Securitization Vs Money supply/Credit creation

Once in Forex class (By Prof. V.K.) I along my friend matti (His full name is Jayadev Mateti) questioned Prof. V.K. about the money supply/credit rotation in the name securitization. How many times in an economy a mortgage credit securitized package can be can be rotated? He avoided that question by pulling my leg by asking whether I want to become president or what? But according to me this rotation of credit (in the name of securitization) contradicts the basic funda of money supply/credit creation in the economy.

Before proceeding further I would like to make clear what is Securitization and money supply in economics.

Money Supply

In economics, money supply is the total amount of money available in an economy at a particular point in time.

Money supply is broken down into 3 parts as M1, M2 and M3 depending upon the monetary policy effect on the money supply. M1 is called narrow money and M3 is called broad money. Monetary policies have immediate and more affect on M1 (Narrow money) and where as m3 is not easily affected.

M1: Currency;
M2: M1+ Savings/Current Account;
M3: M2+ Fixed deposits.

Central banks decide the credit creation in relation to the money supply. Simple example for credit creation is as follows.

Out of Rs 100 banks can retain Rs. 30 as reserve and credit Rs. 70
Out of this Rs. 70 again retain Rs. 20 and lend Rs. 50.
Out of this Rs. 50 retain Rs. 15 and credit Rs. 35

Like this way credit creation happens in the economy. Now let’s look at the securitization.

Securitization

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security and selling to investors.

Now my point of argument is in U.S. instead of keeping their mortgages in their books, banks sold the mortgages in the name of the securitization to investors, hedge funds & institutes like Fannie Mae and Freddie Mac.

So they got the amount immediately, what they supposed to get after maturity period of credit/loans. So by using this they can again give credits and repeat the securitization package process. So there will be compounding effect. Therefore money supply or credit creation in the economy increased enormously. At the time of real estate boom in the US this securitization process increased the liquidity in the hands of the common man which fuelled the demand for housing and related properties. And due to excess demand in the economy sub prime lenders and receivers generated. And when the real estate bubble was burst the rest of the scenario you guys know and still reading and experiencing!!!

And in Sunday Times of India news paper Swami Nathan S Anklesaria Aiyar (One of my favorite writer & my interest generator in finance and economics) writes as below

The biggest Wall Street firms Fannie Mae and Freddie Mac held mortgages and other assets totaling $5 trillion, five times India's GDP. Fannie Mae was created by Roosevelt to shore up the housing market in the Great Depression. Freddie Mac was created later to compete with Fannie Mae.

Although they had private shareholders, these firms carried an implicit government guarantee. So, they could borrow much more and more cheaply than rivals. This implicit subsidy was justified as reducing the cost of home loans for all. These institutions bought and underwrote mortgages originated by the whole banking system. This reduced risks for banks, enabling them to spread home loans far and wide.

Now, as mortgagers of last resort, Fannie and Freddie should have kept a watchful eye on the housing market. But instead of being watchdogs, the mortgage twins became active participants in inflating the bubble. Many experts warned that the bubble would burst. These warnings were ignored by politicians, who refused to rein in the bubble-makers.

Next came a financial innovation - securitization. Instead of keeping mortgages on their books, banks sold these to Wall Street firms that chopped them into bits, bundled top-grade mortgages with dubious ones, and sold the bundles as mortgage-backed securities to investors. These securities gave relatively high returns, yet appeared safe because they were backed (and bought) by Fannie and Freddie.

As securitization grew explosively, banks lowered lending standards to shovel out ever more sub prime loans to poor borrowers, without verifying their income, assets or ability to repay. By 2006 they were giving NINJA (No Income, No Job or Assets) loans. Many banks offered teaser loans with low interest for a short period followed by soaring rates, attracting poor borrowers who didn't realize what they were getting into.

Why did banks take such risks? Because the risk was transferred to investors, who bought the loans and mortgage-backed securities, including Fannie and Freddie. The buying spree of the supposed watchdogs yielded them high profits when home prices rose, but made them bankrupt when home prices started falling. The government had to take them over.

Experts like Alan Greenspan had warned over the years of the risks of concentrating such huge financial power with such light regulation on Fannie and Freddie. Breaking them into smaller entities, subject to stricter regulation, was urged by many reformers.

In sum, financial inclusiveness is fine in small doses, but leads to disaster on a really large scale. India is just at the start of financial inclusion. But as it prospers, political pressures for cheap loans to the poor will grow. The lesson from the US is that inclusive loans on a sufficiently large scale can sink the whole financial system.

So, the poor and needy should be given grants, not loans that they cannot repay, or may be encouraged by politicians not to repay. We have already received warning of this from the fiasco of IRDP, India's first inclusive loan Programme in the 1980s. The US crisis drives home a similar lesson.


Bottom-line

As I posted in my previous posts there should be stricter rules in lending, monetary policies and implementing any new financial instrument like securitization.



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