Securitization Drought Exposes Policy Bind, Threatens Recovery

The New York Times has a good update on the progress, or more accurately, lack thereof, in the efforts to return to normalcy in the credit markets. The story highlights the fact that the securitization markets, to the extent they are operating, are heavily dependent on government intervention and it does not appear likely that they will function at their present level if support were withdrawn:

The continued disarray in debt-securitization markets, which in recent years were the source of roughly 60 percent of all credit in the United States, is making loans scarce and threatening to slow the economic recovery. Many of these markets are operating only because the government is propping them up.

But now the Federal Reserve has put these markets on notice that it plans to withdraw its support for them. Policy makers hope private investors will return to the markets, which imploded during the financial crisis….

“Given the imperative for securitization markets to fuel bank lending, we won’t have meaningful economic growth until securitization markets are re-established,” said Joseph R. Mason, a professor of banking at Louisiana State University…

Enormous swaths of this so-called shadow banking system remain paralyzed. Depending on the type of loan, certain securitization markets have fallen 40 to 100 percent.

A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.

The market for securities backed by commercial real estate loans is in worse shape. No new securities of this type have been issued in two years.

“The securitization markets are dead,” said Robert J. Shiller, the Yale University economist and housing expert who predicted the subprime collapse. The government is supporting them, he said, but it’s unclear what will happen when it extricates itself. “We’re stuck,” he said.

What is intriguing about these comments is the tacit assumption that we have to go back to status quo ante, of having a significant amount of loans on-sold into credit markets rather than retained on bank balance sheets. Yet we have seen the superficial appeal of that system comes at considerable cost. Securitization allows for more “efficient” banking, in the sense that banks can operate with far less equity than if they conducted banking the old-fashioned way, by holding the loans they originate.

But this prized efficiency comes at high social cost. First, the idea that these loans were really off balance sheet in many cases was spurious. For some types of conduits, like credit card trusts and SIVs, banks did intervene when the supposed off balance sheet vehicles got in trouble. Indeed, credit card receivables could not have been off-loaded absent parent support. So the supposed efficiency gain was phony; the banks were simply using off balance sheet vehicles as a way to run with less equity than they actually should have had, but the regulators accepted the charade and looked the other way.

Second, as we know, securitization reduces the incentives to do proper borrower assessment and even worse, means no one is monitoring the borrower on an ongoing basis. There is no good substitute for traditional credit screening. The idea that simple metrics are an adequate proxy for credit assessment and local knowledge is utter rubbish. A banker who is a member of the community can factor in qualitiative considerations in (how stable is the employer for whom the prospective borrower is working? Is the local economy improving or weakening?) that get lost in simple minded scoring systems. And for corporate borrowers, the lender is the only party in a position to obtain non-public information that will allow for a better assessment of the lending risk. That is not to say these procedures are perfect; they aren’t, but they are better than what we have experimented with over the last 20 years.

As a result of the first two failings, we have the third problem: the public covertly and overtly has provided greater backstops to securitized credit than the traditional sort. We had Fannie and Freddie and Ginnie making the first wave of mortgage securitizations possible, and after those became well accepted, banks pushed into private (meaning non-government-backstopped) securitizations. But when a fair portion of them ran into trouble, the loans could not be restructured (increasing the social cost) and the banks that were exposed (by holding securitized mortgages, or warehoused mortgages due to be securitized) wound up being rescued. So the now greater level of support to the banking system is not a mere unfortunate side effect of the credit bubble, but a direct result of securitization, a process that leads to an undercapitalized banking system and a degradation of the lending process.

It is also noteworthy that the article fails to mention the fix proposed by the Obama administration, of having the originator retain 5% of the deals they on-sell. That is simply too low a percentage to change behavior. And a hold-back high enough to make a difference (probably at least 25%) will mean banks will have to hold more capital and will thus undermine the efficiency gains that are the raison d’etre of securitization.

Before the contraction entered the near-meltdown phase (fall 2008), central bankers appeared to have some willingness to have banks go back to a more old-fashioned model, even though it implied financial firms would have to raise massive amount of equity. Dizard depicted this line of thinking as wildly unrealistic, but it is noteworthy that is was the tacit plan until the wheels started coming off the financial system:

Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning….

The US banks and dealers are through the first quarter [of 2008], and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower…

It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model. A credit crunch, in Fed chairman Ben Bernanke’s own language, is: “A significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.” ( The Credit Crunch , Brookings Institution, 1991) That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.

Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.

All of it? I do not think so. The private equity people have other ideas. To raise anything like the bank capital the Fed and the other authorities such as the Treasury want, it would be necessary to have a series of road shows for the investing public that would be the size of theme parks. That could be done with difficulty and with great dilution for shareholders and, more seriously, career damage for senior management. The Fed itself would have to be a co-sponsor in some form.

Quietly arranged deals, first with sovereign wealth funds, then with private equity partnerships, are not enough. It is a bit like attacking militias in Basra without adequate forces or preparation. Some investors might throw down their arms and defect to the short-selling side.

Another way large banks are de-leveraging is to hive off assets, such as the $12bn of leveraged financing commitments Citibank laid off on a group of private equity funds, at a discount to the original price. The problem there is that while Citi is providing what a distressed homeowner would call “seller financing”, it is a lot less than the leverage available if the commitments were to be funded on Citi’s own books, or on the books of other banks. Multiply that $12bn by a raft of other deal announcements and you have the “leftward shift” Mr Bernanke referred to. Maybe more than one shift, come to think of it.

Readers no doubt also remember that that $7 billion recapitalization of WaMu was a very unhappy experience for the private equity investors who ponied up the money.

But now that we are only (according to the IMF) 60% of the way through the losses that US banks will realize thanks to the crisis, it will be hard simply to bring the banks back to a dim resemblance of pre-crisis levels of equity after the writeoffs are factored in. The additional capital needed for on-balance sheet lending seems an impossible goal. Yet there seems to be no realistic plan for bringing back the securitization markets, which is what has to happen for a restoration of status quo ante. And some question the wisdom of that goal. From Marshall Auerback:

….the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Unfortunately, ideas like this are simply unacceptable right now. The path of least resistance is to find a way to declare victory, which in this case will be to continue to prop up the securitization markets while somehow claiming they are operating on their own.