Why Securitization Is Necessary

Why Is Securitization Necessary?

The world has been without a functioning securitization market since the summer of 2007. During this period, world industrial production has closely tracked the decline of the 1930s fall. This according to recent research by Barry Eichengreen of UC Berkeley and Kevin O'Rourke of Trinity College, Dublin. This web link can be used to view the updates of their April 2009 work.

According to the authors, declines in industrial output for Germany and Britain parallel their 1930s declines while those of France and Italy are worse. The U.S. and Canada "continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around."

The question that needs to be asked is whether the freezing of the securitization market is a principal cause of this decline in industrial output and whether restarting securitization should be a primary focus of policy makers and regulators, albeit in a safer, more transparent mode than previously. Gillian Tett, perhaps the finest financial journalist across the pond, has given a resounding explanation as to why securitization matters. While discussing her recent book, Fool's Gold, at the London School of Economics, Tett likened the bucolic notion of returning to bank lending to "falling back on snail mail if we woke up one day to find the Internet and cell phones had broken down."

In essence, securitization isn't absolutely necessary. We can instead accept a substantial decline in global GDP or attempt to ward it off with trillions of dollars of government guarantees and taxpayer funds, thereby burdening our progeny as our legacy.

While that may appear at first read as an overstatement, make no mistake about it. The modern economy functions on credit and securitization provided more than 1/2 of the credit needs of the United States. The Federal Reserve and Treasury have attempted to step into the breach to keep markets functioning on government life support, but whether they have the ability to continue this process without securitization is truly an open question.

In a December 12, 2008 report, "Does the World Need Securitization," the authors maintained:

The G-7 leaders in their five-point action plan from early October 5, as well as other governments and regulators, clearly recognized it is not possible to remove the securitization financing from about $8 trillion in global assets. Securitized products have helped finance between 30–75% of lending in various markets and a total amount of $16 trillion. In the credit card sector, most banks securitized roughly 50–60% of their managed assets. But in some sectors securitization is key as roughly 91% of auto industry sales are financed via auto ABS. About 30% of US consumers own their home free and clear, but the remainder have a mortgage. The unavailability of credit has a significant impact on the economy, and the reinstatement of these products as financing options may be vital for business and consumers.

Gillian Tett analyzed this report in an April 2009 article for the Financial Times in which she maintained that bank lending was not imploding. That conclusion left her to state the following:

What is imploding though is the securitisation world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds were sold in markets, and this year market issuance is minimal.

Indeed, the only group really acquiring repackaged debt now are western central banks, which have taken huge volumes of securities on to their own books (and away from the market), as part of their liquidity-injection measures.

At that point in April 2009, what were governments doing? Tett continued:

On both sides of the Atlantic, industry leaders are also drawing up plans to make the securitisation process much more transparent, and thus, hopefully, more credible to future investors. Another idea is to impose a so-called "5 per cent rule". This would force banks that issue securities to retain at least 5 per cent of them on their own books, to ensure they have a vested interest in monitoring the creditworthiness of end borrowers.

On paper many of those ideas look sensible. And if they are all implemented, they might eventually enable the securitisation market to return to life, albeit on a more sober scale. But "eventually" is the key word here: right now, most parts of the securitisation market are all but dead. The longer that politicians wail about the supposed "failure of banks to lend", while ignoring the bigger source of the credit crunch, the harder it will be to wean the system away from government support.

As we know, the EU acted first by passing the amendments to the Capital Requirements Directive imposing the 5% "skin in the game" requirement and fashioning a transparency provision that looked to loan-level detail as the means to bring in future investors (who they knew were on strike over the issue of transparency).

In yesterday's Financial Times, an article on the growing problem with commercial real estate financing bears close reading. The frozen securitization market is front and center of a $3,400bn financing issue -- the frozen CMBS market.

It's nice to believe that we can grow our way to recovery with prudent bank lending, massive government interventions and taxpayer life support, but that's delusional at best. When Tett states that the longer politicians ignore the securitization issue in the credit crunch, the harder it will be to wean the financial system from government support, she echoes the thoughts of some very influential people, including Paul Volcker. See this link and the preface to the organization's January 2009 release, "Financial Reform: A Framework for Financial Stability". This entry on December 23rd of last year reflects my thinking on the matter.

If Eichengreen and O'Rourke are correct in their analysis and Tett is correct in her reporting, the eerie similarities we are seeing may well be related to the credit contraction caused by the freezing of the securitization market. For now, they appear to have the upper hand.

Comments

[CautiousInv...:]

Some securitization has accounted for up to 70% of the credit made avaialble over the past fifteen years.

The reason securitization became so widespread is that it is cheaper than on-balance-sheet bank lending. Traditional lending requires banks to recoup their cost of equity and FDIC insurance premiums; for assets that can be packaged, securitization is more attractive.

From a policy perspective, securitization broadens (1) access to credit (2) relieves banks from having to continually raise equity to support expanded lending and (3) keeps already too big to fail banks from becoming yet larger.

The present debate is how to prevent banks from selling dross and the Geithner proposals call for issuers to have skin in the game by retaining 5% of what is issued and eliminating the gain on sale accounting treatment. The first is geared towards addressing quality while the latter is designed to reinforce the notion that sale of securities should be viewed and manged as a long term business.

There is no silver bullet and the correct policy response will be that which best balances the cost of securitizing with insuring that banks do not sell junk. Since costs to banks will increase, and there is no free lunch, it is unlikley securitization will approach previous levels.

Jun 24 09:29 AM

[Gregman2:]

"The question that needs to be asked is whether the freezing of the securitization market is a principal cause of this decline in industrial output..." The same point could be made about fractional reserve banking, which creates new money via lending (based on collateral asset valuations). If many of the large pensions are effectively broke, where's the capital to finance such securitizations?

Jun 24 12:47 PM

[Moon Kil Woong:]

Even if banks sell it without better risk analysis and transparency no one will buy it. Even if you get a re-insurer to stamp a AAA on it like before with some shady derivative counter party risk still rears its ugly head. With financial companies holding more garbage than they can deal with, we must really ask ourselfves, is more really better? Especially since it usually comes with growth of derivatives which has already become a $500 trillion dollar monstrosity.

Can't we say, enough is enough. Do we really need to start playing with numbers in the quadrillions when it comes to derivatives? Isn't trillions enough?

Jun 24 11:08 PM