2.1 Legal Structure

“Securitization” means selling securities whose principal and interest payments are exclusively linked to a pool of legally segregated, specified, cash flows (promised loan payments) owned by a special purpose vehicle (SPV). The cash flows were originated (“underwritten”) by a financial intermediary, which sold the rights to the cash flows to the special purpose vehicle. The securities, called “asset-backed securities” (ABS), are rated and sold in the capital markets. Historically, the financial intermediary would have held the loans on-balance sheet until maturity. But, with securitization, the loans can be financed off-balance sheet.

Figure 5 shows a simplified overview of the securitization process. The originating firm is at the top of the figure. This firm, a financial intermediary, employs lending officers and actively engages in the process of finding lending opportunities. Whether a potential borrower represents a good lending opportunity or not is the primary decision that this intermediary must make. It determines underwriting criteria or lending standards, and proceeds to make loans. These loans must be funded, and they can be funded by the intermediary borrowing, or by selling the loans to a “special purpose vehicle” (SPV), which is a legally separate legal entity. In the figure this entity is labeled “Master Owner Trust.” This SPV is not an operating entity. Indeed, no one works there and it has no physical location. Instead, it is an artificial firm that functions according to pre-specified rules, and it contractually outsources the servicing of the loans.

The SPV purchases the loan cash flows by selling securities based on seniority, called “tranches”, to investors in the capital markets, shown at the bottom of the figure. These securities are claims that are linked to the cash flows of the portfolio of loans that the SPV then purchases from the operating firm (the intermediary). The cash flows are passive in the sense that the underwriting decision has already been made, so there is nothing further to do except wait to see if the cash flows are repaid as promised.

2.2 Securitization Example: Credit Card Securitization via the Chase Issuance Trust

To illustrate some of the important features of securitization that we will subsequently focus on, it is useful to very briefly examine an actual example. For this purpose we will look at the Chase Issuance Trust, which is the JP Morgan Chase master trust for the securitization of credit card receivables underwritten by First USA and Chase USA. Chase merged with First USA in 2005, so credit card receivables can come from Chase or from the old First USA bank. The entity, Chase Issuance Trust, is a special purpose vehicle that periodically receives/buys credit card receivables and issues securities in the capital markets. We will highlight the important features of the structure, which are basically common to all securitizations.

The structure of the securitization is shown in Figure 6. The box labeled “Master Owner Trust” is what the deal documents refer to as “Chase Issuance Trust”. The figure shows the various special purpose vehicles and participants in the securitization. Along the right-hand side of the figure are the governing legal documents corresponding to each part of the structure. At the very top of the figure are the consumers who have borrowed money on their credit cards, as customers of Chase Bank. Chase transfers/sells the receivables, depending on whether they were originated in the First USA or Chase bank to one of two master trusts, either First USA Master Trust or Chase Master Trust.

There is a two-tiered structure. Each of First USA Master Trust and Chase Master Trust is a special purpose vehicle, a trust. A business trust is a separate legal entity, created under a state’s business trust law (see Schwarcz (2003)). Each of these trusts is able to purchase the receivables by selling collateral certificates representing interests in the cash flows that credit card holders are obligated to pay to the Master Owner Trust–Chase Issuance Trust. Chase Issuance Trust issues securities in the capital markets called CHASEseries Notes that are differentiated by seniority, with Class A notes being the most senior (AAA/Aaa) and Class C notes the most junior of the publicly issued notes. In the figure, these notes are linked to one specific vintage of credit card receivables, called “Asset Pool One”. Periodically, different pools of receivables are sold by Chase USA to the trusts, with different series of securities periodically issued that are contractually linked to the various pools. Securities issues by Chase Issuance Trust to capital market participants are generically known as asset-backed securities.

The structure involves multiple special purpose vehicles, which are legal entities, but not really operating companies, as there are no decisions to be made. In this example, Chase Issuance Trust is a Delaware statutory trust, a separate legal entity that is an unincorporated association governed by a trust agreement under which management is delegated to a trustee. The master trusts’ activities are limited to (according to the Prospectus Supplement dated May 12, 2005):

The trust makes no managerial decisions, but simply executes rules that are written down in the contracts.

As indicated in Figure 6, the mechanics of collecting payments from the credit card holders, monitoring them, distributing payments to note holders, and so on, is outsourced via “pooling and servicing” contracts and trustees. Servicers perform the necessary tasks needed to enforce and implement the debt contracts with respect to cash flows, while trustees monitor adherence to indentures.

There are three important features to the securitization structure. First, the SPV is tax neutral; second, the SPV is liquidation-efficient in that it avoids bankruptcy; and third, that it is bankruptcy remote from the sponsor—Chase in this example. The SPVs used in securitization, whether they are trusts, limited liability corporations, or limited partnerships can be structured so that they qualify for “pass through” tax treatment with regard to state and federal income tax purposes. This avoids income tax at the entity level. The debt issued by the SPV is then not tax advantaged, as is on-balance sheet debt issued by the sponsor. This means that the sponsor’s decision about on- versus off-balance sheet financing has an important tax dimension.

Bankruptcy by an SPV is an event that effectively cannot occur; we call this liquidation-efficient. Under US law, private contracts cannot simply agree to avoid government bankruptcy rules, but private contracts can be written so as to minimize this possibility. While we discuss more of the details later, here we note the most important, namely, what happens if the underlying pool of securitized loans does not pay off enough to contractually honor the coupon payments to the note holders. Normally, under a debt contract, if note holders are not paid what has been contractually promised them, then they can force the borrowers into Chapter 11 bankruptcy. Importantly, that does not happen with asset-backed securities.

According to the prospectus, events of default include:

An event of default, however, does not trigger bankruptcy. If the SPV cannot pay the contractually obligated coupons, it declares an “early amortization event”. The contract states that:

It is not an event of default if the issuing entity fails to redeem a series, class or tranche of notes prior to the legal maturity date for those notes because it does not have sufficient funds available or if payment of principal of a class or tranche of subordinated notes is delayed because that class or tranche is necessary to provide required subordination for senior notes.

After an event of default and acceleration of a tranche of notes, funds on deposit in the applicable issuing entity bank accounts for the affected notes will be applied to pay principal of and interest on those notes. Then, in each following month, available principal collections and available finance charge collections allocated to those notes will be deposited into the applicable issuing entity bank account and applied to make monthly principal and interest payments on those notes until the earlier of the date those notes are paid in full or the legal maturity date of those notes. However, subordinated notes will receive payment of principal prior to their legal maturity date only if, and to the extent that, funds are available for that payment and, after giving effect to that payment, the required subordination will be maintained for senior notes. (Chase Issuance Trust Prospectus (May 12, 2005), p. 8)

Thus, contractually there is a living will for the SPV. In particular, if the underlying pool cannot pay the contractual coupons owed to holders of the asset-backed securities, the contractual remedy is to use the available funds to start paying down principal early. Other early amortization events include the following (among other events):

The “excess spread” refers to the difference between what the underlying portfolio of loans yields in a month minus the amounts owed to note holders in that month (the coupon payments), the monthly servicing fee (paid to the servicer of the loans) and any realized losses on the loans.

Bankruptcy remoteness refers to the effect of the possible bankruptcy of Chase, the originator/sponsor, on the assets held by the SPV. The potential problem is that the claimants on the sponsor, Chase, could in bankruptcy seek to recover the assets that were “sold” to the securitization SPV.⁵ In the early days of securitization there was some confusion about the necessary accounting steps needed to ensure that the receivables had, in fact, been sold to the SPV, rather than constituting a secured loan. To clarify this, FASB required a two-step approach, like the one shown in Figure 6. This is known as the “Norwalk two-step” because FASB is located in Norwalk, Connecticut. As we discuss later, case law has to date upheld the bankruptcy remoteness of securitization SPVs.

In the very early days of securitization, each time a pool of loans was securitized, a new SPV had to be set up. Later, the master trust became the main vehicle and different vintages of loan pools were sold to the same trust, with securities issued by the SPV as needed, corresponding to each vintage of loan pool. Figure 7 shows the outstanding receivables in the Chase Issuance Trust over time. It varies as new vintages of loans are sold to the SPV, while older vintages mature.

The Pooling and Servicing Agreement describes the eligible loans that can be sold into the trust periodically, in this case credit card receivables. The agreement states that:

It is the job of the trustee and of the rating agencies to ensure that new loans sold to the trust satisfy the contractual criteria for eligibility. The contract specifies the eligibility criteria for loans to be securitized. The italicized part of the agreement above provides that, at least contractually, if the eligibility criteria are not fine enough to prevent adverse selection, then there will be ex post recourse.

