings fig.
In the remainder of this section, I discuss some reasons why investors may have purchased securities that, at least in retrospect, seem to be bad investments. The last reason can explain why investors may purchase a security that they believe has a worse risk-return tradeoff than alternative investments. In the back- ground of these arguments is the role of the credit rating agencies. ROSEN Yield spreads to corporate bonds for structured finance products HEL ABS CMBS Auto ABS Basis points 50 0 Jan Jan Jan Jan Jan Jan Jan Jan Jan Figure 2. Still, for many of the complex securities, there is no consensus valuation, or even valuation method see, e. This excess of material and lack of con- sensus on valuation complicates the decision of whether to buy a security at a given price. The literature on behavioral finance offers a number of psychology-based reasons why investors may not act as pure profit maximizers.
One aspect of behavior evident from prior work is that investors tend to be overly optimistic or overconfident I will generally use overconfidence to cover both overoptimism and overconfidence. There is also evidence of confirmation bias, the tendency to interpret evidence in a way that is consistent with prior beliefs. Confirmation bias leads individuals to put more weight on evidence that confirms their prior beliefs than on evidence that contradicts the beliefs. These aspects of investor behavior may have played a role in the evolution of structured finance and in setting the conditions for the financial crisis that started in Several studies have explored whether so-called rational inattention can be used to explain macroeconomic phenomena see, e.
Sims, , and Reis, This can lead prices to deviate from their fundamental values. A form of rational inattention, especially when combined with overoptimism and overconfidence, may have helped set the stage for the financial crisis. How should an investor make the decision to purchase a structured security? One way is to carefully analyze the prospectus and to make projections about future asset prices and default rates. This is extremely time consuming, and as noted above, there may be no consensus valuation method. These credit rating agencies have a long track record of evaluating securities. As I discuss below, whether the credit ratings of the NRSROs should be considered credible and reliable is controversial see, e. The track records of the rating agencies may have led investors to pay less attention to the complicated details of each deal and instead to use the ratings assigned by the credit rating agencies as a starting point and possible ending place for any analysis.
In essence, the credit rating of a security may serve as an anchor around which the investor can interpret any additional evidence. The investor may want the extra yield offered by the MBS, but not be certain of how to value the security. She may look into the details of subprime mortgage defaults, which were relatively stable and low for over five years prior to , and evaluate prepayment risk. The implied losses on the MBS bonds based on outside assessments of mortgage default and prepayment rates at that point would imply that the subprime MBS bond yields provide adequate compensation for the risk.
This is a reasonable amount of work, and still suggests that the MBS are a good buy. ROSEN the table by the market. The point at which an investor stops her analysis may depend on how she rates her ability to price securities relative to others in the market. The more confident she is, the more willing she might be to believe that the market is mispricing the security. This may mean that more confident investors stop their analysis earlier than their less confident brethren. An overconfident investor can believe that a high yield on the security is money left on the table. If she considers herself better at analysis than the average investor, she may believe she can estimate default risk better than others.
This means that for the securities she chooses to purchase, the overconfident investor incorrectly believes the high yields exist because other investors wrongly, in the mind of the overconfident investor, overestimate default risk. Also, if an over- confident investor believes she can make more precise estimates of the possible return paths of a security than other investors, she can place a lower price on true risk than other investors since true risk is greater than her perception of risk. Thus, overconfidence can sway an investor toward structured securities because of their high yield relative to their credit rating. Enough overconfident investors can drive yields below a level commensurate with their risk, even if the yield stays high compared to alternative traditional securities. Rational inattention may explain why an investor would shift from doing her own analysis of a particular type of security to relying on a credit rating.
The investor has access to two public signals: the payments on the security and the credit rating. During the — period, most struc- tured securities based on pools of mortgages or other assets had very low defaults. After doing a detailed analysis once or more and finding that the credit rating provided a floor for the risk, the investor may decide that the credit rating is reliable enough to allow her to purchase the securities without doing a full analysis. A busy investor allocates her time toward decisions where she believes it is best used. When the securities are performing and there is no external signal to suggest an increase in the expected default rate in the underlying assets, she can choose to be inattentive to the detailed information and rely instead on the credit rating because her initial analysis suggests the information from the rating is a good enough signal to allow her to avoid costly information acquisition.
