Securitization as a response to monetary policy

• Author: Xiaonian Xu,Jiarui Zhang
• Date: 01 July 2019
• DOI: http://doi.org/10.1002/ijfe.1721
• Published date: 01 July 2019

RESEARCH ARTICLE

Securitization as a response to monetary policy

Jiarui Zhang

1

| Xiaonian Xu

2

1

Department of Finance, Accounting, and

Economics, Nottingham University

Business School China, Ningbo, China

2

Department of Economics and Decision

Sciences, China Europe International

Business School, Shanghai, China

Correspondence

Jiarui Zhang, Nottingham University

Business School China, Trent Building

362, 199 Taikang East Road, Ningbo

315100, China.

Email: jiarui.zhang@nottingham.edu.cn

Funding information

China Europe International Business

School Faculty Research Grant

JEL Classification: D82; G21; E52

Abstract

This paper studies how monetary easing provides incentives for banks to take

risk and issue mortgage‐backed securities (MBS) and, because MBS have the

“lemon”property, why MBS buyers are willing to purchase high‐risk securities

at high prices. Banks need equity to attract deposits. Monetary easing reduces

this need, and banks leverage up and reduce their monitoring efforts. The

internal need for liquidity and risk sharing motivates banks to issue MBS.

Security buyers understand the moral hazard problem that banks face but

are willing to purchase bank securities at high prices because monetary easing

would also reduce their cost of funds.

KEYWORDS

monetary policy, mortgage‐backed securities, risk taking

1|INTRODUCTION

On what caused the financial crisis of 2008, there are two

schools of thought. One, represented by the chairman of

the Federal Reserve, Ben Bernanke, holds financial dereg-

ulation and the consequent outburst of exotic financial

innovation such as mortgage‐backed securities (MBS)

the primary cause (Bernanke, 2010). The other, advanced

by John Taylor (2008, 2012) and others, holds monetary

policy as the primary factor contributing to the unprece-

dented U.S. housing boom that eventually led to the crisis.

Although some researchers blame MBS for providing

banks with additional liquidity and incentives to take

excessive risk (Dokko et al., 2009), we conjecture that

monetary easing policies induced banks first to take risk

and then to sell MBS as a rational response to meet capi-

tal constraints or to transfer risk away. Indeed, Figure 1

shows that the issuance of MBS did not lead to explosive

growth until 2002. The timing coincides with the onset of

a low interest rate period. Furthermore, Figure 2 shows

an almost one‐to‐one correspondence between the

subprime MBS market value and subprime mortgages

from 2003 to 2006. A divergence is seen in 2007, when

the MBS market suffered a major correction. Thus, a cou-

ple of questions naturally arise: Could monetary policy be

a driving force behind the surge in subprime mortgages?

Would banks have then hedged against the increased risk

of their loan portfolio by selling more MBS? If both ques-

tions can be answered in the affirmative, monetary policy

and financial innovations cannot be treated as parallel

and equally responsible for the housing bubble. Rather,

the former may be considered the definitive cause and

the latter a consequence.

In a previous study, Xu and Zhang (2017) show that if

the central bank cuts its benchmark interest rate, com-

mercial banks will lower their lending standards by

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided the

original work is properly cited.

© 2019 The Authors International Journal of Finance & Economics Published by John Wiley & Sons Ltd

Received: 11 August 2017 Revised: 2 February 2018 Accepted: 31 December 2018

DOI: 10.1002/ijfe.1721

Int J Fin Econ. 2019;24:1333–1344. wileyonlinelibrary.com/journal/ijfe 1333