2.3 Other Forms of Securitization

This survey focuses on securitization, the process of moving pools of loans off-balance sheet by selling them to a special purpose vehicle, which in turn finances the purchase of the portfolio of loans by selling securities in the capital markets. The SPV then owns claims on cash flows that are essentially passive, and consequently the SPV is not an actively managed vehicle. There are a number of other, related, securitization vehicles/methods which are not our focus, but which are very briefly discussed in this subsection. These include loan sales, asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs). What follows is a partial literature survey about these forms of off-balance sheet activity.

Loan sales refer to the sale of a single commercial and industrial loan, or part of such a loan, by writing a new claim that is linked to the loan, known as a secondary loan participation. Loan sales are significant in size. For example, in 2006, the ratio of on-balance sheet loans (totaling $1,126 billion) to the secondary loan market volume was 21%. See Gorton (2010). Not only are loan sales quantitatively significant, they are important as well simply because they occur. Loan sales are not supposed to happen according to the traditional theories of banking, but following the advent of the junk bond market, banks began to sell loans. Although not required to retain part of the loan, banks in fact do retain pieces, more so for riskier borrowers. Also, loan covenants are tighter for riskier borrowers whose loans are sold. On loan sales, see, e.g. Pennacchi (1988), Gorton and Pennacchi (1995, 1989), and Drucker and Puri (2009). Loan sales are a topic in their own right, and we do not pursue them here.

ABCP conduits and SIVs are limited-purpose operating companies that undertake arbitrage activities by purchasing mostly highly rated medium- and long-term ABS and funding themselves with cheaper, mostly short-term, highly rated commercial paper and medium-term notes. ABCP conduits peaked at just over one trillion dollars outstanding just before the financial crisis. The differences between ABCP conduits and SIVs are described by Moody’s (February 3, 2003), Moody’s (January 25, 2002), and Standard and Poor’s (September 4, 2003). During the crisis many of vehicles were forced to unwind, or they were re-absorbed onto the sponsors’ balance sheets, as investors refused to roll their short-term liabilities. See Covitz, Liang, and Suarez (2009).

There are several important differences between the special purpose vehicles (SPVs) used in securitization and ABCP conduits and SIVs. First, securitization SPVs are not managed; they are robot companies that are not marked-to-market. New portfolios of loans may be sold into these SPVs, but they simply follow a set of prespecified rules. Unlike securitization vehicles, ABCP conduits and SIVs are managed, and though there are strict criteria governing their decisions; portfolio managers make active decisions. Second, they are market-value vehicles. That is, they are required by rating agencies to mark portfolios to market on a frequent basis (daily or weekly), and based on the marks they are allowed to lever more or required to delever. On SIVs, see Moody’s (January 25, 2002), and on ABCPs see Moody’s (February 3, 2003).

CDOs and CLOs are special purpose vehicles that buy portfolios of ABS, in the case of CDOs, and commercial and industrial loans, in the case of CLOs. These are financed by issuing different tranches of risk in the capital market, rated Aaa/AAA, Aa/AA to Ba/BB. These vehicles are also managed, that is, not completely passive. CDOs are described by Duffie and Garleanu (2001) and Benmelech and Dlugosz (2009); also see Longstaff and Rajan (2008). CLOs are discussed by Benmelech, Dlugosz, and Ivashina (2010).

The securitization that is the focus of this survey is quantitatively by far the most important.

3.1 The Size and Growth of the ABS Market

As discussed in the Introduction, securitization was sizeable prior to the recent financial crisis. To briefly review, Figures 1–4 show the issuance amounts annually for US mortgage-related ABS, non-mortgage ABS, and European issuance. Mortgage-backed securities represent a very large asset class. See Table 1. By looking at non-mortgage ABS, and comparing that to US corporate issuance, a better sense of the significance of securitization is portrayed; see Figure 2. Indeed Figure 2 shows that in 2005 issuance of non-mortgage ABS exceeded corporate bond issuance by a small amount. The main categories of non-mortgage ABS include credit card receivables, automobile loans, and student loans. Tables 2 and 3 show the amounts of non-mortgage ABS outstanding amounts and amounts by issuance, respectively.

Table 1 US asset-backed securities outstanding ($ billions)

Sources: Bloomberg, Dealogic, Fitch Ratings, Moody’s, prospectus filings, Standard and Poor’s, Thomson Reuters, compiled by the Securities Industry and Financial Markets Association.

^aAuto includes truck loans and wholesale auto receivables, and as of 2008 includes floorplans, motorcycles, rentals, and recreational vehicles. Prior years have not been revised to include these categories yet.

^bCredit Cards include charge cards.

^cEquipment does not include aircraft leases.

^dHome Equity contains both 1st and junior lien home equity loans and lines of credit, subprime, small balance issues, and servicing rights; these numbers do not overlap with mortgage-related issuance in other SIFMA statistics.

Table 2 US asset-backed securities issuance ($ millions)

Sources: Bloomberg, Dealogic, Fitch Ratings, Moody’s, prospectus filings, Standard and Poor’s, Thomson Reuters, compiled by the Securities Industry and Financial Markets Association.

^aAuto includes truck loans and wholesale auto receivables, and as of 2008 includes floorplans, motorcycles, rentals, and recreational vehicles. Prior years have not been revised to include these categories yet.

^bCredit Cards include charge cards.

^cEquipment does not include aircraft leases.

^dHome Equity contains both 1st and junior lien home equity loans and lines of credit, subprime, small balance issues, and servicing rights; these numbers do not overlap with mortgage-related issuance in other SIFMA statistics.

Table 3 US mortgage-related securities issuance^a (USD billions)

Sources: FDIC, GSEs, Thomson Reuters, Bloomberg, compiled by the Securities Industry and Financial Markets Association.

^aIncludes GNMA, FNMA, FHLMC mortgage-backed securities, CMOs, private-label MBS/CMOs. Does not include certain subprime categories, which are included in the Home Equity category of ABS.

^bNon-agency includes CMBS and RMBS, and may include re-REMICs.

^cFDIC transactions are structured transactions backed by assets of failed banks and may include non-mortgage related collateral; NCUA transactions are structured transactions backed by assets of failed credit unions and may include non-mortgage related collateral.

^dAgency transactions include both single and multifamily MBS and CMOs.

Securitization is not just a US phenomenon. It is a global phenomenon. The amounts issued in Europe are also significant. Figure 4 shows European issuance of some selected asset classes of ABS. Tables 4 and 5 show European securitization outstanding amounts and amounts by issuance, respectively. Table 6 breaks down European issuance by country. Securitization is also important in Asia and Latin America; see, e.g. Gyntelberg and Remolona (2006) and Scatigna and Tovar (2007)

Table 4 European securitization outstanding, USD millions

Sources: AFME & SIFMA Members, Bloomberg, Thomson Reuters, prospectus filings, Fitch Ratings, Moody’s, S&P, AFME & SIFMA, compiled by the Securities Industry and Financial Markets Association.

Table 5 European securitization issuance, USD millions

Sources: AFME & SIFMA Members, Bloomberg, Thomson Reuters, prospectus filings, Fitch Ratings, Moody’s, S&P, AFME & SIFMA, compiled by the Securities Industry and Financial Markets Association. 2. WBS: Whole Business Securitization. Certain WBS structures may be bucketed in other categories (ABS and CMBS) based on the nature of the transaction and are evaluated on a case by case basis.

^aSME: Small and Medium Enterprises

Table 6 European securitization issuance, USD millions

Sources: AFME & SIFMA Members, Bloomberg, Thomson Reuters, prospectus filings, Fitch Ratings, Moody’s, S&P, AFME & SIFMA.

^a“Multinational” contains collateral from multiple and/or unknown countries; most CDOs are bucketed in this group.

^b“Other” countries include countries too small to be displayed: Austria, Sweden, Denmark, Finland, the Channel Islands, Hungary, Iceland, Poland, Switzerland, Turkey, Ukraine, and the United States.

^c“PanEurope” collateral consists of collateral predominantly sourced from multiple European countries.

.

Further, securitization prior to the financial crisis was growing in the sense that new asset classes were increasingly becoming securitized. Table 7 lists some of the asset categories that have been securitized. The securitization of life insurance assets and liabilities is an important new asset class; see Cummins (2004) and Cowley and Cummins (2005).

Table 7 Major securitized asset classes

Source: Rating agency reports.