There is evidence that investors in AAA securitization were less informed about the quality of the securities than investors in lower-rated securities Adelino, TOO MUCH RIGHT CAN MAKE A WRONG 53 An investor may not bother to do a detailed analysis even for new securities as long as they seem to her to be close in structure to securities she is already comfortable with, since the cost of the analysis may not be worth the expected improvement in valuation. Confirmation bias would likely push the investor toward believing that a reliance on credit rating was a good decision, reducing her perceived need to do a detailed analysis of new securities.
Thus, it may not be until well after there are risk signs that an investor starts to pay careful attention to the details about a particular class of securities. An investor more confident about her ability to evalu- ate securities is likely to need a bigger change in securities or signals to prompt careful attention. The above argument suggests that investors may react to a strong track record for a particular type and rating of structured security or any other investment by spending less time investigating the details of the invest- ment and, if they are overconfident, becoming more certain that they can analyze the securities better than other investors.
These possibilities give issuers an opening to slightly change the structure of the securities they issue so as to increase risk but maintain the same credit rating. This is important because issuers have a strong incentive to add risk because they get fees for arranging securitization deals, and to arrange deals, the issuer needs underlying assets. The evolution of deals suggests that, over time, SPV pools got riskier and this led to riskier securitized bonds. Take, for example, subprime MBS. One measure of risk of a subprime mortgage is whether the mortgage was written with full documentation of income, assets, and employment as opposed to those written without full documentation so-called low-doc or no-doc mortgages. Not surprisingly, low-doc loans were more likely to default than full-doc loans.
Consistent with a move toward riskier securities, the share of low-doc loans in subprime security pools increased from to no-doc loans made up less than one percent of all subprime loans in pools during the period. ROSEN consistent with overconfidence, confirmation bias, and rational inattention given the anchor of credit ratings. The new securities that were introduced as the market evolved were often somewhat riskier innovations on prior securities. For example, subprime MBS were similar to prime MBS but slightly riskier because subprime mortgage default rates were historically higher and more variable than prime mortgage default rates.
CLOs looked like other ABS such as those based on pools of automobile loans in the sense that both were based on the payments on pools of loans. But, because CLOs included a small num- ber of large loans that required monitoring rather than a large number of small loans that were not monitored unless payments were missed, there were bigger moral hazard problems than in other ABS. Securities like CDOs based on pools of MBS and ABS securities were yet more complicated. Investors may have been lulled into a false sense of security by the high yields offered, the strong performance of structured securities in general, and the credit ratings. Thus, overconfident and inattentive investors could be been led into riskier securities without requiring compensating yield increases. That is, the fact that a structured security offered a higher yield than an equivalently rated corporate bond may have attracted investors, but the excess yield may not have been enough to compensate for the additional, but somewhat hidden, extra risk.
The argument relies on the premise that a credit rating does not reflect the true risk of a security, and that this problem was magnified for later vintages of structured securities. This suggests that the credit rating agencies did not do a good job. But that suggestion depends on what credit rating agencies thought their job was. The role of the credit rating agencies was controversial, even before the financial crisis. There has long been a debate about how well credit ratings anticipate future defaults, as evidenced by their failure to accurately anticipate the default of bonds issued by firms such as Washington Public Power System and Enron Partnoy, ; Hill, It has been argued that credit rating changes lag changes in risk Altman and Rijken, Some believe that these problems at least partially stem from conflicting incentives that can lead the credit rating agencies to sacrifice ratings accuracy in an effort to satisfy other concerns Mason and Rosner, ; Partnoy, The credit rating agencies get most of their revenues from issuers, and this could give them a reason to please issuers at the expense of ratings accuracy.
