Securitization without risk transfer

We analyze asset-backed commercial paper conduits which played a central role in the early phase of the financial crisis of 2007-09. We document that commercial banks set up conduits to securitize assets while insuring the newly securitized assets using credit guarantees. The credit guarantees were structured to reduce bank capital requirements, while providing recourse to bank balance sheets for outside investors. Consistent with such recourse, we find that banks with more exposure to conduits had lower stock returns at the start of the financial crisis; that during the first year of the crisis, asset-backed commercial paper spreads increased and issuance fell, especially for conduits with weaker credit guarantees and riskier banks; and that losses from conduits mostly remained with banks rather than outside investors. These results suggest that banks used this form of securitization to concentrate, rather than disperse, financial risks in the banking sector. 1 Authors are grateful to Matt Richardson and faculty members at Stern School of Business, New York University for discussions on the topic and to research staff at Moody’s and Fitch Ratings for detailed answers to our queries. We are grateful to Amit Seru (discussant) and seminar participants at Stockholm Institute of Financial Research (SIFR) conference on the Financial Crisis of 2007-09, European Central Bank and Federal Reserve Bank of New York. This paper represents the views of the authors and not necessarily those of the Federal Reserve System or its Board of Governors. 2 Viral V Acharya, Department of Finance, Stern School of Business, New York University, 44 West 4th Street, Room 9-84, New York, NY-10012, US. Tel: +1 212 998 0354, Fax: +1 212 995 4256, e-mail: [email protected]. Acharya is also Academic Director of the Coller Institute of Private Equity, a Research Affiliate of the Centre for Economic Policy Research (CEPR) and Research Associate in Corporate Finance at the National Bureau of Economic Research (NBER). 3 Philipp Schnabl, Department of Finance, Stern School of Business, New York University, 44 West 4th Street, Room 9-76, New York, NY-10012, US. Tel: +1 212 998 0356, Fax: +1 212 995 4256, e-mail: [email protected] 4 Gustavo A Suarez, Research & Statistics Division, Federal Reserve Board, 20th Street & Constitution Avenue, NW, Washington, DC-20551, US. Tel: +1 202 452 3011, Fax: +1 202 728-5887, email: [email protected] -1Securitization was traditionally meant to transfer risks from the banking sector to outside investors and thereby disperse financial risks across the economy. However, in the period leading up to the financial crisis of 2007-09, banks increasingly devised securitization methods that allowed them to concentrate risks on their balance sheets which eventually led to the largest banking crisis since the Great Depression. In this paper, we analyze one form of securitization, namely asset-backed commercial paper conduits (henceforth, conduits), as an example of how banks exposed themselves to such risks. Conduits are structured purpose vehicles set up by large banks. Conduits typically hold long-term assets claims, such as mortgages, which are financed by issuing short-term asset-backed commercial paper. Similar to regular banks, conduits thus exhibit a significant maturity mismatch between assets and liabilities. As shown in Figure 1, before the financial crisis asset-backed commercial paper was an important funding source for commercial banks growing from US$650 billion in January 2004 to US$1.2 trillion in June 2007. However, the rise in asset-backed commercial paper came to an abrupt end in August 2007. On August 7, 2007, the French Bank BNP Paribas halted withdrawals from three funds invested in mortgage-backed securities and suspended calculation of net asset values. 5 The announcement read: “[T]he complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating... Asset-backed securities, mortgage loans, especially subprime loans don't have any buyers... Traders are reluctant to bid on securities backed by risky mortgages because they are difficult to sell on... The situation is such that it is no longer possible to value fairly the underlying US ABS assets in the three above-mentioned funds.” (Source: “BNP Paribas Freezes Funds as Loan Losses Roil Markets”, Bloomberg.com, August 9, 2008). Even though defaults on mortgages had been rising throughout 2007, the suspension of withdrawals had a profound effect on the asset-backed commercial paper market. Apparently investors in