What Caused the Financial Crisis

7. How Securitization Concentrated Risk in the Financial Sector

Chapter 7 How Securitization Concentrated Risk in the Financial Sector VIRAL V. ACHARYA AND MATTHEW RICHARDSON There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble. In the five-year period covering 2002–2007, the ratio of debt to national income increased from 3.75:1 to 4.75:1. It had taken the prior full decade to accomplish an increase in debt of this magnitude, and it had taken fifteen years to do the same thing prior to that. Moreover, from 2002 to 2007, house prices grew at an unprecedented rate of 11 percent per year. When the ‘‘bubble’’ burst, a severe economic crisis was bound to come. The median family, whose house was highly leveraged and whose equity represented 35 percent of its wealth, would not be able to continue to consume as much as it did through 2007. The economy was going to feel the brunt of it. It is much less clear, however, why this combination of events led to such a severe financial crisis: that is, why we had widespread failures of financial institutions and freezing up of capital markets. The systemic crisis that ensued reduced the supply of capital to creditworthy institutions and individuals, amplifying the effects on the real economy. There is no shortage of proximate causes of the financial crisis. There were mortgages granted to people with little ability to pay them back, and mortgages designed to systemically default or refinance in 184 Viral V. Acharya and Matthew Richardson just a few years, depending on the path of house prices. There was the securitization of these mortgages, which allowed credit markets to grow rapidly, but at the cost of some lenders having little ‘‘skin in the game’’—contributing to the deterioration in loan quality (Berndt and Gupta 2008; Dell’Ariccia, Igan, and Laeven 2008; Keys et al. 2008; Mian and Sufi 2009). Finally, opaquely structured securitized mortgages were rubber-stamped AAA by rating agencies due to modeling failures and, possibly, conflicts of interest, as the rating agencies may have been more interested in generating fees than doing careful risk assessment. Somewhat surprisingly, however, these are not the ultimate reasons for the collapse of the financial system. If bad mortgages sold to investors hoodwinked by AAA ratings had been all there was to it, those investors would have absorbed their losses and the financial system would have moved forward. The crash would have been no different, in principle, from the bursting of the tech bubble in 2000. In our view, what made the 2008 crisis so much worse than the crash of 2000 was the behavior of many of the large, complex financial institutions (LCFIs)—the commercial banks, investment banks, insurance companies, and (in rare cases) even hedge funds—that dominate the financial industry. These LCFIs ignored their own business model of securitization and chose not to transfer the credit risk of securitized assets to other investors. The legitimate and worthy purpose of securitization is to spread risk. It does so by removing large concentrations of risk from the balance sheets of financial institutions and placing many small concentrations into the hands of large numbers of investors. But especially from 2003 to 2007, the main purpose of securitization was not to share risks with investors, but to make an end run around capitaladequacy regulations. The net result was to keep the risk concentrated in the financial institutions—and, indeed, at a greatly magnified level, because of the overleveraging it allowed. Banking: The Old Model and the New The simple theory of banking is that banks act as financial intermediaries between depositors and borrowers (Diamond 1984). Depositors How Securitization Concentrated Risk 185 provide funds to make loans, and banks provide expertise in assessing the creditworthiness of borrowers. Historically, then, the asset side of a commercial bank’s balance sheet would consist of loans funded by deposits (as well as loans funded by non-deposit debt and equity). A bank’s loans, such as its mortgages, are considered assets because they are owed back to the bank. Deposits are considered liabilities because, upon demand, they must be returned by the bank to its depositors. In the meantime, however, most deposits have been lent out to borrowers, such as mortgagors; the interest on these loans is the main source of the bank’s profits. Most deposits, therefore...