Straight Talk from Geithner on Securitization

Sunday morning (March 29) Treasury Secretary Geithner appeared on Meet the Press to explain his plan for rescue of the financial system. He described a series of actions to not only fix the banks, but to get the securitization markets working as well. For perhaps the first time we heard a (relatively) clear rationale explaining how the Treasury expects the toxic asset rescue plan to lead to the restoration of credit for consumers and entrepreneurial business.

The interview started with an explanation of the difference between bank lending and securitization. Per Geithner, “Typically somewhat less than half of lending for business and consumers comes from the securitization markets.” As I have written previously the current financial crisis was created by an explosion of debt to unsustainable levels in great part through the mechanisms of the shadow banking system, which includes the securitization markets. This created a massive amount of liquidity, much of which was not captured in traditional measures of the Money Supply. The collapse of these mechanisms beginning in August 2007 created the credit crunch. Sec. Geithner believes that, until these non-bank markets are restored, the financial system can’t be fixed.

There’s been much loose talk in the media claiming that lending to small business entrepreneurs can’t be restored until the toxic assets come off the balance sheets of the banks. Here is what Geithner said on the subject of the toxic asset bailout:

This is a better way to get these markets working again. Let me just step back for one second. What we’re trying to do is get the entire financial system – our complicated financial system - working again so that we get credit where it needs to go in the economy. And that requires strengthening our banking system. It requires making sure there is enough capital in the financial system to withstand a wider and deeper recession. And we’re going to make sure that capital comes with conditions to make sure that banks restructure; that there’s accountability for boards and management; that the firms emerge stronger, not weaker; and that there are tough conditions to protect the taxpayer. That is a critical part of what we’re going to do. But our system is much more complex, depends on more than just banks. So we have to do things to get these markets working again by providing financing directly to those markets that small business, consumers depend on. (Emphasis added.)

So what does this really mean? The last sentence above clearly states that the toxic asset rescue will do nothing directly to encourage small business and consumer lending. That’s a job for TALF. The bottom line is this. The Treasury believes that a restoration of the securitization markets is critical to restore lending by non-bank lenders. Securitization is the province of a few big banks in New York. Two of these, Goldman Sachs (GS) and Morgan Stanley (MS), have said they don’t need further help from the government. So basically the task at hand is to save the other major players (primarily the four biggest banks) on which the securitization markets depend so that they can restart the merry-go-round.

Underlying all of this is a bit of sordid history. Securitization is essentially an agency function. Prior to the repeal of Glass-Steagall, securitization was conducted by investment banks, which were limited by their (relatively) small capital bases from taking on significant principal risk. They bought loans for short holding periods during which the bankers and lawyers packaged the loans and quickly sold them off to investors. If they got caught short and couldn’t unload the paper, they were soon out of business or merged into a larger player.

By the late 1990’s Wall Street had found these limitations to be too constraining. As the instruments became more and more complex, it became more and more difficult to market the riskiest portions of the loan packages (the “toxic waste”). If the toxic waste couldn’t be sold, there would be no deal. No deal meant no commissions. And no commissions meant no bonuses. The repeal of Glass-Steagall enabled an ingenious solution. Where the investment banks had no choice but to unload the toxic waste because there was no place to hide on their balance sheets, the major money center banks had much larger and deeper balance sheets and complex corporate structures with multiple regulators. Aided and abetted by the invention of credit default swaps, which enabled the pooling of toxic waste into “investment grade” securities which could be sold to third parties or into off balance sheet conduits created and managed by the banks, the major players in these markets dramatically ramped up the securitization engine between 2003 and 2007, fostering the housing bubble.

While much of this activity was not conducted directly by the banks, the bulk of it was ultimately for the account of bank lenders, which in effect supported proxy institutions in the securitization market through lines of credit and asset purchases. This appears, for example, to have been the case with Bank of America’s (BAC) support for Countrywide mortgage. When the music stopped, the biggest non-bank participants were quickly rolled up into the major banks (Countrywide and Merrill into Bank of America and Bear Stearns into J. P. Morgan (JPM)).

The toxic assets the Treasury is now proposing to deal with through its bailout plan are the detritus of the securitization collapse that these banks could not unload on third party investors when the music stopped in the fall of 2008. This was confirmed by Lloyd Blankfein of Goldman Sachs following last week’s meeting between the big bank heads and Pres. Obama, when he was asked whether Goldman would be selling assets into the new program. His response was that with its business model Goldman didn’t have much exposure to that type of consumer assets and what it did have had already been marked to market, i.e. Goldman (and likely Morgan Stanley as well) stuck to its knitting as investment bankers, quickly moving the paper it had created off its balance sheets and did not retain the types of principal risk taken on by the big banks.