This is likely to be a bigger problem for structured securities than for traditional corporate bonds, because one big issue in rating structured securities is setting up the tranche structure. It is claimed that choosing the tranche structure often can be an iterative process where the rating agencies give feedback to the issuer, who then can modify the proposed structure Mason and Rosner, There is a lot of room for subtle changes in risk through small changes in subordination. Whether or not it was due to conflicts of interest, there is evidence that credit ratings agencies did not account for the predictable risk of some structured securities, and that this problem was strongest right before the financial crisis in Mason and Rosner, ; Ashcraft et al.
Structured securities were often very complicated and hard to price. This was especially true when the pools of assets were divided into a large number of tranches. Additionally, the estimated value of some securities was very sensitive to the assumptions on asset default. The models use by credit ratings agencies may have missed many of the subtleties because they use simplifying assumptions for trac- tability. The risk estimates were also based largely on historical data. This was an issue for many securities because recent history generally did not include a major downturn. Also, because of changes in lending patterns, some of the history was probably not relevant to current pools of assets.
As evidence of the last point, consider subprime mortgages. The typical subprime mortgage borrower in was probably much riskier than the typical subprime mortgage borrower in So, using default rates on subprime mortgages to predict default rates on mortgages would likely underestimate true risk. An analysis based on old default rates would mean that an AAA rating in implied a higher risk than the same rating in While investors could have learned some of the details about rating agency models, it is likely that few of them spent the time to do this. To sum up, overconfidence and inattention may have contributed to the expansion of the SBS and to the severity of the financial crisis.
Whatever their motivations for purchase, early investors did well. ROSEN during the — period meant that very few structured securities defaulted. This strong performance reinforced the opinions of investors and may have led them to rely more on credit ratings that is, become less attentive. Given the issues with credit rating agencies, this all meant there was room for issuers to produce riskier securities at a given credit rating, something they did. In Section 1, I discuss the differences between direct and intermediated finance. But within inter- mediated finance, there are differences in the number of steps between savers and borrowers. In traditional bank financing, a saver deposits with a bank, which then makes loans.
However, the process for structured secu- rities and other investments can be much more complicated. The chain from a saver to the ultimate borrower can be long see Shin, , for some examples. These long chains can increase agency problems. Consider the simple case of an individual investing in a bond mutual fund see fig. The mutual fund manager, acting as an agent for the individual, uses the investment to purchase securities, including perhaps structured securities. The structured securities are put together by an issuer Loaned funds Borrower Lender MBS issuing intermediary Loan Purchase Loan sale payments price fees Special purpose vehicle Investment MBS Investor Mutual fund Mutual fund shares fees Mutual fund manager Figure 2. The banks lend to the borrowers. How should the mutual fund manager choose what to invest in? The fund manager is likely aware that investors tend to put more money in funds that outperform their peers see, e.
In order to increase her compensation, the fund manager needs to attract investors. This gives her an incentive to report high returns both relative to her peers and overall. Thus, even if a fund manager believes that the yields on structured securities are insufficient to compensate for their risk, she may still rationally invest in them. There is evidence of return persistence among mutual funds that perform worse than their peers Hendricks et al, To avoid being categorized as a poor performer, a fund manager would want to avoid having her fund perform poorly when other similar funds were performing well.
This gives her an incentive to follow the herd see Scharfstein and Stein, , on herd behavior. So, if enough fund managers start investing in structured securities to get new investors, other managers will have an incentive to follow them. Combining the incentives to chase yield to attract new customers and the incentives to herd with overconfidence only reinforces the attractiveness of structured securities. It also gives issuers more reason to be innovative. Securities with high yields where risk is concentrated are likely to be attractive to those investing money for others. High yields are popular with the ultimate investors, and concentrated risk means it is unlikely that the agent investing for others will look bad although when things get bad, they can be very bad.
