12 February 2008

FT comment: Subprime chains

It is the standard regulatory principle: prevent the last crisis. If the financial system blows up in some new and exciting way you will be blamed, but if it blows up in the same way as last time then public and political fury will know no end. The credit squeeze started with bonds backed by US subprime mortgages – so there will be intervention in that market. Rather than cumbersome rules, however, regulators should work through the incentives of the banks and brokers involved.

In days past, when a bank lent a borrower money, the incentives involved were simple. The bank wanted to lend to borrowers who would pay the money back. But in the chain from the mortgage brokers who deal with subprime customers, through assorted banks and lenders, into asset-backed bonds and finally to investors, different players have different priorities.

There is a also widespread suggestion that banks allowed low-quality lending to happen because of “moral hazard”: they did not care about defaults because they intended to pass the risk on to other investors via asset-backed bonds. One solution is to insist that banks keep some of the risk. For example, banks could be forced to keep the first 10 per cent of losses on any mortgage that defaults.

But there are problems with this approach. If banks take the first loss, in exchange for keeping all of the interest above a certain level, then their returns on a mortgage are like those on a call option. The upside is considerable, provided the borrower repays, but losses are limited, so this structure may actually encourage the creation of risky mortgages. If regulators do adopt this route, they must also insist that banks hold enough capital to offset the risks that they run.

Such requirements might encourage a better form of asset-backed security: the covered bond. Popular in some European countries, they have the same low borrowing cost as mortgage-backed bonds, but are fully guaranteed by the bank that sells them. The result is that simple self-interest, not complicated rules, keeps the quality of lending high.

© Financial Times