3.2 The Default and Ratings Performance of ABS

We next present a general overview of the default and ratings performance of asset-backed securities. There are several ways to describe performance. One way is to examine default rates. Another is to look at credit rating changes. Our goal is modest. We want to convey some sense of performance, by these measures. We do not present an analysis of this asset class in a portfolio context. We start by looking at Standard and Poor’s default rates, in Table 8. The table shows cumulative default rates (conditional on survival) as a percentage for all globally issued asset-backed securities, over the period 1978–2010. Also, for comparison purposes are cumulative default rates for US corporate bonds. The table looks at cumulative default rates for one year through ten years. Standard errors are in parentheses. The table shows the following:

Table 8 S & P global structured finance cumulative default rates conditional on survival, 1978–2010 (%; standard errors in parentheses)

Source:Standard’s (2011a, 2011b).

Table 9 is similar in that it looks at cumulative impairment rates for ABS, and separates ABS without excluding subprime-related securities, the top panel, from subprime mortgage-backed securities, in the middle panel. In the bottom panel is comparable information for globally issued corporate securities. Impairment is different than default, which is a more certain endpoint for the security. Default is relevant to debt and includes: (1) a missing or delayed contractually obligated interest of principal payment; (2) bankruptcy or receivership; (3) distressed exchange; or (4) change in terms of payment imposed by a sovereign that result in a lower financial obligation. “Impairment” includes those four events and also includes cases where: (1) there has been an interest shortfall or principal write-down or loss that has not been cured; (2) the security has been downgraded to Ca or C; or (3) has been subject to a distressed exchange. Impairment status may change over time if a security cures an impairment event. See Moody’s (2011).

Table 9 Cumulative impairment and default rates

Source:Moody’s (2010a, 2010b).

Table 9 breaks out subprime, revealing some very important differences:

Table 10 shows time series 5-year default rates for global ABS over the period 1978–2010, by year and rating. The financial crisis took place during 2007–2008, but the effects on ABS defaults have a lag. These data show that the years of 2009 and 2010 account for the higher default rates. This is the effect of the financial crisis. Below we will look at the financial crisis in terms of spreads.

Table 10 S & P global structured finance 5-year default rates, 1978–2010 (%)

Source:Standard and Poor’s’s (2011a).

3.3 ABS Performance in Terms of Spreads

We next examine ABS spreads. As with credit ratings, we use the spreads on AAA corporates, namely, Industrials, as a benchmark. The Industrials are in the form of credit default swaps. We focus on AAA because corporate bonds and asset-backed securities with this rating should be the most comparable. We compare Prime Auto ABS with a 3-year maturity and Credit Card ABS with a 5-year maturity, to AAA Industrials with a maturity in the 3–5 year bucket.

The data are from a dealer bank and represent on-the-run bonds. We focus on the difference in spreads to highlight the difference between AAA Credit Card ABS and Industrial Corporates, conditional on rating. Figure 8 shows the difference in spreads over the period 2001–2005, a relatively normal period. Several points stand out. First, the difference in spreads is typically positive, that is, AAA Credit Card ABS trade higher than AAA Industrial Corporates. Second, looking at the scale on the y-axis, the difference in spreads is typically very low, around 10 basis points. Also, not observable is the observation that the Industrial Corporate spreads are more volatile. No research that we know of has investigated whether these observations are true more generally.

3.4 Performance During the Financial Crisis

In terms of ratings we saw the effects of the financial crisis above. Figure 9 again looks at the difference in spreads between AAA Credit Cards and Industrial Corporates, as in Figure 8, but now for the period 2005 through March 2011, spanning the financial crisis. The spread on AAA Credit Cards spikes during the crisis, relative to Industrial Corporates. Figure 10 shows the level of the spread for AAA Credit Cards and Industrial Corporates, as well as AAA Prime Auto receivables. During the crisis, all three asset classes moved together, although none are subprime. See Gorton and Metrick (2012).

Although SPVs are separate legal entities, during the financial crisis sponsors brought their credit card off-balance sheet vehicles back on balance sheet. For example, in December 2007 Citigroup brought $49 billion of SPV assets that had been securitized back on balance sheet. JP Morgan and Bank of America also did this. See Scholtes and Guerrera (2009). We discuss this later.

In Section 8 we further discuss the financial crisis and related literature.

5.1 The Supply of Securitized Bonds

Why did banks switch from on-balance sheet financing to off-balance sheet financing? Above, we have outlined the factors affecting this decision. In this subsection we ask what changed to alter this calculation. Banking scholars have documented important changes in US banking starting in the early 1980s that caused the traditional banking model to become less profitable.¹⁰ Securitization appears at the same time, suggesting that it was a response to this decline in profitability. In the context of the model, these changes can take many forms, or it could just be that increased competition forces managers closer to the profit-maximizing ideal of our model, and less likely to rely on monopoly rents to lead a quiet life. We briefly review these factors below, although no one has explicitly linked these changes to the origins of securitization.

Basically, the argument is that commercial banks were protected from competition in various ways following the legislation passed during the Great Depression, allowing them to earn monopoly profits. But, this position starts to erode in the 1980s due to competition and innovation. Coming out of the Great Depression, banks had unique products, bank loans, and demand deposits. Demand deposits were insured and access to corporate debt markets was limited to large firms. Entry into banking was limited for two reasons. First, entry was limited because until 1994 branching across state lines was prohibited.¹¹ Second, entry into banking was restrictive because banks had to obtain a charter from either the federal or state government. Peltzman (1965), in a famous paper, concluded that competition for chartering banks was reduced by the passage of the Banking Act of 1935. He found that the federal control of chartering had reduced the rate of bank entry by at least 50%, based on a comparison of the rate of entry before 1936 to the rate during the period 1936–1962. Due to limited entry, banks had local monopolies on demand deposits, e.g. see Neumark and Sharpe (1992), and Hannan and Berger (1991). There were also more direct subsidies to banks in the form of interest rate ceilings on deposit accounts (Regulation Q, which had its origin in the original deposit insurance legislation), until lifted by the Monetary Control Act of 1980.¹² On the asset side of bank balance sheets, bank loans were the main source of external funding for nonfinancial firms. In particular, prior to the 1980s firms with no presence in the capital markets relied on banks for funding. In short, having a bank charter was valuable. In the banking literature this became known as “charter value”.

The traditional and comfortable model of banking changed dramatically during the 1980s and 1990s. These changes have been much noted and much studied, so we only briefly review them here. Berger et al. (1995), who exhaustively document the changes, put it this way in 1995: “Virtually all aspects of the US banking industry have changed dramatically over the last fifteen years” (p. 55). They go on to describe the 1980s and the first half of the 1990s as “undoubtedly the most turbulent period in US banking history since the Great Depression” (p. 57). Limited entry protection disappears during the 1980s. Keeley (1985) argued that: “The recent deregulation of banking, in particular the removal of deposit-rate ceilings on almost all types of consumer accounts, appears to be taking place in an environment in which entry restrictions have been effectively eliminated or at least have been substantially relaxed.” A large literature documents the decline in bank charter value; see, e.g. Keeley (1990).

Two particular changes are worth briefly noting, one on each side of the bank balance sheet. On the asset side, substitutes for bank loans arose and took market share away from banks. In the 1980s there was a dramatic shift in corporate finance: junk bonds and commercial paper became substitutes for bank longer-term and shorter-term loans, respectively, and represent an important step in the unbundling of the traditional intermediation process. Junk bonds (high yield bonds or below investment-grade bonds) substituted for bank loans. Instead of regulated commercial banks, other firms, notably Drexel Burnham Lambert, specialized in underwriting debt for below investment-grade companies. Taggart (1988a, 1988b) documents this change, observing that bank loans accounted for 36.6% of the total credit market debt raised during the period 1977–1983, but only 18.2% of the total debt raised between 1984 and 1989. Borrowing via public debt markets increased from 30.5% to 54.2% over this period. The junk bond market grew from $10 billion in the early 1980s to over $200 billion by the end of the decade (see Taggart (1990)). This growth came at the expense of bank loans. Benveniste, Singh, and Wilhelm (1993) provide evidence that junk bonds and bank loans are substitutes. They examine the abnormal returns to money center banks associated with the SEC’s actions against Drexel and find statistically and economically excess returns associated with these events. In other words, bad news for Drexel was good news for large commercial banks; and good news for Drexel was bad news for the money center banks. Small banks’ stocks were not affected, but other investment banks benefited when there was bad news for Drexel, and vice versa.