These characteristics are consistent with the evolution of structured finance and the SBS. One theme running through the argument so far is that smart issuers innovated to take advantage of investors. One potential criticism of this story is that most of the losses from the financial crisis that started in were borne by banks and other financial firms. One estimate is that financial firms would suffer roughly one-half of potential losses from subprime mortgages Greenlaw et al. Not all of these losses were from structured securities, but there is abundant evidence that investment banks and com- mercial banks had major losses on structured securities in and ROSEN difficult to sell. In order to keep the fees coming, issuers sometimes keep bonds from the tranches that are less attractive to the market.
This may have been a function of overconfidence on the part of traders. But it also may have reflected a culture of risk taking, perhaps related to compensation schemes Diamond and Rajan, So, people in different parts of a financial firm can have different incentives. The firm can be both intermediating the sale of risky securities and buying them at the same time. As a side note, for the overall argument here to hold, it is not necessary that all investors were overconfident, inattentive, or agents for others. There may have been investors that made decisions about whether to purchase structured securities based on a purely profit maximizing basis. However, the rapid increases in the sale of these securities and the losses investors took on them suggest that the profit-maximizing investors may not have been setting the prices for the securities.
Why did these investors not short the securities to benefit from any mispricing caused by overconfident and inattentive investors? One possible reason is that it may not be optimal for investors with limited capital to try to bet against non—profit-maximizing investors see, e. How this Crisis Was Different The early s, the period leading up to the crisis in , was characterized by significant financial innovation with, by and large, investor acceptance of if not enthusiasm for the new instruments. As I described above, one feature of the innovation was the production of more complex securities that often have significant risk. However, this risk may not have been fully priced into the securities. Above, I argue that investor overconfidence and agency problems contributed to this by giving issuers an incentive to produce more complex securities.
In this section, I first provide several examples to show that this pattern is not an isolated incident. Then, I explore some possible reasons why the crisis was especially severe. The pattern in the recent crisis mirrors that in prior incidents. A parti- cular investment or class of investments has realized returns that are higher than many other investment opportunities. Investors flock to this apparently hot market. As investors crowd in, the investment opportunities change. In particular, the investments get riskier. These incidents can end with investors suffering large losses. This investor-intermediary risk cycle is apparent in other crises and bubbles. One example is the investment in emerging market countries in the period ending with the currency crises in and Focusing on Asia, many countries were relaxing regula- tions on financial markets and capital accounts in the early s.
In part because of this, capital flows into these countries increased dramatically. However, the increases in capital flows occurred following economic growth and appear not to have increased growth Chan-Lau and Chen, One could argue that investors were chasing high returns. Over time, it is likely that investments became riskier on average. There is some evidence that investment banks used the desire of investors to enter markets such as these as an opportunity to sell high-margin products. A similar pattern happened in what were then called less-developed countries LDC in the s. Famously, when asked about the riskiness of investing in LDC debt, Walter Wriston, the then-chairman of Citicorp, said that countries do not go bankrupt.
Of course, later, some LDC countries defaulted on their debt. The rise of the technology bubble in the s also had investors moving into risky securities following a period of strong performance on existing securities, in this case, technology stocks. The evolution of investments from those that are safe and easy to understand to those that are risky and hard to understand is present for individual firms as well. In the s, Bankers Trust BT entered into a number of interest rate swap agreements with Gibson Greetings, a mid- size company specializing in greeting cards and related products. The evolution of the swaps shows a pattern similar to the evolution of MBS ten years later the history here follows Overdahl and Schachter, Companies can use swaps to hedge interest rate risk, and the first swap Gibson Greetings entered into with BT was designed to do that. ROSEN London interbank offer rate LIBOR. After BT and Gibson settled the plain vanilla swap, BT convinced Gibson to enter a series of swaps, where each swap was typically riskier and more complex than the prior one.
Initially, the realized path of interest rates meant that Gibson made money on the swaps. This may have led Gibson to believe that they were able to understand and make money from their swap contracts. Over time, this overconfidence may have led Gibson to pay less attention to the details of each subsequent swap. But, when inter- est rates started rising in , Gibson began losing money on its swaps. This fits the broad pattern of the investor-intermediary risk cycle that led to the financial crisis: initial success may have fed overconfidence and inattention to details for the investor Gibson Greetings.
