Prudent Lending Restored is an excellent resource for anyone seeking an in-depth analysis of the 2007 global mortgage meltdown and the future of the securitization industry. It is an anthology of well-written, rigorously argued academic papers presented at a 2008 conference dedicated to the future of securitization. The book covers a fascinating range of topics, but the first three papers are the most important. Collectively, they explain the major causes of the crash and suggest sensible reforms.
Following a short introductory chapter, the book begins with a paper by Robert A. Eisenbeis containing a detailed historical analysis of the macroeconomic conditions leading to the crash and the various responses of central banks and government policymakers. Eisenbeis begins by arguing that the subprime meltdown was caused by a “series of international and domestic macroeconomic fiscal and monetary policy mistakes.” He enumerates four distinct causes, all of which share a common thread—“extreme leverage enabled by ample liquidity and low risk spreads.”
The remainder of the paper describes the events of the crash as they unfolded. Eisenbeis covers each major development in both the United States and Europe (e.g., Lehman Brothers and Northern Rock) and explains the relationship between the various failures and the economic conditions of the time. He also describes and analyzes central banks’ specific responses in their attempts to contain the problems. Interestingly, Eisenbeis argues that none of the central bank responses stood out as superior:
Despite both the varied responses and complaints of critics, there is little convincing evidence that any of the central banks considered here significantly outperformed the others in terms of the quality of their responses.
He concludes with a lengthy list of specific policy recommendations, including establishing coordinated monetary and regulatory policies, improving failure resolution regimes, and requiring leverage limits.
Joseph R. Mason provides another historical analysis of the crash, but he covers a very different topic. He analyzes the features and specific failings of the most highly leveraged and thus most problematic structured products: constant proportion debt obligations, structured investment vehicles, and auction-rate securities. Mason’s thesis is straightforward: The benign credit environment in which these instruments were issued masked their inherent risks, and their extreme leverage magnified the losses as market conditions deteriorated.
Mason does not provide as many policy recommendations as Eisenbeis does, but he does succinctly summarize the key issue:
From a policy perspective, innovative structures created in periods of relative calm may need to be closely monitored so that their effects can be appropriately contained.
Günter Franke and Jan P. Krahnen explore a completely different cause of the crash. They argue that “the agency problem,” or the inherent conflicts of interest between the participants in the securitization value chain (originators, investors, mortgage servicers, rating agencies, etc.), contributed substantially to the meltdown.
Franke and Krahnen make the eminently plausible claim that because the industry was so fragmented and laden with informational asymmetries, service providers constantly placed their own interests ahead of their clients’ interests. One good example (among many possible choices) is the relationship between the product issuers and their investors. Essentially, in many cases, the investors did not fully understand how the structures worked, so the issuers were able to charge excessive premiums.
To combat the agency problem, the authors make two basic policy recommendations. First, they assert that manager incentives need to change to become aligned with investors’ interests. Franke and Krahnen argue that this would be best achieved by tying manager compensation to future asset values and establishing a bonus-cum-malus system, whereby the manager receives a negative bonus for poor performance. Second, they maintain that transparency must increase throughout the entire securitization process. One specific recommendation is to require collateralized debt obligation (CDO) originators to disclose exactly how much of the equity tranche they retain. Such disclosure would help investors gauge the riskiness of each deal. Similarly, Franke and Krahnen advocate more effective disclosure of counterparty risks.
The remaining chapters of the anthology are interesting, but they lack the broad appeal of the first three papers.
Jennifer E. Bethel, Allen Ferrell, and Gang Hu analyze the “legal and economic issues in litigation” arising from the mortgage meltdown. Specifically, their paper examines the nature of legal claims that have been or will be brought by CDO and mortgage-backed securities purchasers as well as claims against investment banks. The authors describe the legal hurdles plaintiffs will have to overcome in order to prevail in court, and they predict that a high percentage of lawsuits will fail. Note that this is challenging material for readers who lack a background in law.
Jack Guttentag and Igor Roitburg’s contribution is fascinating, but unlike the other papers, their recommendations are a bit radical. The authors make a provocative yet persuasive case for completely changing how the mortgage finance industry operates. They argue that the current risk-based pricing of mortgages should be replaced with a new type of mortgage insurance that reflects default risk. A portion of insurance premiums would be placed in reserve, cushioning the economy should another epidemic of defaults occur.
In the book’s final chapter, Eiichi Sekine, Kei Kodachi, and Tetsuya Kamiyama describe the current state of the Japanese securitization industry. They argue that it is in better shape than the U.S. and European markets, but they acknowledge that it is also less sophisticated. Sekine, Kodachi, and Kamiyama conclude by asking whether the Japanese market will evolve to be more like its U.S. counterpart (i.e., more sophisticated and more risky) or whether it will retain its present character.
On the whole, Prudent Lending Restored is an outstanding book. Even seasoned securitization practitioners who lived through the meltdown will find value in its pages. Newcomers to the topic will also benefit, although they should be prepared for a dense read that covers a vast amount of material in depth.
—C.S.