The competitor for short-term bank loans is commercial paper (CP), a short-term debt contract issued directly by firms into the capital markets. The growth in this market is described by Post (1992). Over the 1980s, the CP market (outstanding) grew at a 17% average annual compound growth rate (see Post (1992)). Also see Hurley (1977). CP has many of the attributes of short-term, unsecured, bank loans, but it is not a good substitute for loans for all firms because only the largest most credit-worthy firms can issue CP.

Commercial banks also came under attack on the liability side of the balance sheet; see Keeley and Zimmerman (1984), Keeley and Zimmerman (1985). Another very marked transformation to the financial system was the shift in the source of transaction media away from demand deposits toward money market mutual funds (MMMFs).¹³MMMFs were a response to interest rate ceilings on demand deposits (Regulation Q). In the late 1970s MMMFs were around $4 billion. In 1977, interest rates rose sharply and MMMFs grew in response, growing by $2 billion per month during the first five months of 1979 (see Cook and Duffield (1979)). The Garn-St. Germain Act of 1982, however, authorized banks to issue short-term deposit accounts with some transaction features, but with no interest rate ceiling. These were known as “money market deposit accounts”. In the three months after their introduction in December 1982 these accounts attracted $300 billion. Keeley and Zimmerman (1985) argue that the response of banks resulted in a substitution of wholesale for retail deposits, and direct price competition for nonprice competition, both responses resulting in increased bank deposit costs.

Competition and deregulation lowered bank profits starting in the early 1980s. The traditional model of banking broke down. This is the environment in which securitization arose. If banks found that off-balance sheet financing was cheaper than on-balance sheet financing, given that the cost of bank capital rose, for example, due to deposit rate ceilings being lifted, among other things, then there was an incentive to securitize. This, however, remains an important topic for future research.

5.2 Relative Convenience Yield and the Demand for Securitized Bonds

If banks had an incentive to supply asset-backed securities starting in the 1980s, where did the demand for these securities come from? Institutional investors no doubt provided one source of the demand. The amount of money under the management of institutional investors also grew exponentially during this period. Pozsar (2011) surveys the rise in demand for securitized bonds from institutional investors. The demand for securitized bonds may also be linked to a significant extent to the growth in the demand for collateral. In different parts of financial markets participants need to post collateral. The collateral must be high-grade bonds. If the demand for collateral exceeds the available stock of US Treasury bonds and agency bonds, then asset-backed securities would be needed as collateral. In the language of our model, the increased demand for safe collateral would be an increase in the convenience yield of securitized bonds (ρ’) and a decrease in the relative convenience yield of bank deposits (ρ). This appears to have been the case, though the evidence is very indirect.

Demands for collateral come primarily from three areas. First, in the last thirty years derivative products, e.g. interest rate swaps and swaptions, foreign exchange swaps, have grown from nothing to many trillions of dollars of notional. Derivatives require posting collateral when the position becomes a liability for one side of the transaction. Second, clearing and settlement requires the posting of collateral. Ironically, securitization increases the volumes in clearing and settlement as it creates securities out of previously non-tradeable loans. Third, with the rise of institutional investors and more sophisticated corporate treasury departments, the use of sale and repurchase agreements (repo) appears to have increased dramatically. Repo requires the use of collateral. Added to these increases in demands is the fact that a very large fraction of US fixed income securities are held abroad and not available for use as collateral. Prior to the government response to the financial crisis, it seems that there was an insufficient amount of US Treasuries available for use as collateral, and ABS have many design features that make them a useful substitute.

Securitization has important features that make it very attractive as collateral. A desirable feature of collateral is that it is information-insensitive (see Gorton and Pennacchi (1990), and Dang, Gorton, and Holmström (2011)), so it preserves value. “Information-insensitive” refers to the property of debt that it is not (very) profitable for an agent to produce private information about the payoffs of the security. Such securities can be traded without fear of adverse selection. ABS are debt claims, and so are senior securities. Further, asset-backed securities have some unique features that make them particularly valuable as collateral. First, the SPV organized as a trust has no equity that is traded, so no one has an incentive to produce information about this residual claim, and so as a by-product there is no information produced that would have an impact on the ABS. Second, there is no managerial discretion that can dramatically alter the risk profile of the underlying assets. Since the assets are passive cash flows, emanating from many contractual arrangements, the assets of the SPV are expected to retain their value. In other words, the payoffs are more certain, since they are not affected by managerial discretion. Schwarcz (2003, p. 561): “The essential difference between [commercial trusts and corporations] turns on the degree to which assets need to be at risk in order to satisfy the expectations of residual claimants. In a corporation, the residual claims are sold to third-party investors (shareholders) who expect management to use corporate assets to obtain a profitable return on their investments. But that creates a risk that the corporation will become insolvent … In contrast, a commercial trust’s residual claimant is typically the settler of the trust, who … does not expect a risk-weighted return. The expectations of the trust’s senior and residual claimants are therefore the same: to preserve the value of the trust’s assets.”

With respect to the use of collateral for derivatives positions, there are surveys conducted by the International Swaps and Derivatives Association (ISDA). According to ISDA (2009), “the amount of collateral used in connection with over-the-counter derivatives transactions grew from $2.1 to $4.0 trillion during 2008, a growth rate of 86%, following 60% growth in 2007” (p. 2). Growth in collateral for derivatives grew not only because the use of derivatives grew, but also because the use of collateral to mitigate counterparty risk in derivatives grew, and the use of two-way collateral agreements has grown.¹⁴ Also, see Bank for International Settlements (BIS) (2007).

With regard to clearing and settlement, real-time gross settlement systems (RTGS) have been widely adopted in the last twenty years (see, e.g. BIS (1997)).¹⁵ Problems can arise in a RTGS system when one bank does not have enough funds in its central bank account, in which case the transaction can be rejected or the central bank can extend intraday credit. The possibility that credit may be extended to a bank raises the question of collateral requirements. Many central banks provide intraday credit through fully collateralized intraday overdrafts or intraday repos. In general, the amount of collateral required varies across different RTGS systems and across the parties involved. There are no data available to determine how much collateral is used for clearing and settlement.

The final source of demand for collateral is the repo market. In a sale and repurchase agreement (or repo) one party (the lender) deposits cash with another party, the borrower. The transaction is short-term, usually overnight, and the depositor receives interest on their deposit. To ensure the safety of the deposit, the depositor receives collateral, which he takes physical possession of. The issue is: What is this collateral?

The repo market appears to have grown enormously over the last 30 years, but there is limited data with which to measure this growth. According to Federal data, primary dealers reported financing $4.5 trillion in fixed income securities with repo as of March 4, 2008. But, this covers only a fraction of the repo market in the US.¹⁶ The US Bond Market Association (now known as the Securities Industry and Financial Markets Association) conducted a survey of repo and securities lending in 2005, estimating that the total exceeded $5.21 trillion. Estimates of the size of the repo market in total lead roughly to a market that is about $10 trillion. See Gorton and Metrick (2012), Singh and Aitken (2009), and Hördahl and King (2008) for different approaches to estimating the size of this market. While the available evidence is very suggestive that the repo market is very large, it is impossible to say exactly how large.

As mentioned, these three sources of demand for collateral may have outstripped the available collateral in the form of agency and Treasury bonds. In fact, of all the available collateral consisting of US Treasuries, agency bonds, corporate bonds, and asset-backed securities, a large fraction is held abroad, which may not then be available to use as collateral. Foreign holdings of US securities have grown significantly in recent years. In June 2007, foreigners held 57% of US Treasuries, 21% of US government agency debt, and 23% of US corporate and asset-backed securities. See US Treasury (2010). It is not known how much of this is unavailable for use as collateral.

There is no direct evidence that these demands for collateral led to increased asset-backed security supply. With a lack of relevant data, the evidence that there is a shortage of collateral is indirect. For example, the Bond Market Association Research (February 1998, p. 2) writes:

… repo activity involving financial assets other than US government obligations are increasing due to dealers’ and investors’ desire to achieve the least expensive and most efficient funding sources for their inventories. In recent years market participants have turned to money market instruments, mortgage and asset-backed securities, corporate bonds and foreign sovereign bonds as collateral for repo agreements. Many market participants expect the lending of equity securities to become a growing segment of the repo market, in light of recent legislative and regulatory changes.

And the Bank for International Settlements (2001):

The use of collateral has become one of the most important and widespread risk mitigation techniques in wholesale financial markets. Financial institutions extensively employ collateral in lending, in securities trading and derivatives markets and in payment and settlement systems. Central banks generally require collateral in their credit operations.