More than half of U. S. banking assets are held by four banks that are also major players in the securitization markets: Bank of America, Citigroup (C), J. P. Morgan, and Wells Fargo (WFC). Almost certainly a far larger percentage of the securities and loans that will be purchased from U. S. based banks under the toxic asset plan will be from the balance sheets of these four institutions. If you believe that these new multibillion dollar conduits created by Treasury are going to be purchasing bad subdivision loans to clean up the balance sheet of Podunk Thrift Bank for Savings to enable it to make loans to local businesses, then I’ve got a bridge in Brooklyn I need to sell you.

So why, you might ask, should we be willing to put the U. S. Treasury on the line for $1 to $2 Trillion to bail out these banking behemoths? Sec. Geithner’s answer today is that we must save the banks to restart the securitization engine. What he doesn’t say, but which is likely far closer to the truth, is that the government is deathly afraid not to. An outsized percentage of outstanding corporate debt was issued by the major bank holding companies. When the government allowed a comparatively smaller player (Lehman Brothers) to fail, the world’s financial markets ground to a halt. Geithner’s unspoken answer: we’ve got to bail out the bondholders of the big banks because their failure will crater the system. Since it’s politically impossible to do so directly, we’ll do so by allowing these banks to unload their underwater assets on the Treasury. We’ll dress it up by getting a few friendly institutions (many of which will likely be big holders of corporate debt) to take a small slice of the risk so we can put the pricing decision on them rather than the Treasury. Once the big banks are cleaned up, they can again raise money in the capital markets and we can depend on them to again create a vibrant private securitization market so that the merry-go-round can again turn.

All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks. There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks. To not do so could irreparably damage the U. S. standing in the world capital markets. I do object to selling this plan as being necessary to “get the banks lending again” or to provide liquidity to entrepreneurs. That’s not what this plan is about.

The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society. Inherent in the Geithner plan are a number of assumptions, which are presented as givens not open for discussion. At a minimum the following questions need airing and extensive public debate:

1. Is a banking system in which more than 50% of the assets are controlled by four institutions good for the economy, the political system or the social fabric of America?
2. Should the taxpayers ever be called on to preserve the equity value of the shareholders of insolvent private entities?
3. Should the Treasury be committed permanently to an implied guaranty of the debt (as opposed to consumer deposits) of “systemic” financial institutions and, if so, is there a regulatory structure that can be created that is adequate to protect the Treasury from the need to conduct similar bailouts in the future?
4. Is a system in which 50% of credit is created through securitization healthy for the long run stability of the economy? Do we have regulatory and monetary tools in place that can deal with the impact on the larger economy of the market swings inherent in such financing?
5. Is our focus on the big banks preventing the allocation of capital to those institutions (community and regional banks) that have traditionally provided most of the financing for entrepreneurial businesses?

Let’s do what it takes to save the economy, but not at the cost of an open democracy. It’s time to demand a debate over the real issues at stake, rather than blindly accepting the PR smokescreens of those with trillion dollar vested interests in the outcome.

Comments

[Moon Kil Woong:]

Great article. I think Krugman and other also put it into perspective. Even if the bad part of the securitization market were to be cleaned out it will not result in a securitization market that can replace the old one. Simply put, no financial institution will be fool enough to be the butt of this joke twice.

So say good bye to huge gearing until some other scandal, oops I mean financial instrument, can replace the CDS and other interesting derivatives that plague the market today.

The Geithner solution will help the banks but won't restart the securitization market. So what will come next? The government will be the next brokerage?

Mar 30 06:15 AM

[atlasman:]

"The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society. "

There is no way you can hold an honest debate over something like this when probably less than 1% of the public and media really understands it. AIG bonues is about as close as you can come to a financial debate in this country.

Beyond that cynical observation your questions and points are good. I am honestly of mixed views about all of your questions with the exception of #5. Most banks are getting the capitol they need through deposits and are starting to make a great profit due to the upward sloping yield curve. If you have good credit with a history, you can get a car/home/ or small business loan today. As long as the government does not screw this up they will be just fine.

Mar 30 06:29 AM

[user344210:]

"All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks. There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks. To not do so could irreparably damage the U. S. standing in the world capital markets."