This, in turn, encouraged the issuer BT to offer investments that were riskier and harder to evaluate, but more profitable for the issuer. The overconfident investor may not fully examine the risks, leading to big losses when conditions changed. However, while some of the earlier situations led to localized crises, none led to anything near the magnitude of the crisis. There are a number of factors that may have made the crisis more severe. Among them are the length of the precrisis period, the shift from financial intermediaries to the SBS, the increasing interconnectedness among financial firms, and the increased leverage at some financial firms. The evolution of products offered during the run-up to a crisis suggests that the longer the run-up period, the riskier are the products eventually offered. Overconfidence, inattention, and potential agency problems give issuers more scope to issue risky products when investors as investors have a longer track record of successful investments.
Thus, one potential explanation for the magnitude of the crisis was that, for whatever reason, there was a longer than usual period of higher returns on the affected asset class, in this case securitizations and other structured securities. There are also structural reasons why the crisis may have been particularly severe. This introduced screening problems, as inattentive investors may have allowed issuers to include lower quality loans into securitization pools. Adding to this problem, one difference between the intermediation done in banks and that done using structured securities is the length of the intermediation chain Shin, For the most part, in traditional bank financing, the bank balance sheet sits directly between savers and borrowers.
With securitization, there is at least one more link in the intermedia- tion chain as the SPV stands between a lender and the ultimate investor. As discussed above and in Shin, , the chain can be much more complex. Each link in the chain introduces potential agency problems and the possibility of overconfident or inattentive decision makers. This increases the scope for bad assets to be funded, specifically those that are riskier than investors think they are. This can happen by a breakdown in screening or through innovations such as CDOs that are so opaque as to be nearly impossible to evaluate. It should also be clear that the problems become more severe the longer the intermediation chain. This suggests that while securitization in particular and long intermediation chains in general may have some advantages in broadening the potential investor base and spreading risk and avoiding regulatory costs , they bring with them the problem that misaligned incentives get worse during boom periods.
There are also some other differences between the current crisis and previous ones. In recent years, banks and other financial institutions have become more intertwined, in part because of securities issued in the SBS Gorton, This means that damage to one institution can spread to others more easily than in past years. In addition, the leverage of interme- diaries was much higher in the mids than in earlier periods in part because investment banks had higher leverage than commercial banks. Once there is a precipitating event, high leverage causes market partici- pants to worry about the solvency of banks. Since both commercial and investment banks are largely financed with short-term debt Diamond and Rajan, , the event can lead to a run, much as some argue the losses on subprime mortgages did in e. While the broad structure of the financial industry is not new, its intertwined nature and high leverage may have made the shocks in propagate more widely than prior shocks did.
The evidence suggests that the investor-intermediary risk cycle that was at the root of the run-up to the financial crisis that started in was common to other crises, but that there were aggravating factors that may have made the crisis more severe than earlier crises. ROSEN the need to address both the risk cycle and the aggravating factors when considering reforms to the financial system. Concluding Comments The financial crisis that started in exposed a number of flaws in the financial system. Many of these flaws were associated with financial instruments that were issued by the SBS. The growth of the SBS as an alternative to traditional banking products had been going on for a number of years, but accelerated rapidly with the expansion of securitization in recent years. In particular, the expansion of securitization included many new, intrinsically riskier securities. I explore how natural tendencies of investors may have allowed issuers of securitized bonds and other SBS products to increase the risk of these securities without many investors realizing it.
Paradoxically, the good news of the years up to may have led to the bad news that started in The strong performance of structured securities such as securitized bonds fed into the natural overconfidence of some investors. The performance reinforced the decisions of these investors to buy structured securities. It also may have led investors to rely more on credit ratings, since the high credit ratings many bonds received seemed to be confirmed by their performance. Busy investors may have become more willing to trust the ratings since that would allow them to focus their scarce attention elsewhere. This could have led these investors to reach for the high yields offered by structured securities even if they thought that the high yield was insufficient to compensate for the risk of the securities.