Over the last decade, the use of collateral in wholesale financial markets has grown rapidly. The collateral most commonly used and apparently preferred by market participants are instruments with inherently low credit and liquidity risks, namely government securities and cash. With the growth of collateral use being so rapid, concern has been expressed that it could outstrip the growth of the effective supply of these preferred assets. Scarcity of collateral could increase the cost of financial transactions, slow or inhibit financial activity and potentially encourage greater reliance on more inefficient non-price rationing mechanisms, such as restricting access to markets. (p. 2)

The demands for collateral may have led to demands for asset-backed securities, raising their issue prices and thus making them more attractive to issue. This too is a subject for future research.

5.3 Securitization and Financial Innovation

Since the use of ABS as collateral rests on its contractual features, the growth of securitization may be related to financial innovation in the structure and design of the special purpose vehicle. Securitization requires that some legal entity buy the pool of loans sold by the originator. One important issue concerns the legal form of this entity, the special purpose vehicle or special purpose entity. The first question to be broached in this subsection concerns the choice of legal entity for the SPV, and further, whether there was some innovation with regard to the legal entity that facilitated the growth of securitization. The second question concerns “bankruptcy remoteness”. This is the issue of the separation of the assets sold to the SPV from the originator, in the legal sense that if the originator enters bankruptcy, the assets sold cannot be clawed back. Finally, there is the issue of the structure of the SPV so that it cannot enter bankruptcy.

The SPV cannot be an incorporated firm because incorporation faces double taxation, at the corporate level when the income is earned and then again at the shareholder level when the firm pays dividends to distribute the income. (Although Subchapter S allows this to be avoided, it has some drawbacks.) There are alternatives. Many new legal forms for business organizations are relatively recent arrivals. In the last thirty years limited liability companies, limited liability partnerships, and statutory business trusts have all come into existence. See Hansmann, Kraakman, and Squire (2005). These legal forms are alternative legal structures for housing businesses.

In the example considered above, the Chase Issuance Trust, the SPV was a Delaware Trust, a statutory business trust. The business trust appears to be the basic legal form of the SPV used in securitization. Trusts are also the dominant form of organization for structuring mutual funds and pensions.¹⁷ There is little research on why this is so. In fact, Schwarcz (2003, p. 560) notes that: “There are not even clear answers to the fundamental question of whether trusts are a better form of business organization than corporations or partnerships.” Innovation, if it did occur, is related to the use of the business trust and its subsequent evolution into a statutory trust, as explained below.

Trusts are very old, and most commonly were donative trusts, that is, they were used to holds gifts of property, for a beneficiary. Historically, the property was land and buildings. However, the legal form of the trust has been adapted to a more modern use. As Langbein (2007) puts it: “What is new is that the characteristic trust asset has ceased to be ancestral land and has become instead a portfolio of marketable securities … modern trust property typically consists of these complex financial assets…” (p. 1072). This evolution of the type of property held by trusts, also described by Langbein (1995), required legislation to adapt the trust form for this new purpose. For example, trustees need expanded powers and more discretion. Sitkoff (2011) discusses fiduciary obligations in trust law. The Uniform Trusts Act of 1937 and the Uniform Act for Simplification of Fiduciary Security Transfers of 1958 were two such pieces of legislation (see Langbein (2007)). For securitization, another issue was prominent.

There was legal uncertainty about the legality of the trust form and about the limited liability of trusts. Some states explicitly rejected trusts as a legal form, viewing them is incompatible with corporate regulatory rules. There was no statutory recognition of limited liability. Consequently, the promulgation of the Delaware Business Trust Act (1988) was important; it eliminated this uncertainty. The motivation for this act, according to Sitkoff (2005, p. 36) was to provide a viable alternative legal form for business organizations. This act removed the uncertainty about limited liability (see Hannsmann and Mattei (1998), p. 474, note 8), and contained no restrictions on the form of business (see Ribstein (1992, p. 423)). Sitkoff (2005, p. 32), under this act: “The statutory business trust is not only exceedingly flexible, but more importantly it resolves the problems of limited liability and spotty judicial recognition that have cast a pall over the use of the common-law business trust.”

It is also important that Delaware took this step, as this state dominates corporate law. As Levmore (2005, p. 205) put it: “… Delaware is significant, and perhaps as important, in partnerships and limited liability companies as it is for corporations. Whatever the source of its dominance in corporate law, that … carries over to uncorporate law.” Various states adopted general business trust statutes following Delaware (though a few states predate it).

Delaware’s laws, and similar laws adopted by other states, can suffer from the fact that not all states recognize these laws. The Uniform Law Commission, adopted in 1892, centralizes the drafting of laws so that all states can adopt the same set of rules. The commission has commissioners appointed by the governors of all the states. This commission has, historically, played an important role in transforming traditional donative trust law into statute (see Langbein (2007)). In 2003, a drafting committee for a Uniform Business Trust Act was set up by the National Conference of Commissioners on Uniform State Law. Sitkoff (2005, p. 6): “The Uniform Statutory Trust Entity Act, now in draft form, validates the statutory trust as a permissible form of business organization.” In 2009 the Uniform Statutory Trust Entity Act was passed, and is currently being revised. See Rutledge and Habbart (2010) for a summary.

The Delaware act was important for modifying and clarifying a number of troublesome features of the traditional trust. But the issue of bankruptcy remoteness was still troubling. One of the most important issues in securitization concerns the status of the claims of the SPV investors in the event that the originator of the SPV’s assets goes bankrupt. See Hunt, Stanton, and Wallace (2011) for an overview of the history of bankruptcy remoteness. That is, the issue is whether there was a “true sale”, so that the creditors of the originator cannot claim to be entitled to the securitized assets. This issue first arose in the bankruptcy case of LTV Steel Company, in which LTV challenged its own securitizations, claiming that they were not true sales.

The LTV Steel case (In re LTV Steel, Inc., No. 00-43866, 2001 Bankr. LEXIS 131 (Bankr. N.D. Ohio Feb. 5, 2001)) threatened the bankruptcy remoteness concept, but the parties settled prior to a court decision and agreed that there had been a “true sale” of the assets to the SPV. ¹⁸ Although the outcome was ambiguous, it did not seem to hamper the growth of securitization. In part, that may have been due to another change, the Bankruptcy Reform Act (2001), which provided a safe harbor for ABS. According to Schwarcz (2002, p. 353-54), writing before the act was passed: “… the Reform Act would create, for the first time, a legislative “safe harbor” regarding what constitutes a bankruptcy true sale in securitization transactions.” Under the Act, there is an explicit exclusion from the estate of the bankruptcy entity of an “eligible asset” transferred to an “eligible entity” related to an “asset-backed securitization.” The Act also more broadly defines “transferred” with regard to the sale of the assets to the SPV.

The safe harbor part of the Bankruptcy Reform Act of 2001 was still viewed as being uncertain. So, the State of Delaware enacted the Asset-Backed Securities Facilitation Act (“the Securitization Act”) in January 2002. This Act also addressed the issue of what constitutes a “true sale” for the purpose of bankruptcy, attempting to strengthen it further. Why was this needed? Carbino and Schorling (2003): “The entire federal interest issue might be moot, however, because an argument exists that the plain language of Bankruptcy Code section 541 expressly preempts the Securitization Act.” But, “Our review of federal interests that have been implicated in bankruptcy cases did not reveal a federal interest that expressly trumps the Securitization Act’s purpose to ensure that receivables transferred to an SPV are not recaptured as ‘property of the estate’ in the originator’s bankruptcy.” The authors conclude that “ … the efficacy of the Securitization Act remains uncertain. While the Securitization Act may provide some additional level of comfort to investors when Delaware law applies, it is by no means a panacea.”

President Bush signed “The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005” on Wednesday, April 20, 2005, making it law. The legislation does not appear to have created a safe harbor for securitizations. Section 541(b)(8) states “any eligible asset (or proceeds thereof), to the extent that such eligible asset was transferred by the debtor, before the date of commencement of the case, to an eligible entity in connection with an asset-backed securitization, except to the extent such asset (or proceeds or value thereof) may be recovered by the trustee under section 550 by virtue of avoidance under section 548(a).”

On April 16, 2009, General Growth Properties, Inc. (GGP), a publicly traded real estate investment trust, filed for bankruptcy under Chapter 11 of the Bankruptcy Code and included in its filing more of its solvent SPVs that owned property and acted as borrowers under the property-specific loans, which were performing in most cases. The case came as a shock to participants in the securitization market. The issue essentially was whether the SPVs’ assets would be substantively consolidated with GGP.

