Starting Sunday, the remnants of the securitization industry will be at the annual American Securitization Forum ("ASF") Conference in Las Vegas. Just as the securitization and securities industry led the nation into the current crisis, if the economy is going to revive itself, this industry needs to lead the financial sector out of the crisis. The shadow capital markets-based banking system that existed in 2006 and early 2007 dwarfed the capacity of the banking industry and drove both healthy and unhealthy lending. While it is easy to blame banks for not lending enough to consumers and businesses, without restarting the capital markets, banks simply do not have enough capacity to turn around the economy. Simply put, for the economy to turn around, the capital markets need to restart first.
Prior to the credit crisis, the amount of new credit provided by the capital markets to consumers, businesses and municipalities was estimated to be three to four times the amount of new credit provided by banks. However, since the credit crisis began, the capital markets haven’t worked and the economy has been strangling.
The below table contains the amount of new bond issuance for selected types of capital markets financing in the first quarter of 2007 (before the crisis) and the third quarter of 2008 (in the middle of the crisis) (all amounts in billions of USD). The below data shows that the capital markets issuance shrunk by a large amount and, unless we want the economy to shrink by a similar amount, capital markets lending needs to get moving again. But, the below table doesn’t show how bad things really got because it doesn’t include Q4 2008 data. After Lehman Brothers collapsed, things got a lot worse in the last 3 months of 2008.
Municipal | Mortgage Related | Corporate Debt | Federal Agency Securities | Asset-Backed | Total | |
| 1st quarter 2007 | 107.6 | 540.4 | 305.6 | 265.4 | 323.2 | 1542.2 |
| 3th quarter 2008 | 89.6 | 286.6 | 82.6 | 198.8 | 23.5 | 681.1 |
| percentage difference | 16.73% | 46.97% | 72.97% | 25.09% | 92.73% | 55.84% |
Source: Securities Industry and Financial Markets Association
According to the FDIC, the total growth of all forms of lending (loans and leases) by all banks during 2006 was only a little more than $500 billion. And 2006 was a banking “bubble” year when unsafe and unsound credit was extended. Even if banks suddenly start increasing credit at a peak pre-crisis bubble rate, it won’t compensate for the loss of capital markets credit formation. But banks are strapped for capital and won’t be able to push 2006 amounts of credit out the door for many years.
The stakes are high for the U.S. economy. Losses in the automobile, motorcycle, RV and pleasure boat industries are all in part related to the lack of consumer financing caused by the drop in asset-backed securitization. Other industries that are hard hit include education (the capital markets were a material source of financing for students loans), commercial real estate (prices are starting a downward spiral because of a lack of financing) and import/export manufacturing (a high proportion of trade receivables were “securitized” and sold into the capital markets).
The history of how the capital markets developed and how they crashed provides clues for how to restart. The first companies to crash were the formerly AAA rated monoline bond insurers (followed quickly by government sponsored entities such as Freddie Mac and Fannie Mae). These companies started their lives with a much more modest mission; to enhance market efficiency by providing insurance on low risk transactions. The categories of transactions included municipal bonds and tax exempt financings, residential mortgages, consumer loans (such as credit cards and auto loans) and simple business assets (such as trade receivables and certain types of commercial real estate).
The bond insurers and government sponsored entities combined the functions of rating agencies, underwriters and ongoing credit administrators but with the twist of putting “their money where their mouth was” with a AAA rated insurance wrap that guaranteed full and timely payment. Investors were able to “outsource” most of their credit work to the bond insurers and were still able to be prudent because the insurers had their capital on the line. Market efficiency was dramatically enhanced because the credit and administrative costs of investing were low. Instead of each investor having to do their own fundamental research and monitoring, which is very expensive, they were able to rely upon a single bond insurer to do it for them. With the efficiency of many being able to rely upon the work of one, the capital markets developed. For more than 30 years this system worked in a safe and sound manner. There were other government sponsored and private bond insurers that existed and for many years did a great job executing their mission including SallieMae, FarmerMac and a range of private mortgage insurers.
The insurers and government sponsored entities lost their way over the last 10 years and blew themselves up when they tried to expand their mission far beyond its original scope. The government sponsored entities exponentially expanded their balance sheets and leverage when they transitioned from being “insurers” to “investors” and the insurers stretched their core businesses into esoteric and dumb transactions. Some government sponsored entities gave up their special status and mortgage insurers totally changed their business model. Everyone was looking for the quick buck and thought that the “grass was greener” in things other than their core business. However, despite the industry failures, a safe and sound restart of these companies is the essential first step to restarting the capital markets.
The private market doesn’t have the will power or capital to restart the bond insurance industry. The Obama Administration needs to step in and immediately license and capitalize government owned bond insurance companies to cover the major asset classes that are dependent on the capital markets for liquidity. These new companies need to be properly capitalized (to beyond minimum AAA levels) as well as have an explicit government guaranty so that their insurance is of unquestionable quality. The goal of these companies should be to be privatized within 7 years and the companies should only be allowed to provide bond insurance on loans and portfolios of loans that were originated after January, 2009 (that way banks don’t use the program to dump old assets).
The Obama administration should form and license two municipal bond insurance companies, two companies that insure asset-backed financings made up of consumer loans, two companies that insure asset-backed financings made up of commercial loans and trade credit, two companies that insure commercial real estate related transactions and two companies that insure residential and multi-family real estate transactions (i.e., competition for Freddie Mac and Fannie Mae).
So, let’s hope that this week what goes on in Las Vegas doesn’t stay in Las Vegas. It is the remnants of the structured finance industry that has the human capital to staff new companies and get financing moving again. With leadership from the Obama Administration (and lots of tight regulation) they can get the job done.
