By Eller College
Before the banking industry took a major hit in 2008, Eller assistant professors of accounting Monica Neamtiu and Mei Cheng and department head Dan Dhaliwal were examining data to uncover what implications securitization of assets has on originating banks.
“From the bank’s point of view, there are a lot of advantages to securitizing assets,” Neamtiu says. “Securitization opens up another source of capital. Some argue that it is a way to game the regulatory environment. But our paper is focused on the consequences for the banks’ investors.”
Specifically, the study examines whether banks that undertake securitization transactions face higher or lower levels of information uncertainty compared to banks that do not obtain financing through securitizing assets.
The topic fits into Neamtiu’s broader research, which looks at the consequences of information asymmetry between different market participants. “When there’s information asymmetry, someone is
always making more of a profit,” she explains.
Looking back on the recent meltdown, she says, “Of course there was a lot of uncertainty. But at the point in which the market was working, we believed it could go either way. It’s important to understand securitization in normal market conditions — though it’s hard to define ‘normal.’”
Up to a few years ago, she says, people believed that securitization of assets could actually reduce informational uncertainty. “Banks always know more than outside investors,” Neamtiu explains. “But they are subject to increased disclosure through the process of registering bonds with the Securities and Exchange Commission. A lot of practitioners thought there would be increased transparency.”
Any time a bank issues a loan, it’s uncertain whether the borrower will pay it back, so for the bank to exchange the loan for a known amount and use the proceeds for investment in more transparent assets seemed like a sound strategy. The difficulty, Neamtiu points out, is that when banks transferred securitized assets to subsidiaries to be packaged into bonds, the systems were so complex and non-standard that it was difficult to track risk transfer. “All of the transfer contracts have some form of explicit recourse,” she says, “but the banks also implicitly agree to protect the bonds.”
Those implicit promises often amounted to verbal agreements, so before the meltdown, it wasn’t clear who would bear the losses. “Well, now we all know what happened,” Neamtiu says. “The banks were forced to take the losses. So they didn’t transfer all the risk with the securities.”
Asset securitization has largely dried up, but Neamtiu says banks are likely to revisit it. “Securitization has its merits and its issues,” she says. “There are so many possible ways to structure securitizations — it’s clear that banks need to focus on simpler structures. They wouldn’t be as profitable, but they wouldn’t be as risky either.”
She likens the situation to the junk bonds of the late 1980s. “That market was completely wiped out,” she says. “But the most salient pieces of the product stayed and the bad were weeded out. That’s what happens when this type of innovation matures.”