On August 11, 2009 the bankruptcy court delivered a fifty-page opinion that denied the motions to dismiss the case brought by several property-level lenders. See Memorandum of Opinion and Inc. (2009). The court found that the issues should be evaluated based on the group (the company together with the SPVs), but did not substantively consolidate the entities. The opinion is colored by the financial crisis. The court says, “Faced with the unprecedented collapse of the real estate markets, and serious uncertainty as to when or if they would be able to refinance the project-level debt, the Debtors’ management had to reorganize the Group’s capital structure. [Secured lenders] do not explain how the billions of dollars of unsecured debt at the parent levels could be restructured responsibly if the cash flow of the parent companies continued to be based on the earnings of subsidiaries that had debt coming due in a period of years without any known means of providing for repayment or refinance” (p. 30). GGP exited bankruptcy in November 2010. It is not clear what the future impact will be.

Another issue related to the above discussion concerns the case when the originator is an FDIC-insured institution. In 2000, the FDIC adopted a rule that when it acted as conservator or receiver it would not use its statutory authority “to disaffirm or repudiate contracts to reclaim, recover, or recharacterize as property of the institution or the receivership any financial assets transferred by an [insured depository] institution in connection with a securitization” (Federal Deposit Insurance Corporation (FDIC) (2010, p. 2). During the financial crisis there was some uncertainty about how the FDIC would behave with respect to securitizations. But the FDIC ended up continuing the safe harbor for financial assets in securitizations.

Aside from the above issue of the bankruptcy remoteness of the SPV, there is the issue of the SPV itself going bankrupt. The design of the securities issued by the SPV includes early amortization, as discussed above, so holders of these securities are never in a position to put the SPV into bankruptcy if there is not enough cash generated by the underlying portfolio to pay the coupons on the ABS. However, the SPV might still, for other reasons, voluntarily enter bankruptcy. The right cannot be contractually waived under US law (see Klee and Butler (2002)). Consequently, the structure of the SPV must be such as to achieve this waiver in substance. As described by Klee and Butler (2002): “The use of SPVs is simply a disguised form of bankruptcy waiver” (p. 34).

How is this avoidance of the likelihood of voluntary bankruptcy achieved? Standard and Poor’s (2002) lists the following traditional characteristics for the SPV to be liquidation-efficient: restrictions on objects, powers, and purposes; limitations on ability to incur indebtedness; restrictions or prohibitions on merger, consolidation, dissolution, liquidation, winding up, asset sales, transfers of equity interests, and amendments to the organizational documents relating to “separateness”; incorporation of separateness covenants restricting dealings with parents and affiliates; “non-petition” language (i.e. a covenant not to file the SPV into involuntary bankruptcy); security interests over assets; an independent director whose consent is required for the filing of a voluntary bankruptcy petition. These are all features designed to ensure that the SPV will never be bankrupt.

There is no research that we know of that discusses the history of how these features of the trust, designed to prevent it from ever going into bankruptcy, evolved over time.

Hunt et al. (2011) discuss the possibility that the recently introduced Mortgage Electronic Registration System (MERS) may threaten the bankruptcy remoteness of SPVs. A “mortgage” is two contracts, a promissory note contractually obligating the borrower to repay principal and interest and, second, there is a deed of trust which grants a lien interest in the borrower’s house. In a securitization, the originator sells the two contracts to an SPV, which then issues asset-backed securities. In order to have first claim on the house, should there be a foreclosure, the parties involved in the securitization must have been the first to record the mortgage with the state authorities. MERS is an innovation that allows the process of recording mortgages to become more efficient, but in the process it serves as the mortgagee in the land records office. But it is this intermediate step which raises the issue of threatening bankruptcy remoteness.

In summary, the legal form and structure of the SPV used in securitizations has evolved in significant ways over the last thirty years. Whether this evolution was a passive response to the growth of securitization or whether the innovations spurred the growth of securitization is not clear.

7.1 Does Securitization Lower the Cost of Capital?

The ideal experiment to answer this question would be to take all new loan applications, randomly assign some fraction to be securitized, and then see what happens to market rates depending on securitization. Alas, no bank has been willing to run this test yet, so researchers are forced into clever attempts to identify the effect of securitization. This literature is small and needs to get larger. But there are a few informative papers.

Nadald and Weisbach (2011) studied the effects of securitization on the cost of corporate loans. Using a sample of 3000 corporate loans, they find a raw difference of 10–17 basis points between securitized and non-securitized loans. The hard part is identifying the securitization effect in this gap, which they accomplish through a difference-in-differences approach, exploiting the “securitization boom” of CLOs from 2004 to 2007 as the time-series driver. To combine with the securitization boom, the authors identify an important institutional feature of CLOs, driven by the types of corporate loans that tend to be included. Corporate loans are either amortizing (“Term A loans”), non-amortizing (“Term B loans”), or revolving. For a variety of reasons, Term B loans are the best raw material for securitizations, so if securitization lowers the cost of capital, then we should expect a differential effect in Term B loans over Term A loans and revolvers. And this is exactly what the authors find, with spreads on Term B shrinking by 17 and 35 bp, respectively, relative to Term A loans and revolvers. The authors also find that these spread differences are driven entirely by banks active in the securitization market, with no difference in the spreads for banks that do not securitize. Taken together, these results strongly suggest that securitization lowers the cost of corporate loans.

An, Deng, and Gabriel (2009) study the securitization differential in the commercial mortgage-backed-security (CMBS) market. The central comparison in the paper is between non-securitized “portfolio loans” on the balance sheets of banks and “conduit” loans intended for securitization. The CMBS market does not provide a clean setting for difference-in-difference estimates, so the paper uses a reduced-form regression and finds that, subject to a long list of controls, conduit loans are 10 bps lower than portfolio loans.

Of course, it is not possible to know whether this reduced-form regression has important omitted factors or endogeneity problems. The authors look for differences in prepayment and default across the two samples and find none, leaving the onus on any critic to identify other missing factors. Furthermore, inclusion of originator fixed effects increases the estimated differential to 16 basis points, as does restricting attention to a single large originator (Bank of America). Finally, to address concerns that rates and loan-to-value may be jointly determined, the authors estimate a simultaneous equation system and find an even higher spread of 20 bp.

7.2 Components of the Return Differential

In this subsection we discuss the evidence on each of the components of the return differential.

8.1 Securitization and Financial Stability

There may be social benefits to securitization because the marketability of loan portfolios allows risk to be spread and asset-backed securities can be used as collateral in repo, for example. These factors may lead to an increase in lending, furthering economic growth. There is no evidence on this issue of the social benefits to date, however. The financial crisis has dramatically raised the issue of the social costs of securitization. Asset-backed securities played a role in the crisis, as they were used as collateral for repo. See Gorton (2010), and Gorton and Metrick (2012). Did ABS lead to fragility or to real effects during the crisis?

The crisis involved market participants losing confidence in asset-backed securities. ABS thought to be information-insensitive appeared to become sensitive to information. When repo haircuts increased and investors refused to renew commercial paper for asset-backed commercial paper conduits (limited purpose firms that held ABS and financed it mostly with commercial paper), firms were forced to delever, selling billions of dollars of ABS. Gorton (2010), and (Gorton and Metrick (2012), 2010a, 2010c) document the increase in repo haircuts on ABS and show that spreads on ABS completely unrelated to subprime mortgages moved together more in line with measures of counterparty risk than with subprime risk. Covitz et al. (2009) document the contraction in the asset-backed commercial paper (ABCP) market, which fell by 20% when investors refused to roll over their commercial paper. Gorton (2010), Gorton and Metrick (2012, 2010c) and Covitz et al. (2009) describe the events in the repo and ABCP markets as runs.

Manconi, Massa, and Yasuda (2012) document how the price declines of ABS led to price declines in corporate bonds. They study mutual funds and find that when the prices of ABS fell, funds that faced outflows, as investors withdrew, sold corporate bonds. Yield spreads increased more for corporate bonds where the fund had a higher fraction of the portfolio in ABS, compared to bonds of the same issuer that were held by funds less exposed to ABS. The price declines in the ABS market due to fire sales led to price declines in the corporate bond market, a contagion.

These papers document aspects of the role of ABS during the crisis, but they are only suggestive about the social costs related to ABS. There are social costs to crises, but what specifically are the social costs of securitization? At this point there are some theory papers that suggest that there are social costs.