A mix of overconfidence, inattention, and desire for high yields on the part of investors gives the intermediaries in the SBS an incentive to create securities that had high yields but a lot of possibly hidden risk. Beyond that, since many investors were relying on credit ratings, it would be more valuable to the intermediaries if they could issue securities that had more risk for a given level of credit rating. It appears now that the intermediaries were able to do this. There are other examples of similar behavior by investors and intermediaries, although the consequences in the earlier cases were less severe than in the current financial crisis.
Many of the current regulatory reform proposals take on one or the other of these options. The proposals to break the investor-intermediary risk cycle include credit rating agency reform and reducing the role of the SBS. Credit rating agency reform is intended to make credit ratings more accurate by reduc- ing agency problems at the rating agencies. More accurate ratings would reduce the costs for investors of being inattentive to the details of debt securities. Of course, believing that ratings accuracy has increased may lead more investors to rely on ratings rather than on their own research, so the impact of ratings agency reform may be limited. Reducing the role of the SBS may mitigate the effects of agency problems by shortening the intermediation chain Shin, While this would be useful, it may be difficult to accomplish in the long run.
Among the reasons for the rise of the SBS were innovations that increased efficiency and arbitraged around regulatory restrictions. The incentives to increase efficiency and evade regulation will remain. The crisis was made worse because some financial firms were highly levered and interconnected Gorton, Proposals that reduce leverage and interconnectedness, or at least reduce the impact of shocks to banks, may reduce the multiplier impact of a financial shock. Finally, the argument that the investor-intermediary risk cycle com- bined with shifts in screening and monitoring caused by the movement from banks to SBS made a financial crisis more likely does not absolve other agents from blame.
In this chapter, I have not focused on whether regulators contributed to the problems that led to the recent crisis. Sub-optimal actions by regulators and other parties could have exacerbated the problems caused by a shift to the SBS. In addition, the highly levered structure of financial intermediaries combined with the maturity mismatch of their balance sheets may have contributed to magnifying the effect of the shock to underlying assets Diamond and Rajan, LaBrosse, R. Olivares-Caminal, and D. Singh Cheltenham: Edward Elgar, [forthcoming]. The views in this chapter are those of the author and may not represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. ROSEN Notes 1. The SBS is a slightly more expansive definition of nonbank alternatives than, for example, the securitized banking sector referred to by Gorton and Metrick and the market-based financial intermediation in Shleifer and Vishny The types of firms that are included as part of the SBS are investment banks, hedge funds, monoline insurance companies, the government-sponsored entities GSEs , and a number of specialized entities that are set up to issue derivative financial securities.
Banks can be part of the SBS to the extent that they participate in financing that is different from traditional lending. I dis- cuss the purchase of securities created in the SBS below. SIVs held long-term assets but issued primarily short-term liabilities such as commercial paper to purchase the assets. This exposed them to the risk that they would not be able to roll over their liabilities. The Bank Holding Company Act of separated commercial banking and insurance. There were exceptions, for example, banks could underwrite government securities and privately placed as opposed to publicly traded and registered debt.
The CP market has been around for a long time in the United States and elsewhere. Interestingly, Goldman Sachs got its start issuing CP in For some pools of loans, interest payments were not guaranteed, leaving bondholders exposed to the risk of missed interest payments as well. The GSEs are government-charted private companies. Their guarantees were not explicitly backed by the U. government, but when the GSEs got into financial trouble, the government stepped in to help them technically, by taking them into conservatorship in late Private-sector securitizations backed by mortgages are sometimes referred to as mortgage asset-backed securities. Evidence for the extra yield for subprime MBS is more anecdotal.