The only alternative would probably, as you say, do irreparable damage, so it does seem to boil down to short-term pain for long-term gain. Well, not "gain" so much as "avoidance of even more pain".

As far as "having a debate" goes, someone mentioned that very few people understand the issues. I would estimate that of the people who do (which is probably 10% of the total population), 75% or more are in favor of the plan because they'd benefit from it in some way. The other 25% of people who understand it and oppose it are such a small minority that there's no way to be effective. Given the distribution of tax payments in this country, essentially, the plan is to put wealthy taxpayers who made their money in industries other than banking on the hook for wealthy bankers.

Mar 30 08:23 AM

[yank:]

Let me help you answer Questions 1-5:
!. NO
2. NO
3. NO
4. NO
5. Hell NO.

It is obvious to me that "securitization" is a flawed business model. Since the banks are incapable of regulating themselves they should not be allowed to securitize everything under the sun. Abolishing Glass-Stegall was quite possibly the worst decision EVER made by a sitting Congress. And that is really saying something since they have a less than stellar track record.

Mar 30 09:06 AM

[traden4alpha:]

Securitization is broken on two very deep and fundamental levels that are not well addressed by any existing plans.

1. Securitization suffers from severe moral hazard that Greenspan now admits was latent in the system. The creators (and raters) of securitized debt have great incentive to positively bias the cited quality of the debt either through nefarious fraud or through natural optimism.

2. The mathematics for pricing securitized debt was proven to be invalid due to endogenous changes in the level of default correlation. That is, the math ad no way of handling the change form "good times" to "bad times" Using rear-view mirror numbers and math lead to severe miss-pricing of the debt.

Even if investors regain their risk appetites, they are less likely to take on securitized debt due to the opaque nature of these moral hazard and mathematical risks.

Mar 30 12:43 PM

[Mad Hedge F...:]

so why not just ditch CDO's? There is an easier, cheaper, and faster way to solve the banking crisis which no one is talking about on Capitol Hill. If collateralized debt obligations (CDO’s) are the problem, just get rid of them! Desecuritize them! Just convert them back into the underlying loans. There are $1.4 trillion in CDO’s outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations of perhaps 3.7 million loans. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50%-80% discounts. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks’ balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments or in default can be discounted to maybe 70% because they are still secured by the value of the homes. This would boost the value of the entire asset class from the current 20-50 cents up to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. Of course it would be a massive admin job unwinding the rats’ nests behind some of these securities, but Heaven knows there is abundant subprime and Alt-A expertise available for hire these days. Just sift through the ashes of Lehman Brothers and Bear Stearns. It is a workable plan, and therefore is unlikely to ever see the light of day.

Mar 30 12:53 PM

[henarl:]

Another commenters phrase "nefarious fraud" very accurately describes the past and present operations of the entire financial industry including the Fed and the Treasury. It seems that avoidance of any short term pain for them while accepting the possibility of long term disaster for the general public is their game plan.

Mar 30 02:05 PM

[mindshar:]

The article raises some very good questions. Here's my take on quesitons 1-5:

1. I think 4 is fine. Plus small banks are not going to entirely disappear, with different banks having facing different risks based on their assets, liabilities and leverage. In fact, if government controls start become to onerous on the big banks it may create growth opportunities for the smaller banks.

2. I would separate debt obligations from common shareholders. Bailing out creditors is much more favorable than bailing out shareholders since there's not the same moral hazard issue -- so long as the government is compensated adequately by common shareholders in the form of dilution. (I don't think this was the case with the original TARP)

3. (a) In theory no, but in practice I think it has to in cases in which the entire U.S. financial system is in peril. One could argue that granting the government authority to make this differentiation has inherent risk, however I think this risk is outweighed by the risk of not allowing the government to step in extreme cases, as I believe we have seen empirically in the last year.

(b) I think it can, with reasonable regulations involving risk management, and doing what we can to minimize the moral hazard of the current solution (ie adequate dilution). It will not be easy, and the Devil, as they say, will be in the details.

4. I don't think that securitization itself is to blame per se, and I don't find the 50% number unreasonable. As traden4alpha pointed out above, it was the method in which mathematics were used to disguise and pass along risk which caused the problem, and so long as regulators can make sure that that does not continue to occur we should be OK. In theory, securitization could be a good thing, as it provides more liquidity and pricing efficiency for debt, but we have to make sure that risk is properly identified and priced.

