The Draghi report proposes to relaunch “securitization” to increase the financing capacity of the European banking sector, arguing that it is lagging behind the US market in terms of fundraising.
What is it about?
Securitization is the sale by financial intermediaries of a portion of the loan receivables they have granted to investors seeking an investment. On the one hand, these intermediaries regain liquidity and thus renew their financing capacity, and on the other hand, investors, the new owners of these receivables, receive interest and principal repayments.
Securitization is usually used by mortgage lenders that do not benefit from deposit accounts and thus find a way to obtain liquidity from specialized investors.
This financial technique, encouraged by the authorities to banks, has all the appearance of efficiency and seems to respect the virtuous concern of maintaining their necessary level of equity to finance the economy; it hides, however, serious
dangers. Because most securitizations are now “structured”.
-Structured financial products
Banks sell some of their receivables to investment funds, usually subsidiaries, to create financial investment products. The arrangement of these products consists of amalgamating receivables from various sources, from more or less defined sectors of activity, and whose solvency risk is variable.
This amalgam of different quality receivables increases the profitability of the investment product, by integrating risky receivables which are by definition less well rated and at a higher interest rate. In addition to the arrangement fees they receive in return, banks are encouraged to get rid of their most fragile debts.
Thus, CLOs (collateralized loan obligations) appear: amalgamated bonds of more or less vulnerable medium-sized companies; RMBS (residential mortgage-backed securities) amalgamated dependent mortgage loans in Anglo-Saxon countries of the value of the property, CMBS (commercial mortgage-backed securities) amalgamated commercial mortgage loans related to general commercial activity or ABS (asset-backed securities) which fall under consumer credit or automobile leasing.
In total, not only are “structured” securitized products dependent on uncertain and volatile sectors of activity, but moreover, their profitability is partly based on risky receivables. Moreover, the distribution of these products to all global investors is favored by the concentration and interdependence of financial markets. Of course, the risk of default and thus the failure of a structured product, widely distributed, will concern all investors and all global markets.
-The predictable vicious cycle
Investors in these products, beneficiaries of the additional return due to the integration of risky assets will then be led to guarantee themselves by buying at the same time an insurance product called CDS (Credit Default Swap) from financial institutions issuing insurance.
All the ingredients that caused the financial crisis of 2007-2009 are thus reunited. If subprimes, objects of dubious manipulations have disappeared from securitized receivables, fragile and uncertain receivables persist and continue to be disseminated in all the structured products we have just mentioned. And whatever the share of these fragile claims at high interest rates in each of these products, it is enough that one or a few of them defaults to contaminate the product itself, because here, by construction, the amalgam of claims prohibits the isolation of the components. Investors holding a structured product whose yield is reduced or is bankrupt, will immediately try to resell it and will then enter a cycle of asset devaluation and all, each in turn, will be forced to do so until the beginning then the loss of their own capital.
Given the scale of the exchanges, we will not have to count on any issuer of CDS to absorb a default concerning all these investors: AIG, the main American insurance group and main issuer of CDS during the financial crisis of 2007- 2009 almost died and was saved at the last minute by the United States Federal Reserve which granted it a loan of 80% of its capital.
Despite the recent history of the last major global financial crisis, today we see the development, once again, of these dangerous products for the sole purpose of luring investors to the detriment of awareness of the risk they may incur. And even more serious, these products can only harm the proper functioning of the financial markets themselves.
The financial crisis could then spread rapidly to the global economy, giving way to a new recession.
Added to this is the pressure exerted by the US private banking lobby on the regulatory authorities to call into question or at least reduce the weight of the stress tests. These tests, which measure the adequacy of the capital and liquidity held by banks to cope with crises, have been required since the 2007-2009 financial crisis and are intended to avoid taxpayers having to bail out their banks. The mandate of the new President of the United States, an apostle of deregulation, does not augur well for the future, other than arbitration against the monetary and financial authorities and recourse to blind laisser faire.
It is likely that the beginnings of a new financial crisis are in the making, and given the value of the transactions carried out by the world’s financial markets, this crisis would be more serious than the last one.
-The myopia of disaster
A recent concept used in behavioural microeconomics, that of disaster myopia ( Guttentag / Harrington 1986 ), seems to us to be particularly appropriate to the situation. This concept formalises the behaviour of company directors who measure the occurrence of a risk or economic shock according to the memory they have of it.
This memory depends on the length of time elapsed since the last occurrence of this risk or shock.
When the probability of occurrence is considered almost zero, because it is too distant in time or even considered to have a random periodicity, then we can speak of disaster myopia.
This attitude prevents the understanding and analysis of the warning signs of future difficulties and leads to them being accentuated by aggravating decisions because they forget the lessons learned from previous events.
We can say that we are there….but this time, unfortunately, the “disaster myopia” applies to the scale of global economic and financial authorities.