There are a number of studies of overconfidence in financial markets. Evidence of overconfidence is found in stock trading and financial markets Daniel et al. See Malmendier and Tate for a review of some of the psychology literature on overconfidence and Rabin and Schrag for a discussion of confirmation bias. See also the chapters in the Encyclopedia of Social Psychology on belief perseverance, beliefs, and confirmation bias. There is also empirical evidence of inattention whether rational or not in financial markets. For example, there is evidence that investors respond less to earnings announcements and possibly other news announcements that are made on Fridays DellaVigna and Pollet, In addition, investors tend to be net buyers of stocks that are in the news more Barber and Odean, Anchoring refers to a bias in how individuals assess probabilities.
People tend to anchor on certain pieces of information, effectively ignoring or under- weighting other data e. No thanks. Try the new Google Books My library Help Advanced Book Search. Get print book. com Fishpond Whitcoulls Mighty Ape Find in a library All sellers ». Shop for Books on Google Play Browse the world's largest eBookstore and start reading today on the web, tablet, phone, or ereader. Go to Google Play Now ». Jeff Madura. Packed with today's real examples and practical applications, this engaging edition clarifies the management, performance, and regulatory aspects of financial institutions. You explore the functions of the Federal Reserve and its recent changes, major debt and equity security markets, and the derivative security markets. Expanded coverage now discusses stock valuation, market microstructure strategies, and liquidity in today's financial markets. In addition, new content examines current venture capital funds, private equity funds, and crowdfunding.
Real examples connect concepts to financial trends with exercises specifically developed to strengthen your critical thinking and help you put theory into practice. Important Notice: Media content referenced within the product description or the product text may not be available in the ebook version. Preview this book ». What people are saying - Write a review. Selected pages Title Page. Table of Contents. Contents Overview of the Financial Environment. The Fed and Monetary Policy. Debt Security Markets.
The textbook weaves practical applications and timely examples throughout as it emphasizes the securities traded by and the scope of participation of financial institutions within each market. Students focus on the performance, management, and regulatory aspects of financial institutions and explore the functions of the Federal Reserve System, the major debt and equity security markets, and the derivative security market. S We also have Financial Markets and Institutions 11e test bank, solutions and other instructor resources for sale. Contact for info. NOTE: This sale only includes the eBook by Madura, Financial Markets and Institutions 11th edition in PDF. No online codes comes with the purchase. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. Skip to content Home Education Financial Markets and Institutions 11th Edition By Jeff Madura — eBook PDF. Financial Markets and Institutions 11th Edition By Jeff Madura — eBook PDF.
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Web28/10/ · Financial Markets & Institutions, 13th Edition PDF EPUB by Jeff Madura By Textile eBook Financial Markets & Institutions, 13th Edition Jeff Madura Contents Web16/11/ · (eBook PDF)Financial Markets and Institutions, 13th Edition by Jeff Madura Web1/01/ · Financial Markets and Institutions, 11 edition Author: Jeff Madura Publisher: Cengage Learning Genres: Cookbooks & Food & Wine Publish Date: January 1, WebDownload Solution Manual For Financial Markets And Institutions 12th Edition By Jeff blogger.com This document was uploaded by user and they confirmed that they have WebFinancial Markets and Institutions (11th Edition) By Jeff Madura – eBook PDF Gain a clear understanding of how financial institutions serve financial markets, why do financial Web25/09/ · Financial Markets and Institutions – 9th Edition Author: Jeff Madura Publisher: South-Western College Pu Genres: Audio Books Publish Date: September 25, ... read more
Search Images Maps Play YouTube News Gmail Drive More Calendar Translate Books Shopping Blogger Finance Photos Docs. The bondholders were repaid based on the payments on the loans in the pool. Related Papers. The structure and incentives in arose in part because of choices made in the last major crisis in the s. The implied losses on the MBS bonds based on outside assessments of mortgage default and prepayment rates at that point would imply that the subprime MBS bond yields provide adequate compensation for the risk.
He has published widely in peer-reviewed publications. An SPV would collect some loans into a pool, and then issue MBS. Related to this was the willingness of credit rating agencies to rate the bonds. Comprehensive Project. edu and the wider internet faster and more securely, please take a few seconds to upgrade your browser.
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