PrefBlog

The Investment Industry Association of Canada has released its Securities Industry Performance Report, 2Q09: fixed income trading was highlighted:

Particularly strong was debt underwriting which witnessed a 54% surge in revenue from the previous quarter as narrowing spreads made debt financings more alluring for issuers. Fixed-income principal trading revenue was also robust and totaled $640 million in the second quarter, a record high, and represented a 15% increase from the prior quarter. For the first half of 2009, industry fixed income revenues (debt underwriting plus debt principal trading) total $1.5 billion and already equal the total for the whole of 2008.

Gee, I sure hope nobody gets a bonus because of this surge in gross profit! Paying for performance can lead to … er … something bad.

There’s not enough data in the report even to make a good guess at the reason for the surge in trading revenue, but it seems probable that the desks have made profits for the same reason that my fund’s returns have been so good over the past year: lots of panic, lots of volatility, lots of players who really don’t have a clue.

The Federal Reserve Bank of Cleveland has released the September 2009 Edition of EconoTrends, with short articles on:

• July Price Statistics
• The Yield Curve, August 2009
• The Changing Composition of the Fed’s Balance Sheet
• Borrow Less, Owe More: The U.S. Net International Investment Position
• Real GDP: Second-Quarter 2009 Revised Estimate
• Recent Forecasts of Government Debt
• The Incidence and Duration of Unemployment over the Business Cycle
• The Employment Situation, August 2009
• Fourth District Employment Conditions
• Bank Lending, Capital, Booms, and Busts

The last is under the general heading “Baking and Financial Institutions”, so I guess we’re cooked!

The next chart shows a source of our current problems that many consider more important that pesky bankers’ bonuses:

I will admit that I’m very unfamiliar with the Australian bank market, but the Reserve Bank of Australia has released its September 2009 Financial Stability Review:

A number of interrelated factors have contributed to the relatively strong performance of the Australian banking system in the face of the challenges of the past couple of years. One is that Australian banks typically entered the financial turmoil with only limited direct exposures to the types of securities – such as CDOs and US sub-prime RMBS – that led to losses for many banks abroad. Moreover, they have typically not relied on the income streams most affected by recent market conditions: trading income only accounted for around 5 per cent of the major banks’ total income prior to the turmoil. Banks’ wealth management operations have been affected by market developments, but the major banks still reported net income of around $2.3 billion from these activities in the latest half year.
One reason why Australian banks garnered a relatively low share of their income from trading and securities holdings is that they did not have as much incentive as many banks around the world to seek out higher-yielding, but higher-risk, offshore assets. In turn, this was partly because they were earning solid profits from lending to domestic borrowers, and already required offshore funding for these activities. As a result, Australian banks’ balance sheets are heavily weighted towards domestic loans, particularly to the historically low-risk household sector.

As discussed in detail in the previous Review, there are several factors that have contributed to the relatively strong outcome in Australia, including:

• • Lending standards were not eased to the same extent as elsewhere. For example, riskier types of mortgages, such as non-conforming and negative amortisation loans, that became common in the United States, were not features of Australian banks’ lending.
• • The level of interest rates in Australia did not reach the very low levels that had made it temporarily possible for many borrowers with limited repayment ability to obtain loans, as in some other countries.
• • All Australian mortgages are ‘full recourse’ following a court repossession action, and households generally understand that they cannot just hand in the keys to the lender to extinguish the debt.
• • The legal environment in Australia places a stronger obligation on lenders to make responsible lending decisions than is the case in the United States.
• • The Australian Prudential Regulation Authority (APRA) has been relatively proactive in its approach to prudential supervision, conducting several stress tests of ADIs’ housing loan portfolios and strengthening the capital requirements for higher-risk housing loans.

The Australian housing stress-tests of 2003 have been discussed on PrefBlog.

