October's Consumer Credit Credit Securitization Market

In order to give you a better idea of the degree to which the credit markets are frozen, take a look at the passage below: 

(From the WSJ): "Banks and other finance companies making loans for autos, credit cards and college tuition are having virtually no success in selling those loans to other investors, a potent sign of just how tight credit markets remain.

The market for selling such loans -- by packaging, or securitizing, them into bonds -- had just one $500 million deal for all of October, according to Barclays Capital. That compares with $50.7 billion worth of deals made one year earlier, according to market-research firm Dealogic. The overall market for so-called asset-backed securitization is estimated at $2.5 trillion.

This creates repercussions for lenders and consumers alike.

Banks and other finance companies are stuck holding more loans on their balance sheets, which crimps their ability to offer new loans. That, in turn, shrinks available credit for consumers, who need it to finance an education, buy a new car, or pay for household expenses using a credit card. Banks were already reining in lending to customers as they try to reduce exposure to loans that may ultimately go unpaid.

For years, the asset-backed securitization markets fueled the explosion in consumer borrowing, as it allowed lenders to spread their risk to other investors such as pension funds, hedge funds and insurers. But the securitization pools have dried up after losses in the mortgage markets, where risk was also widely dispersed via securitized bonds.

The October dry spell has caused year-to-date securitization volumes to drop. Credit-card volumes are down 31%, auto loans are off 45% and student loans have fallen about 41%, according to Barclays. October's sole transaction came from AmeriCredit Corp., which provides auto loans to less creditworthy borrowers.

"We are at a standstill," said Craig Leonard, a structured-debt syndicate banker at Barclays Capital said.

The deals that are getting done are also more expensive for the banks. At the end of October, the risk premium charged on a triple-A rated credit-card deal reached 4.67 percentage points over comparable two-year Treasury yields, up almost 3.2 percentage points from June, according to J.P. Morgan data.

Even through June of this year, securities backed by student loans and credit-card debt remained popular with investors. But investors already burned by sinking bond valuations are likely to stay clear of these markets, because of the downturn in the economy and expected increase in job losses."

So the first thing that jumps out is that the securitization market that had (on aggregate) $51 billion worth of transactions last October had only a single $500 million transaction this past one, in other words: the securitization market declined by 99% last month. 

The other issue is that many of the hedge funds that the banks would normally sell securitized loans to no longer exist, the pension funds are trying to preserve capital and the insurers may very well need outside capital infusions just to keep functioning. But the real problem is that the banks used securitization to both spread risk around and raise capital, and now the investors know that these debt securities aren't as safe and dependable as advertised. Especially now that a slowing economy increases the risk inherent in any lending or debt security transaction.

It's hard to get investors to believe in what you're selling when you sold them garbage in the past, and all signs are pointing towards the banks having a weaker pool of customers to deal with on a go-forward basis.

Fixing the situation will require the banks to raise their lending standards so that they're selling higher quality debt securities in the first place, on top of strengthening the economy so that the banks have a stronger pool of customers to work with. Unfortunately while the former is fairly clear cut, the latter is more of an abstraction at the moment.

Moving forward consumers are going to need reset their expectations around credit, because the combination of higher standards (that were too low anyway) and fewer investors in debt securities (fewer hedge funds, other investors being more cautious) is going to make credit harder to come by.

What's unknown at this point is how things will look after the credit crunch: will consumer credit be generally harder to get (compared to the credit boom), or if we'll see more of a "scale back approach where people with $40k/yr salaries will no longer be able to easily finance $45k cars and will have to instead finance $20-$25k ones instead. Hopefully we'll see more of the latter than the former.

On a go-forward basis the ideal situation is one where consumers can easily obtain credit, just not in amounts that are out of touch with one's income level and ability to pay it back. Think: aggregate credit card limits capped at 75% of income, car loans limited to 40-60% of income, mortgages originated at 22-28% of gross monthly, etc.

You can read more here.

Sources:

The WSJ: "Bond Woes Choke Off Some Credit to Consumers" -- Robin Sidel, Prabha Natarajan, November 6, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.