Shleifer and Vishny (2012) introduce a model of financial intermediation in which banks originate loans, but then securitize and trade these loans. They also can borrow using their ABS as collateral. Banks are profit maximizing, but their activity is driven by investor sentiment, which they want to cater to. When asset prices are high, banks expand their balance sheets. To do this they borrow short term, accepting the risk that they may have to sell assets if prices go down. Security prices can deviate from fundamentals due to the investor sentiment and these deviations translate into fragility for the banks. Further, this affects real investment because the banks are making loans. Securitization increases the level of investment, but also its volatility. The model highlights how capital markets and financial intermediation have changed with securitization. But, it is not clear what the welfare implications are, because the investor sentiment is exogenous.

Hanson and Sunderam (2010) focus on the issuance, performance, and information properties of ABS. In the model, investors must determine initially, once and for all, whether they want to be informed investors or not. This choice is made before the state of the macroeconomy is known. Because they expend resources to become informed, they must be compensated for this. After this choice is made, the state of the macroeconomy is revealed. In the model, “good times” mean that the difference in quality between good loan pools and bad loan pools is small (though the type of each loan pool is not known, except to informed investors). After the state of the macroeconomy is realized, lending decisions are made. Following that there is a date when some investors face liquidity shocks, requiring them to trade. This is a problem for uninformed investors, as they will face adverse selection. To minimize funding costs originators want to sell as much information-insensitive ABS as possible. Informed investors earn little in the good state of the macroeconomy, so this reduces their incentive to become informed ex ante. But, then in the bad state, there are too few informed investors, and the amount that can be originated is much lower. The key private problem is that the information-production infrastructure must be built prior to knowing whether the state of the economy is good or bad.

Stein (2011) also builds on the idea that there is a demand for information-insensitive debt. Stein views this debt as money and assumes that it has a convenience yield. In his model, banks produce as much of this short-term debt as they can because it is cheap financing for loans, due to the convenience yield. If there is a need to sell loans or assets (to patient investors) to honor this debt at an interim date, then there is a discount. The patient investors have a fixed amount to spend at the interim date, and can either make real investments at that date or can buy assets being sold by banks. Their indifference condition determines the discount, which each bank takes as given. This discount constrains the amount of safe short-term debt that can be issued. It imposes a collateral constraint on each bank. (Long-term debt is always risky because the loans are risky.) There is an externality because when the collateral constraint binds, an increase in short-term debt by one bank lowers the value of other banks’ collateral; the discount is lowered, and the patient investors end up making less real investment if banks need to sell assets. The social planner would prefer less private money and more real investment.

Gorton and Ordoñez (2011) also consider short-term debt backed by collateral, in their case, in the context of a dynamic production economy. Firms finance themselves by issuing short term debt backed by collateral. Collateral is either high or low value, but all firms are of the same efficient type. The issue central to the model concerns whether investors produce costly information about the collateral or not. It is not always optimal to produce information. Collateral value can evolve through time and investors do not know for sure its true quality, but they have beliefs about this. If information is not produced, and the perceived (uninformed) value of collateral is high, then more and more firms can borrow. For example, a firm that has low-value collateral initially can borrow subsequently because the value of its collateral will in fact evolve such that it can borrow. As this happens firms with low-quality collateral end up borrowing. There is a credit boom. In fact, first best would be the case where no information is ever produced. But, short of that the economy can be very fragile, because after a credit boom a small shock can cause investors to produce information or constrain lending. Endogenously, the economy would select collateral to be complex, such as mortgage-backed securities.

Geanakoplos (2009, 2003, 1997) focuses on collateral, which could naturally be interpreted as ABS. In Geanakoplos (2009) agents are either optimists or pessimists in a market for assets, such as houses or mortgages, or ABS. Optimists want to buy and pessimists want to sell. Collateral and haircuts arise because less-optimistic agents must be convinced that the asset is safe. If bad news arrives, some optimists will have their equity wiped out and so the marginal buyer is someone who is less optimistic. That means that the effect of the shock is amplified.

Like Shleifer and Vishny (2012), Shin (2009) emphasizes the effects of market prices on the behavior of financial intermediaries. If the market value of ABS rises, the risk-taking capacity of the intermediaries can increase and they expand their balance sheets. Shin does not propose a mechanism for why the market prices rise, or perceived default risks fall, but Adrian and Shin (2010) provide empirical evidence for the procyclicality of leverage. They show that changes in dealer bank repos, the main way that leverage is altered, forecasts changes in financial market risk, as measured by innovations in the Chicago Board Options Exchange Volatility Index (the VIX).

8.2 The Federal Reserve and Asset-Backed Securities during the Crisis

Asset-backed securities were at the core of the financial crisis of 2007–2008 because they were, to a large extent, used as collateral in sale and repurchase agreements (repo) and as the assets held by asset-backed commercial paper (ABCP) conduits. Moreover, repo and ABCP were sizeable. ABCP peaked at about $1.2 trillion in July 2007. Repo was around $10 trillion (see Gorton and Metrick (2012) for a discussion of the size of the repo market). These markets are two of the larger money markets, that is, short-term debt obligations that serve essentially like demand deposits in the wholesale market.

In a repo transaction one party deposits/lends money overnight and receives the repo rate. In addition, bonds are provided as collateral to the depositor/lender. The collateral is valued at market rates and is returned to the borrower when the repo matures, if it is not rolled over. This collateral was often ABS, although there are no data to measure the extent of this. Asset-backed commercial paper conduits are managed vehicles which issue short-term debt to finance longer term ABS. Conduits have sponsors, which are financial intermediaries, and the sponsors manage the conduits.

When there was a run on repo and on ABCP conduits, the demand for cash led these intermediaries to sell assets, depressing their prices, leading to further sales, and so on. This is why the prices of ABS completely unrelated to subprime mortgages fell dramatically. Covitz et al. (2009), Gorton (2010), and Gorton and Metrick (2012, c) describe these dynamics of the crisis.

The financial intermediaries at the center of the crisis were dealer banks (the old investment banks), not regulated depository institutions.²⁸ The short-term liabilities of dealer banks are not insured by the government and dealer banks do not have access to the discount window of the Federal Reserve System. Consequently, the US Treasury Department and the Federal Reserve System introduced a number of programs, involving hundreds of billions of dollars, in response to the financial crisis. Several of these programs were either specifically aimed at asset-backed securities or ABS were eligible to be part of the program. In this subsection we briefly discuss these programs and their effectiveness. Table 11 lists some of the lending facilities related to ABS adopted by the Federal Reserve System during the Crisis. Johnson (in press) provides some detail about each facility.

Table 11 Selected forms of federal reserve lending adopted during the financial crisis

Source: Federal Reserve Bank of New York, http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf.

The Term Securities Lending Facility (TSLF) was adopted on March 11, 2008 to specifically address the problems that dealer banks were having with ABS that had become difficult to use as collateral. The haircuts on this type of collateral were rising. A “haircut” refers to a situation where the depositor in repo demands overcollateralization for the deposit. For example, if a deposit of $90 million requires collateral worth $100 million, there is said to be a 10% haircut. Gorton and Metrick (2012, c) document the increases in haircuts. This facility is unique in that the dealer borrows US Treasury bonds from the Fed, posting agency bonds, ABS, or investment-grade corporate bonds as collateral. The exchange is one type of bond for another. Fleming, Hrung, and Keane (2010a, 2010b) and Hrung and Seligman (2011) describe and analyze the TSLF.

All the other facilities involve posting collateral in exchange for cash (funds). The Primary Dealer Credit Facility (PDCF) was adopted on March 16, 2008 during the extremes of the Bear Stearns failure and takeover by JP Morgan. The PDCF allows the primary dealers to borrow cash from the Federal Reserve System on a collateralized basis. The PDCF is akin to the Federal Reserve’s discount window, which was not available to dealer banks, the institutions at the heart of the financial crisis. The PDCF exchanges eligible bonds as collateral for cash funds. See Adrian, Burke, and McAndrews (2009) for further details.

The remaining two facilities listed in the table were aimed at alleviating the problems that arose for the holders of ABCP and the issuers of CP. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) was created to provide collateralized loans to depository banks and bank holding companies allowing them to buy ABCP from money market mutual funds (MMMFs). The AMLF was intended to increase the liquidity of the ABCP market and also to provide a way for MMMFs to sell their ABCP holdings as they faced runs following the failure of Lehman Brothers—to avoid “breaking the buck”. See the discussion in Duygan-Bump, Parkinson, Rosengren, Suarez, and Willen (2010).

