In his speech http://www.bis.org/speeches/sp121106.pdf Mr. Wayne Byres, Secretary General of the Basel Committee on Banking Supervision, makes very interesting remarks about the responsibility of the “Trading book rules” and “Securitization activities” in 2008 Financial Crisis.
He also mentions the consultative paper issued by the Basel Committee on Banking Supervision in which Trading book rules are reviewed.
http://www.bis.org/publ/bcbs219.pdf
What’s the common responsibility of trading book rules and securitization activities with 2008 Financial Crisis?
During the happy years of the real estate bubble (before 2008 financial crisis), the securitization of subprime loans with mortgage-backed securities produced enormous profits for financial institutions. As we’ve discussed here in the past, financial bubbles are a great business while they’re inflated.
Unfortunately, history teaches us that the destiny of any bubble is to be burst, with the sad results that we all know.
As in many previous occasions, the key point for inflating a financial bubble is make the investors look at the short-term price of an asset (normally according to market demand and supply) and not to the sustainable, long-term value of the investment. If investors were able of valuating the intrinsic, long-term value of an inflated asset, nobody would invest in it.
Markets are not stupid, but they can have a blind spot…
The question is: how do we recognize this blind spot?
Making a market’s blind spot requires building a mechanism which hides the intrinsic value of the inflated asset.
The role of that mechanism was played by the securitization of subprime mortgages during the last financial crisis.
If I propose to any of you lending money to a Ninja (No Income, No Job, No Assets) you will refuse, but what happens if I asked you to invest in a profitable security?
Probably you will accept, at the end, investments are driven by greed.
But it’s important that you don’t know that your investment depends on the Ninja paying back his debt; this was the role of the securitization and the trading book rules.
Simplifying, the construction is more or less, as follows.
The bank lends money to the Ninja and sells the mortgage to the market inside of a security.
As the interest paid by the Ninja is higher than the interest paid by a high-rating borrower, the security can also pay higher dividends. With the money of the first investors, the bank borrows more money to other Ninjas, and subsequently it will issue new Mortgage-Backed-Securities.
By the way, maybe some of you already saw that this is not that different of a Ponzi scheme, http://en.wikipedia.org/wiki/Ponzi_scheme
On the other hand, those Mortgage Backed Securities are also traded by other banks and financial institutions. They are hold at the trading book and traded at market price.
While the price of the security goes up, the capital requirements determined by the value-at-risk of the portfolio are relatively small, letting the banks’ managers releasing more funds for inflating the bubble and increasing banks leverage.
This is not new, all the financial bubbles have required a hiding mechanism, more or less sophisticated, but at the end, with the same objective.
Preventing future financial bubbles requires preventing the implementation of hiding mechanisms; we need to provide investors with the intrinsic, long-term sustainable value of an investment.
Once again, disclosure is the word.
Looking forward to read your comments.
Ferran.
He also mentions the consultative paper issued by the Basel Committee on Banking Supervision in which Trading book rules are reviewed.
http://www.bis.org/publ/bcbs219.pdf
What’s the common responsibility of trading book rules and securitization activities with 2008 Financial Crisis?
During the happy years of the real estate bubble (before 2008 financial crisis), the securitization of subprime loans with mortgage-backed securities produced enormous profits for financial institutions. As we’ve discussed here in the past, financial bubbles are a great business while they’re inflated.
Unfortunately, history teaches us that the destiny of any bubble is to be burst, with the sad results that we all know.
As in many previous occasions, the key point for inflating a financial bubble is make the investors look at the short-term price of an asset (normally according to market demand and supply) and not to the sustainable, long-term value of the investment. If investors were able of valuating the intrinsic, long-term value of an inflated asset, nobody would invest in it.
Markets are not stupid, but they can have a blind spot…
The question is: how do we recognize this blind spot?
Making a market’s blind spot requires building a mechanism which hides the intrinsic value of the inflated asset.
The role of that mechanism was played by the securitization of subprime mortgages during the last financial crisis.
If I propose to any of you lending money to a Ninja (No Income, No Job, No Assets) you will refuse, but what happens if I asked you to invest in a profitable security?
Probably you will accept, at the end, investments are driven by greed.
But it’s important that you don’t know that your investment depends on the Ninja paying back his debt; this was the role of the securitization and the trading book rules.
Simplifying, the construction is more or less, as follows.
The bank lends money to the Ninja and sells the mortgage to the market inside of a security.
As the interest paid by the Ninja is higher than the interest paid by a high-rating borrower, the security can also pay higher dividends. With the money of the first investors, the bank borrows more money to other Ninjas, and subsequently it will issue new Mortgage-Backed-Securities.
By the way, maybe some of you already saw that this is not that different of a Ponzi scheme, http://en.wikipedia.org/wiki/Ponzi_scheme
On the other hand, those Mortgage Backed Securities are also traded by other banks and financial institutions. They are hold at the trading book and traded at market price.
While the price of the security goes up, the capital requirements determined by the value-at-risk of the portfolio are relatively small, letting the banks’ managers releasing more funds for inflating the bubble and increasing banks leverage.
This is not new, all the financial bubbles have required a hiding mechanism, more or less sophisticated, but at the end, with the same objective.
Preventing future financial bubbles requires preventing the implementation of hiding mechanisms; we need to provide investors with the intrinsic, long-term sustainable value of an investment.
Once again, disclosure is the word.
Looking forward to read your comments.
Ferran.
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