Did the Securitization Contribute to the Release of the Subprime Crisis? Empirical Investigation of American Banks

ABSTRACT In this paper we examine the hypothesis that the securitization, the act of converting illiquid loans into liquid securities, has largely contributed to an excess of risk taken by American banks on their subprime credit lending. Empirical investigation, conducted over a sample of 6775 US banks between 2003 and 2007, provides evidence to support this assumption. We additionally find that banks which securitize are also those experiencing a decreasing rate of profitability and a risk level higher than the average. Finally, this crisis seems to have a macroeconomic explication, also documented in previous studies, according to which the fall of the house price index since 2006 significantly deteriorates the US bank financial performance. JEL Classifications: G01, G21, G33, G34 Keywords: subprime crisis; US banks; panel logistic regression; securitization (ProQuest: . denotes formulae omitted.) I. INTRODUCTION The financial history was marked in the last decades by a succession of financial crises. Black Monday of Wall Street (1987), the Latin American crisis (1994-1995), the Asian financial crisis (1997) and, recently, the subprime crisis seem to have a periodic distribution. According to the 2009 Global Financial Stability report, the amount of the American assets for the whole financial institutions during the period between 2007 and 2010 may well exceed $2.7 billion, compared to the expected level of $2.2 billion in January 2009. According to the International Monetary Fund, the global amount of the loosed credits in the world is estimated at approximately $4 billion, of which two-thirds belong to banks, and the remainder comes from insurance companies, hedge funds and other financial institutions. Since August 2006, various actions were undertaken by the world's leading central banks for the rescue of the financial markets. This has been materialized by the activation of the lender-of-the-last-resort functions and liquidity injections for several times. We note for example that the amount of liquidity injections by the European Central Bank to help eligible financial institutions experiencing financial difficulty or risking a probable default exceeded the sum of euro500 billion. The Bank of England also injected, until April 2008, euro63 billion for the repurchase of poor quality loans essentially in the forms of asset-backed securities and covered bonds. To the extent that the amount of banks' securitized credits rose substantially from $1268.6 billion in January 2000 to about $2523.4 billion in 2008 (or an increase of about 100%), some economists and finance professionals argued that securitization operations were the origin of the subprime crisis and did contribute to its worldwide propagation. This paper attempts to empirically examine the role of the subprime mortgage-backed securitization in the release of the recent subprime crisis by checking the hypothesis of excessive risk-taking by financial companies in loan granting. This high risk is potentially supported by the possibility for American banks to transform their credits into negotiable evidences of indebtedness through securitization mechanism. Thus, our study joins the very recent literature that investigates the economic consequences of housing price appreciation (Goetzmann et al., 2009; Mian and Sufi, 2010a, 2010b) and the relationship between the securitization activity and the global financial crisis of 2007-2009 (Keys et al., 2010; Piskorski, 2010; Claessens et al., 2010). The main findings, obtained from econometric analysis for the sample of 6775 American banks between 2003 and 2007, indicate that credit securitization leads to an excessive risk-taking behavior of American banks on their subprime credit lending and to a significant increase in their probability of default. The remainder of this paper is organized as follows. Section II provides an overview of the theoretical and empirical literature on the banking and subprime crisis, as well as some stylized facts related to the release of the subprime crisis in the United States. …