MMMFs are a very important set of buyers of commercial paper, so when these funds faced massive redemptions following Lehman Brothers’ demise, issuers faced a problem: there were few buyers when it came time to roll over their commercial paper. The Commercial Paper Funding Facility was intended to address this liquidity problem by extending the discount window to issuers of commercial paper. A special purpose vehicle was created (CPFF LLC) to purchase 90-day commercial paper from highly rated US issuers and essentially pledge it to the Federal Reserve System for cash. See Adrian, Kimbrough, and Marchioni (2011).

An important issue concerns whether these special liquidity facilities were effective or not. There is a small, but burgeoning literature on this topic. The most common approach is a time-series approach that tries to determine if spreads changed when a program was initiated; see, e.g. Fleming et al. (2010a, 2010b), Christensen, Lopez, and Rudebusch (2009), and Taylor and Williams (2009). An alternative uses cross-sectional variation. For example, Duygan-Bump et al. (2010) have rich micro data to evaluate the AMLF, and find that it was successful.

The most relevant study is Hrung and Seligman (2011), who study the TSLF in the context of other programs that increased the amount of US Treasuries outstanding. The TSLF increases the amount of Treasuries outstanding because it allows other bonds to be used as collateral to borrow Treasuries. Open market operations exchange cash for Treasuries or vice versa. In addition, there was the Supplementary Financing Program (SFP) introduced on September 17, 2008—two days after Lehman’s collapse. The SFP was designed to help the Federal Reserve manage bank reserves. Reserves had to be drained as cash was building up in the banking system. The Treasury was also selling debt for budgetary purposes.

Hrung and Seligman focus on the unique feature of the TSLF, in the context of all the various programs that are changing the overall amount of Treasuries in the economy. The unique feature of the TSLF is that it did not just provide a way to get cash into the system. It was very specific, in that instead of cash it allowed high-quality collateral to be substituted for low-quality collateral, i.e. Treasuries for ABS. Hrung and Seligman look at the effect on the spread between the repo rate when Treasuries are used for collateral (the “general collateral” or GC rate) and the federal funds rate, using daily data and the daily changes in the TSLF amounts, conditional on all other programs. Federal funds are uncollateralized transactions while repo is collateralized; collateralized rates are lower, so this spread is negative.

Their main finding is that an increase in collateral due to the TSLF narrows the fed funds-repo spread. An increase of $1 billion of Treasury collateral via the TSLF narrows the fed funds-repo spread by 12 basis points. This is consistent with the notion that the problem was a run-on repo and that dealer banks needed higher quality collateral. The TSLF was a success in this sense.

8.3 Securitization and Monetary Policy

In recent years, an active group of researchers from central banks and international organizations has begun to explore the impact of securitization on monetary policy. The intuition for an effect is securitization that provides banks with an alternative funding source, and thus may weaken central banks’ impact on the bank-lending channel. Researchers have focused on two different mechanisms: the role of securitization on central bank control of interest rates, and the role of securitization on the elasticity of interest rates to output, either analyzed directly through time-series regressions or indirectly through effects on bank lending.

Kuttner (2000) is an early paper in this literature, looking for indirect evidence by comparing the relative growth of securitization and portfolio loans over the business cycle. He finds support for the hypothesis that these two forms of finance are substitutes in the mortgage market, suggesting a weakening role for monetary policy. Estrella (2002), another paper out of the New York Federal Reserve, followed up this work with both direct and indirect evidence and found an interest-rate elasticity close to zero in recent years, suggesting that any impact of monetary policy must come from mechanisms beyond the interest rate.

Recent papers have confirmed these results, with evidence that securitization has both strengthened the direct impact of monetary policy on interest rates while simultaneously reducing the elasticity of interest rates for output and leaving banks more dependent on capital markets for funding. Work by Altunbas, Gambacorta, and Marques (2007), Goswami, Jobst, and Long (2009), and Gambacorta and Marquez-Ibanez (2011) tells a consistent story: with securitization, banks are less reliant on deposits and buffered against interest-rate shocks, whether or not these shocks are policy-driven. With banks more reliant on securitization and capital markets, they are more subject to funding shocks in these markets, thus forcing central banks to take a broader view of “liquidity policy”. With banks more closely tied to capital markets, monetary policy is more easily translated into market interest rates, it is just that these rates are less important for bank lending then they used to be.

Loutskina and Strahan (2006) break the central bank monopoly on this research with a clever natural experiment to study the role of securitization on bank lending. In the United States, GSE securitizations are limited to “conforming” mortgages, which have an upper limit above which loans are classified as “jumbo” and are ineligible for federal insurance. Since jumbo loans have less liquid secondary markets than do conforming loans, the authors exploit the cutoff between the two types to investigate the relationship between mortgage lending and bank balance sheets. They find that asset liquidity and deposit costs are correlated to jumbo lending, but not to conforming lending. That is, banks that appear illiquid or deposit-funding constrained do not reduce their mortgage lending when securitization is relatively easy, but do reduce their lending where securitization is relatively difficult.

Overall, this literature is consistent in finding that securitization has weakened banks’ reliance on traditional funding sources and sensitivity to interest-rate shocks. While this buffering by capital markets has some benefits, it has also increased sensitivity to the vagaries of securitization markets (a harsh lesson during the recent crisis) and likely reduced the efficacy of the traditional interest-rate policy of central banks. These findings have opened up an important set of policy questions about the proper evolution of central bank instruments for measurement and control, and indeed the very meaning of “monetary policy” as distinct from “capital markets policy” and “financial regulation”.

8.4 The Future of Securitization

The future of securitization is uncertain. Securitization was a very significant source of funding for mortgages and consumer finance and remains important. It was also an important source of collateral for repo and ABCP. The sheer size of the securitization market, and its decimation during the financial crisis, makes the future of this market a question to ponder. The decimation is clear from Table 2, for example, which shows that credit card ABS issuance fell from almost $100 billion in 2007 to $7 billion in 2010. And, from Table 3, non-agency residential mortgage-backed securities fell from an issuance amount of $740 billion in 2005 to $12 billion in 2010. Figure 12 shows the nose dive in issuance for the major categories of asset-backed securities. Only automobile receivables show some sign of recovery. Of course, part of the failure to recover for the other categories is the recession. But, the issues are these: Will securitization come back? On its own? What will happen if it remains a dormant market? As John Dugan, the then Comptroller of the Currency (February 2, 2010) put it: “… we are at a crossroads: the collective decisions we make in the next year in an effort to reform and revitalize the securitization market will have profound consequences for consumer and business credit in the United States and abroad…. I believe we need a vibrant, credible securitization market to help fund the real economy going forward.”

Despite the prominent role often ascribed to securitization in the recent financial crisis, national and international regulatory efforts have focused predominantly on traditional financial institutions in writing new laws and regulations. For example, the proposed Basel III rules, while addressing the capital requirements of securitization done by banks, are focused on banking institutions and do not address securitization vehicles themselves. Other international efforts through the G20 and the Financial Stability Board have spoken of securitization and other components of the “shadow banking” system, but have not proposed any specific rules. Reform efforts in many European countries are ongoing, but so far there no strong regulations for securitization have been adopted.

In the United States, the Dodd-Frank Act of 2010 is mostly silent on securitization, except for a still-to-be-finalized “skin-in-the-game” requirement for securitization that would require originators to maintain some stake in their vehicles. Even this provision has been hotly debated and fiercely resisted by the industry, with claims that a severe rule could have a major impact on the cost-of-capital. On this important policy debate, there is no direct research to provide guidance to regulators, a gap in the literature that badly needs to be filled. It is likely that there will be a number of changes to how securitization is done. But, it is less clear whether these changes will foster securitization or repress it. Among other possible changes are alterations to accounting rules, making it harder to move assets off-balance sheet.

While Dodd–Frank did not focus on securitization, the Law did create a council of regulators with significant power to identify and manage systemic risks. Most importantly, this Financial Stability Oversight Council has the power to recommend significant changes in regulation, if such changes are deemed necessary for financial stability. With this authority in mind, Gorton and Metrick (2010b) propose the creation of “Narrow-Funding Banks” as a mechanism for the regulation of securitization. Under their proposal, these limited-purpose institutions would be the only legal conduits for securitization, and their chartering and oversight would provide regulators with the ability to exercise some control over this part of the shadow banking system. The main use of oversight would be to give regulators a direct look into a formally dark part of the financial system, and the main use of control would be to monitor tranches of securitization so as to minimize regulatory arbitrage.