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Handout Professor Minsky prepared for Econ 335A, Fall 1987.

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Handout Econ 335A-Fall 1987

SECURITIZATION

Hyman P. Minsky

Washington University

St . Louis MO 63130

United states

Notes prepared for discussion. First on June 27, 1987 then

edited and expanded in August 1987. Corrected in September

1987.

Heraclitus: “You can not step twice in the same river."

IN MAY 1987. AT THE ANNUAL BANKING STRUCTURE AND COMPETETION

CONFERENCE oF THE FEDERAL RESERVE BANK OF CHICAGO. THE

BUZZWORD IN THE CORRIDORS AND BY MANY OF THE SPEAKERS WAS

"THAT WHICH CAN BE SECURITIZED. WILL BE SECURITIZED".

Introduction

It is necessary to understand what securitization involves

and how it might affect the development of the world economy

if central bank interventions and the government

interventions that guide institutional developments are to

be successful. Thus there is a broader significance to the

emergence of securitization than the impact it will have on

banking and other financial businesses.

Securitization leads to the creation of financial paper that

seems to be eminently suitable for a global financial

structure. There may be a symbiotic relation between the

globalization of the world's financial structure and the

securitization of financial instruments. Globalization

requires the conformaty (sic) of institutions across national

lines and in particular the ability of creditors to capture

assets that underlay the securities.

Securitization reflects a change in the weight of market and

bank funding capabilities: market funding capabilities have

increased relative to the funding abilities of banks and

depository financial intermediaries. If securitization

reaches the potential that some envisage for it then the

shift of funding to market from institutions will be very

great. The institutions that survive will be largely

dependent upon fee income.

Securitization is in part a lagged response to monetarism

and inflation. monetarism led to fighting inflation by

constraining monetary growth which, in monetarist doctrine

meant that the growth of bank and thrift institution

liabilities had to be constrained. This constraint on the

growth of banks and thrifts opened opportunities for

financing techniques that economized on bank or thrift

liabilities. The monetarist way of fighting inflation,

which preceeded (sic) Volcker's 1979 "practical monetarism", puts

banks at a competetive (sic) disadvantage in terms of the short

term growth of their ability to fund assets. Furthermore by

opening interest rate wedges monetary constraint provides

profit opportunities for innovative financing techniques.

In the United States the interest rates of the monetarist

experiment impaired the net worth and therefor destroyed the

funding capabilities of the thrift "industry" by undermining

the value of mortgages. However the ability of the thrifts

to create mortgages was unimpaired. Securitization as we

know it began in the U.S. mortgage market. It enabled the

thrifts to continue to initiate mortgages even though their

funding ability was sorely Compromised. Although modern

securitization may have begun with the thrifts, it has now

expanded well beyond the thrifts and mortgages.

Securitization is also a market response to the cost

structure of banks. Banks seem to need a 450 basis point

margin if fund income is to be the source of profits. This

provides a great deal of space between the price banks pay

for funds and the price they must charge borrowing customers

for innovative suppliers. Bank participation in

securitization is part of the drive, forced by costs, to

supplement fund income with fee income.

The development of the money market funds, the continued

growth of mutual and pension funds, and the emergence of

vast institutional holdings by offshore entities provide a

market for the instruments created by securitization.

Some Implications

Any attempt to place securitization in context needs to

start with early 19th century commercial bill banking in

Britain and a recognition that accepting contingent

liabilities is a fundamental banking act and that this

acceptance enhances the creditworthiness of the initial

instument (sic). The modern contribution is the development of

techniques to "enhance credits" without accepting contingent

liabilities or the creation of equity liabilities.

Securitization throws light on the nature of money: Money

is a financial instrument (a debt) that develops out of the

financing of activity and positions in assets that becomes

generally accepted in an economic community as a means of

payment for goods and services and as an instrument by which

debts are discharged. It is conceivable that in the not too

distant future we can be using $100. (sic) interest bearing short

term securities as currency. Private money is a distinct

possible longer run implication of current developments.

Securitization implies that there is no limit to bank

initiative in creating credits for

1. there is no recourse to and therefor no absorption

of bank capital and

2. the credits do not absorb high powered money.

Both capital and reserve absorption may occur at the

initiating stage of the credit. This has led to the "bridge

financing" terminology.

Securitization lowers the weight in the total financial

structure of that part which Central Banks (Federal Reserve

In the United States) are commited (sic) to protect.

Institutional holders of securities (such as mutual or money

market funds or trustees for pension funds) who are

Committed to protect the market value of their assets may

react to a rise in interest rates by selling their position,

which can lead to a drastic fall in the price of the

securities. Is the danger that units will be forced to make

position by selling out position increased by the

development of securitization?

The new technologies of communication, computation and

record keeping are important in the emergence of

securitization and globalization .

The two fundamental banking interfaces

(Bank is a generic term not restricted to legally defined

banks.)

I. "Bank" and debtors.

1.The initial creation of paper based on cash flows

from income creating activities

The liability is of :

a. Business and therefor is a prior

allocation of profits

b. Households and therefor is a prior

allocation of wages etc.

c (sic) Government and therefor is a prior

allocation of taxes

d (sic) The rest of the world and therefor is a

prior allocation of export earnings

2.Note that such paper links the present and the

future. Today is the future for some past todays. Prior

commitments are falling due even as new commitments are

entered upon. Cash flows as both a source of funds and as

the validation of prior Commitments. The hedge, speculative

and Ponzi characterization of cash flows may be relevant.