Capitalization is also good:

The Australian banking system remains soundly capitalised.The sector’s Tier 1 capital ratio rose by 1.3 percentage points over the 12 months to June 2009 to 8.6 per cent, its highest level in over a decade (Graph 37). In contrast, the Tier 2 capital ratio has fallen by around 0.7 percentage points over the same period, mainly because term subordinated debt declined. As a result of these developments, the banking system’s total capital ratio has risen by almost 0.7 percentage points over the past year, to stand at 11.3 per cent as at June 2009. A similar pattern has been evident in a simpler measure of leverage – the ratio of ordinary shares to (unweighted) assets – which has risen by around half a percentage point over the past six months. The credit union and building society sectors are also well capitalised, with aggregate total capital ratios of 16.4 per cent and 15 per cent.

In response to falling profits, many banks have cut their dividends (Graph 39). Despite these lower dividends, the major banks’ dividend payout ratio increased to around 80 per cent over the past year.

Most banks are endeavouring to increase their share of funding from deposits, in response to markets’ increased focus on funding liquidity risk. For some of the smaller banks, it is also because of a lack of alternative funding options, given the difficulties in the securitisation market. These factors have led to strong competition for deposits, especially for term deposits, and deposit spreads have widened. For instance, the average rate paid by the major banks on their term deposit ‘specials’ is currentlyaround 175 basis points above the 90-day bank bill rate, compared to about 75 basis points as at end December 2008.

I’m not sure just what a “special” might be … can any Australians elucidate the matter? I assume that a “bank bill” is essentially a bearer deposit note, but confirmation would be appreciated.

After the review of the current environment, there is a discussion of The International Regulatory Agenda and Australia:

As noted in The Australian Financial System chapter, following the capital raisings by the Australian banks this year, the Tier 1 capital ratio for the banking system is at its highest level in over a decade. In addition, APRA’s existing prudential standard requires that the highest form of capital (such as ordinary shares and retained earnings) must account for at least 75 per cent of Tier 1 capital (net of deductions); other components, such as non-cumulative preference shares, are limited to a maximum of 25 per cent. In some other countries this split has been closer to 50:50.

The old Canadian standard was 75%; after relaxing to 70% in January 2008, OSFI debased capital quality requirements in November 2008 to 60%.

The Boston Fed – a rich source of high quality research – has released a paper by Ryan Bubb and Alex Kaufman titled Securitization and Moral Hazard: Evidence from a Lender Cutoff Rule:

Credit score cutoff rules result in very similar potential borrowers being treated differently by mortgage lenders. Recent research has used variation induced by these rules to investigate the connection between securitization and lender moral hazard in the recent financial crisis. However, the conclusions of such research depend crucially on understanding the origin of these cutoff rules. We offer an equilibrium model in which cutoff rules are a rational response of lenders to perapplicant fixed costs in screening. We then demonstrate that our theory fits the data better than the main alternative theory already in the literature, which supposes cutoff rules are exogenously used by securitizers. Furthermore, we use our theory to interpret the cutoff rule evidence and conclude that mortgage securitizers were in fact aware of and attempted to mitigate the moral hazard problem posed by securitization.

I am astounded that cut-off rules exist, but they do and they are step functions:

One promising research strategy for addressing this question is to use variation in the behavior of market participants induced by credit score cutoff rules. Credit scores are used by lenders as a summary measure of default risk, with higher credit scores indicating lower default risk. Examination of histograms of mortgage loan borrower credit scores, such as Figure 1, reveal that they are step-wise functions.

Using step functions to evaluate differences in complex systems is suspicious at the very least. Any time you hear a portfolio manager talk about a “screen” for instance, you should ensure that the screen is very coarse, throwing out only the most ridiculous of potential investments. For proper, verifiable, assessments of single entitites in a complex universe – whether it is a universe of government bonds, preferred shares, common equity, or mortgage applicants – you need a coherent system of continuous smooth functions.

The only rationale I can think of for using step functions at all is suggested by the authors: lenders must make a decision regarding whether or not to incur costs to collect additional data to feed into (a presumably rational) evaluation system and incurring such a cost – whether it’s a single charge, or a member of a sequence of possible charges – is a binary decision, implying a stepwise preliminary evaluation. But anyway, back to the paper:

It appears that borrowers with credit scores above certain thresholds are treated differently than borrowers just below, even though potential borrowers on either side of the threshold are very similar. These histograms suggest using a regression discontinuity design to learn about the effects of the change in behavior of market participants at these thresholds. But how and why does lender behavior change at these thresholds? In this paper we attempt to distinguish between two explanations for credit score cutoff rules, each with divergent implications for what they tell us about the relationship between securitization and lender moral hazard.

