Sunday, March 22, 2009

Securitization and risk

Securitization (practice of parcelling and selling loans to other investors) has been blamed, along with leverage, as being the prime responsible for inflating the sub-prime and other derivative bubbles. Though it was meant to disperse risks associated with bank lending among those better able to absorb risks and losses, Hyun Song Shin argues that securitization undermined financial stability by actually concentrating risks in the banking sector.

He writes, "Banks wanted to increase their leverage – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks (and other financial intermediaries) bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself."

As studies show, approximately $1.4 trillion total exposure to subprime mortgages, around half of the potential losses were borne by US leveraged financial institutions, such as commercial banks, securities firms, and hedge funds. Including foreign leveraged institutions, the total exposure of leveraged financial institutions rises to two-thirds. So, far from passing on the bad loan to the greater fool next in the chain, the most sophisticated financial institutions amassed the largest holdings of the bad assets. The graphic below captures the story nicely.

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