3. A banker operates on the basis of expectations of

cash flows. What determines such expectations? In

particular "How do expectations change?" is a fundamental

analytical-banking question in a market based financial

structure?

4. In banking collateral is of secondary importance in

the creation of credit for the bank customer relation has

failed whenever there is a need to capture collateral. The

importance of collateral is that it furnishes a way to wipe

out failed credits. The weakness of the way the sovereign

Latin American debts were structured is that they did not

provide for any way by which failed debts could be

recognized and therefor wiped out. Real progress on Latin

American debts and the availability of new credits to Latin

America depend upon the invention of some "bankruptcy

proceedure" (sic) which recognizes failed credits and wipes them

off of the lenders books.

5. Asset or collateral based lending implies that the

cash flows to validate commitments will be forthcoming from

the sale of the asset. The buyer obviously expects cash

flows that will validate the price he pays.

II. Bank and "Funders".

1. Households as the ultimate owners;

2. Intermediation and layers of intermediaries; the

descriptive insights of Gurley and Shaw on the one hand and

Goldsmith on the other.

III. The relations

1. A bank deals with both the issuer of debts and the

funder; a bank's balance sheet reflects this two sidedness

of banking. Fund income depends upon the gap between the

cost of money and the return on earning assets. Bank equity

“enhances credits”. Deposit insurance as the enhancer of

credit for today's bankrupt banks and savings and loan

associations in the United States. Deposit insurance as a

government guarantee rather than insurance. "What are the

actuarial relations?" was never addressed in deposit

insurance.

2. In securitization the bank's balance sheet

disappears from the financing once the transactions are

completed. No question of contingent liabilities and

recourse if there is no fraud.

3. In securitization financial instruments and the cash

flows they are expected to generate are the proximate basis

for issuing marketable paper. Income from paper (cash

flows) is substited (sic) for the profits earned by real assets,

household incomes, or tax receipts as the source of the cash

flow the paper pledges.

The steps and the players

1: A. debtor: the fundamental paper emitter and source of

the cash flows from income that validate the securities.

2: The paper creater (sic): the bank loan officer who structures

the credit and accepts debtor's promises to repay;

The negotiations between 1 and 2 ends up with paper that can

be negotiated. Steps 1 and 2 are like conventional bank

customer relations.

Query: If a credit is to be securitized will the "loan

officer" be as prudent as he would have been if the paper

was going into his institutions portfolio?

3: The investment banker: (NOTE THAT THE INVESTMENT BANKER

INTERFACES WITH MANY DIFFERENT TYPES OF UNITS. )

finds and negotiates with the paper creater (sic), buys the paper (bridge financing, the funding

of bridge financing, the relation to commercial banks,

exposure, out the window are terms that enter here).

The paper becomes the corpus

of a trust. (In Britain a separate corporation may be set

up for each corpus. In this case there may be an actual

equity investment.)

On the basis of the assets in

trust the investment banker creates securities, devising

ways to enhance credit (insurance, Complex of liabilities,

erzatz (sic) equity in the form of junk bonds)

The investment banker hires "econometricians" or financial economists to demonstrate

that the risks of default on interest and principle of some

class of the securities it proposes to issue are so small

that these instruments deserve to have an investment rating

that implies a low interest rate.

Securitization is viable, profitable for all concerned if the total cash pledged by

the securities is less than the total cash the corpus of the

trust is expected to yield.

4: The trustee: holds the basic paper-the corpus of

collateral for the securities-; acts in the interest of the

security holders; recieves (sic) the cash flows from the

underlying instruments, forwards them to the security

holders, empowered to end the trust, sellout the corpus,

and transmit proceeds to security holders according to the

hierarchy of rights if the rating of securities fall below

some agreed level. If the corpus of the collateral are

instrUments such as mortgages which provide for the periodic

repayment of principle then the trustee will call the

remaining libilties (sic) and liquidate the trust when the

principle outstanding falls below some stated value.

If securitization spreads the trustee business will boom.

The need to develop equivalents to the U.S. trust Company if

securitization is to be truly global.

5: The servicing organization: (often the paper creater)

recieves (sic) payments from the corpus and transmits the funds to

the trustee. Also may be the agent who acts for the trust

if paper in the corpus doesn't perform. This is a source of

fee income.

6: The rating services: places the resulting securities

into risk classes. In the security contract there is a

commitment to keep at least some of the securities in some

particular set of low risk classes. If the securities fall

below some rating or perhaps are threatened to fall below

some rating the trustee is supposed to act to protect the

interests of the security holders. This may lead to the

sale of the underlying assets, the corpus of the trust.

There is a danger that the equivalent of making position by

selling out position will result.

7: The maker of a secondary market. Often the underwriter,

the initiating investment banker. This is usually? (sic) a dealer

not a broker market. This will be a thin market if price

and quality of the securities deteriorate.

8: T (sic)

he funders: household, pension fund, banks with poor paper

creating facilities, mutual funds, foreign institutions etc.

Transcriber

Mariam Topuria

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