5. At first blush this sounds correct, but if after thinking about I do think that stabilization of the largest banks has an indirect stabilizing influence on smaller banks. The biggest risk small banks face is huge chunks of their leveraged loan portfolio defaulting while depositors race to withdraw their money causing them to go insolvent, which I think would be very possible if big banks started failing. Making sure that such a collapse doesn't happen helps to prevent more widespread failures of small banks.

Does that mean that small banks are going to start making SBA loans right away? No. But maybe the best we can do is to keep them in business while they shore up their balance sheets on their own. Banks (and many consumers as well) *need* to de-leverage to reduce risk, and I'm not sure there's a way to accelerate the process except to keep the economy moving as best we can while banks and consumers alike start to reduce their liabilities.

Now is there a way that we could try to stimulate the smaller banks? Possibly. But my feeling is that in order for TALF to work to (1) make sure that the funds are used appropriately, and (2) to make sure that the right balance is struck in the terms of the deal, including regarding equity participation, each deal will need to be custom, which will not be possible with the thousands of small banks across the nation. This is a triage situation, and the government is (correctly in my opinion) tackling the most important and critical problems first. And I wouldn't be surprised to see a follow-on program for smaller banks in the future.

Mar 30 03:48 PM

[mark ferraris:]

Two comments:

- I don't know what statistics the Secretary was looking at but the combined activity of the securitiazation markets (which includes the activity of the mortgage agencies) has for more than 15 years outstripped the balance sheets of the banks. It is not less than half.

- Every single fix that was introduced prior to the recent "toxic asset plan" was window dressing. The new plan is the main course and probably should have been introduced first. Many folks just get it wrong in terms of how the securitization markets work. The first phase of the process is the underwriting of the underlying assets. That's what the banks do best (although not so well recently). What securitization does is allow these banks to clear their balance sheets of yesterday's loans or originations by selling them off to what some call the "second market" through securitzations. The investors in this second market are nearly exclusively sophisticated institutions. Nevertheless, these investors need to be able to rely on the underwriting acumen of the banks that created the underlying assets. Over the past two plus years the complete erosion in the "confidence" that these investors have in the underwriting and structuring acumen of the banks is what has brought the securtization market to its knees and clogged up the balance sheets of even the most healthy banks. Programs like TALF will help to prime the pump but the toxic asset plan will have a far greater impact (by multiples of ten or more) on freeing up room on the balance sheets of the banks to create more assets (loans).

Mark Ferraris
Principal
Orchard Street Partners LLC

Mar 30 04:25 PM

[John Slater:]

My personal estimate is that about 70% of credit creation was occurring outside the regulated banking system at the peak. Of course much of this was structured by the banks to get the assets off their balance sheets, so this is a little misleading. We have not come close to replacing this credit creation capability, which helps explain the deflationary forces still at work in the economy. It will be interesting to see if the big banks can regain the confidence of the markets. It has happened before, but I am skeptical, at least in the short run. Way to many of the pieces of the machine are broken, starting with origination, underwriting, rating of the securities and distribution. I think its going to be a long slog back.


On Mar 30 04:25 PM mark ferraris wrote:

> Two comments:
>
> - I don't know what statistics the Secretary was looking at but the
> combined activity of the securitiazation markets (which includes
> the activity of the mortgage agencies) has for more than 15 years
> outstripped the balance sheets of the banks. It is not less than
> half.
>
> - Every single fix that was introduced prior to the recent "toxic
> asset plan" was window dressing. The new plan is the main course
> and probably should have been introduced first. Many folks just
> get it wrong in terms of how the securitization markets work. The
> first phase of the process is the underwriting of the underlying
> assets. That's what the banks do best (although not so well recently).
> What securitization does is allow these banks to clear their balance
> sheets of yesterday's loans or originations by selling them off to
> what some call the "second market" through securitzations. The investors
> in this second market are nearly exclusively sophisticated institutions.
> Nevertheless, these investors need to be able to rely on the underwriting
> acumen of the banks that created the underlying assets. Over the
> past two plus years the complete erosion in the "confidence" that
> these investors have in the underwriting and structuring acumen of
> the banks is what has brought the securtization market to its knees
> and clogged up the balance sheets of even the most healthy banks.
> Programs like TALF will help to prime the pump but the toxic asset
> plan will have a far greater impact (by multiples of ten or more)
> on freeing up room on the balance sheets of the banks to create more
> assets (loans).
>
> Mark Ferraris
> Principal
> Orchard Street Partners LLC

Mar 30 10:22 PM