A Capital Idea
Traditionally, banks have made money by holding assets on their balance sheets that could not always be readily sold for cash at face value. Banks have earned their profits by learning how to take prudent risks with the funds entrusted to them. After all, once a loan is made, the lender often has little ability to dispose of it without taking a loss. Consequently, banks have always had strong incentives to know their borrowers and how to work with them to keep loan payments current.
Over time, some bankers changed their business model from “originate and hold” to “originate and sell.” In the second model, banks and others, such as independent mortgage companies, underwrite loans but then sell them off to a third party. This third party, which might be an investment bank, can pool together large numbers of loans and sell fractional interests in the pool to other investors, such as insurance companies and pension funds, in the form of securities. These are often called asset-backed securities because the repayment of principal and interest ultimately depends on the performance of the underlying loans to back investors’ claims.
The advent of securitized markets for mortgage and other loans enabled banks to build on their fundamental skills in loan origination and to tie up less of their capital than they would have, had they kept the loans on their own books. In addition, some traditional lenders gained another revenue stream by selling off their loan servicing rights to specialized financial companies that could operate the servicing business more profitably on a larger scale. Loan servicing companies operate on behalf of those who own the loan and expect a return from principal and interest payments. When loans do not perform as expected, the servicing companies decide when, how, and if the terms of the loan should be modified.
The media have made much of how badly the securitization of residential mortgage loans has turned out, both for investors in asset-backed securities and for many people who obtained mortgages as a result of lax underwriting standards and the unprecedented availability of funding. It is still not clear whether we have seen the worst of mortgage loan defaults and foreclosures, nor do we yet know the full extent of the losses to investors in mortgage-backed securities. Financial markets continue to be agitated by these uncertainties, to be sure, but now the turmoil is calling into question the banking system’s willingness and ability to provide credit to sound borrowers. But why should commercial lending in Boston and Cleveland be affected by mortgage foreclosures in Florida and California?
Unexpected complications have resulted from financial engineers’ piece de résistance—designing financial instruments backed by pools of securities that were themselves backed by pools of other securities. Billions of dollars worth of these instruments were offered to investors through special-purpose financial entities that existed for no other reason than to distance them from their sponsors. Having created this separation, the sponsors—often commercial banking organizations—believed that they need not hold much, if any, capital against potential losses suffered by their progeny. However, just as some parents worry that their children’s financial misfortunes could damage their own credit, some sponsors of special-purpose entities are standing behind their progeny and taking the assets back onto their own balance sheets. These sponsors are acting to preserve their reputation with customers and investors, even though such actions dilute capital ratios.
In much the same way, secondary markets for various loans have been affected by investors’ concerns about the quality of the underlying assets, whether or not those assets are funded through special-purpose vehicles. Some banks that have come to rely on secondary markets to take loans off their balance sheets are now obliged to fund these assets themselves. Such unplanned funding needs have made it more difficult for certain banks to find stable sources of funding—at a cost they consider reasonable—to replace sources that used to be available.
During the next several months, we will learn more about the magnitude of losses for financial institutions, mortgage insurers, and investors. Though it is possible that some financial institutions will allow their balance sheets to shrink to fit what capital they have, others will find investors to put in more capital. In fact, some prominent financial institutions have already announced new capital infusions. Over time, the current turmoil will dissipate, and lending markets will normalize. What will then constitute “normal” for these markets is still uncertain, but it seems likely that the new financial architecture will benefit from a sounder capital footing.