We refer to the explanation currently most accepted in the literature as the securitizer-first theory. First put forth by Keys, Mukherjee, Seru, and Vig (2008) (hereafter, KMSV), it posits that secondary-market mortgage purchasers employ rules of thumb whereby they are exogenously more willing to purchase loans made to borrowers with credit scores just above some cutoff. This difference in the ease of securitization induces mortgage lenders to adopt weaker screening standards for loan applicants above this cutoff, since lenders know they will be less likely to keep these loans on their books. In industry parlance, they will have less “skin in the game.” Because lenders screen applicants more intensely below the cutoff than above, loans below the cutoff are fewer but of higher quality (that is, lower default rate) than loans above the cutoff. We call this the “securitizer-first” theory because securitizers are thought to exogenously adopt a purchase cutoff rule, which causes lenders to adopt a screening cutoff rule in response. Under the securitizer-first theory, finding discontinuities in the default rate and securitization rate at the same credit score cutoff is evidence that securitization led to moral hazard in lender screening.

We offer an alternative rational theory for credit score cutoff rules and refer to our theory as the lender-first theory. When lenders face a fixed per-applicant cost to acquire additional information about each prospective borrower, cutoff rules in screening arise endogenously. Under the natural assumption that the benefit to lenders of collecting additional information is greater for higher default risk applicants, lenders will only collect additional information about applicants whose credit scores are below some cutoff (and hence the benefit of investigating outweighs the fixed cost). This additional information allows lenders to screen out more high-risk loan applicants. The lender-first theory thus predicts that the number of loans made and their default rate will be discontinuously lower for borrowers with credit scores just below the endogenous cutoff.

Such a cutoff rule in screening also results in a discontinuity in the amount of private information lenders have about loans.

We investigate these two theories of credit score cutoff rules using loan-level data and find that the lender-first theory of cutoff rules is substantially more consistent with the evidence than is the securitizer-first theory. We focus our investigation on the cutoff rule at the FICO score of 620. We do this for two reasons: of all the apparent credit score cutoff thresholds, the discontinuity in frequency at 620 is the largest in log point terms; also, 620 is the focus of inquiry in previous research. After reviewing institutional evidence that lenders adopted a cutoff rule in screening at 620 for reasons unrelated to the probability of securitization, we use a loan-level dataset to show that in several key mortgage subsamples there are discontinuities in the lending rate and the default rate at 620, but no discontinuity in the securitization rate. Without a securitization rate discontinuity at the cutoff, the securitizer-first theory is difficult to reconcile with the data.

Having established that the lender-first theory is the more likely explanation for the cutoff rules, we then interpret the evidence in light of the theory. We find that in the jumbo market of large loans, in which only private securitizers participate, the securitization rate is lower just below the screening threshold of 620. This suggests that private securitizers were aware of the moral hazard problem posed by loan purchases and sought to mitigate it.

However, in the conforming (non-jumbo) market dominated by Fannie Mae and Freddie Mac (the government sponsored enterprises, or GSEs), there is a substantial jump in the default rate but no jump in the securitization rate at the 620 threshold. One explanation for this is that the GSEs were unaware of the threat of moral hazard. An arguably more plausible explanation is that, as large repeat players in the industry, the GSEs had alternative incentive instruments to police lender moral hazard.

The authors conclude:

Interpreting the cutoff rule evidence in light of the lender-first theory, our evidence suggests that private mortgage securitizers adjusted their loan purchases around the lender screening threshold in order to maintain lender incentives to screen. Though our findings suggest that securitizers were more rational with regards to moral hazard than previous research has judged, the extent to which securitization contributed to the subprime mortgage crisis is still an open and pressing research question.