Half of all subprime mortgage backed securities wound up on the balance sheets of banks. This fact surprises many people who think that the problem with securitization is that it let banks off-load risky loans onto investors. If that was the strategy, however, banks wouldn’t have wound up with such huge holdings of subprime securities.
So why did banks snap up so many mortgage backed securities? Even banks that were originating mortgage loans preferred to securitize them, and then hold the securities. Why would they do that rather than just hold the loans?
The answer is that bank regulations encouraged them to own securities rather than loans. Under the international Basel capital requirements, a well-capitalised bank was required to hold $4 for every $100 in individual mortgages—a 4% reserve requirement. But if it held the securitized AAA and AA tranches, the bank only had to hold $1.60 in capital. That’s a huge incentive to trade in a loan for a mortgage backed security.
But the capital regulations did more than just create incentives to own mortgage backed securities. They allowed banks to dramatically increase their balance sheets. The lower reserve requirement allowed banks to buy even more securities than it could make loans. A bank with $4 billion in reserve could hold $100 billion in loans. But that same $4 billion could instead be used to invest in $250 billion worth of mortgage backed securities.
Another way of looking at this is that banks were basically making money—turning $100 into $250—by flipping mortgages into securities. It looked like instant profits. Almost magical. And that extra capital could then be reinvested in search of more profits.
This created a huge appetite for securitized mortgages. In fact, banks wanted more mortgages than they could possibly originate, which meant that banks needed independent mortgage companies to make loans that could be securitized. This lead to a dangerous dependence on mortgages made by outside lenders, which in turn meant that banks could not possibly know very much about the quality of the mortgages.
And they didn’t really want to know very much. Keep in mind that the banks got the benefit of this capital reserve arbitrage regardless of the quality of the mortgage, the documentation provided or the loan-to-value of the underlying mortgages. This made buying mortgage securities of any type—as long as they were rated high enough—look like a sure fire bet.
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