Shadow Banking System: Death from Nowhere

Includes: ICF, IYF, IYR, KBE, XLF
by: Jeffrey Bernstein

This article was first published on Urban Digs on Feb. 28, 2009.

Credit is likely to be tight for several years and it probably doesn’t even matter. That’s a bold statement to be sure. But let’s explore the reasons behind the declining lending capacity in the U.S. market and consider the fall-out – as unpleasant as this may be,it’s probably a good planning exercise for us all.

A recent Wall Street Journal blog post entitled “Bankers to Congress: We are Lending, We Swear!” discusses the fact that banks really are lending at a pretty satisfactory level considering the economic circumstances. The blog quotes some lending figures that I have updated/modified. According to the FDIC, total loans & leases oustanding for all FDIC-insured banks was $7.875 billion for the fourth quarter of 2008, compared with $7.906 billion at the end of the fourth quarter of 2007. Indeed, as the article states, this does seem to validate Ken Lewis’ admonition to Congress “Make no mistake: We are still lending.”

The piece also quotes economic researcher James Bianco as saying, “Every other time we’ve been 12 months into a recession and this goes back to the early 1970s, we’ve had negative growth in loans, but now we’ve got barely positive.”

That does not mean that underwriting has not tightened up signficantly and that the amount of leverage people are able to use – as expressed by loan-to-value ratios (LTV), loan-to-cost ratios (LTC) or debt service coverage ratios, has not fallen. I can tell you from my own personal experience that they definitely have in commercial real estate (including the return of personal guarantees being the rule rather than the exception), and the move has been dramatic at the margin, because some lenders were giving credit for pro forma income levels (and property values based on these) previously and they are now looking strictly at current run rate results. Additionally, appraisals of collateral now include negative time adjustments, because comparative transaction values from several months ago are not indicative of the new lower values being "discovered" as the economy slows.

The real issue for the lending market now and for the indefinite future is the disappearance of the “shadow” banking system. Now the shadow banking system means different things to different people. Many people consider the $43 trillion of credit default swaps (at year-end 2007) according to the Bank for International Settlements) or total derivatives of $500 trillion as part of this market. This is partly because securitized loan portfolios were often hedged in the interest rate derivatives and credit default swap markets and synthetic securitization exposure created through side bet vehicles called ABS CDOs. Further, many securitized loans were held in levered bank sponsored SIVs, (which ultimately have gone back on bank balance sheets or could) creating a nasty cocktail of leverage and counter-party risk. While I recognize that if the credit default swaps and derivatives markets went tapioca all at once we would all be living in caves (the reason why AIG will have an unlimited credit line with Uncle Sam), I don't consider these markets to be central to future credit availability because this activity didn’t really fund any loans directly, although it allowed the lending market to grow significantly, in an unregulated fashion and pumped up the money supply without central bankers really knowing it. What I am referring to as the shadow banking system is just the securitization market broadly, not to diminish the grave importance of this smaller market.

One of the greatest drains on lending capacity in the economy to date has been the virtual shutdown of the securitization market. According to the American Securitization Forum's Winter/Spring 2009 issue, "U.S. financial institutions securitized just under half the credit they originated between 2005 and 2007." According to the Wall Street Journal blog article, Dealogic reports that asset-backed security issuance has declined 90% year to year to $2.6 billion from $32.1 billion.

Securitization began because of the need for additional debt capacity in the economy beyond traditional bank loans when banks' capacity to lend was impacted by the 1980s/1990s S&L crisis. It allowed for discrete credits, be they auto loans, commercial real estate loans, college loans or small business loans to be packaged together with other loans of like kind, thus diversifying borrower risk to buyers of these securities. By slicing the packages of securities into first loss, or higher loan-to-value pieces and pricing these tranches differently, securitizations also tailored risk and reward to different investor objectives. Adding an insurance wrapper to these securities was believed to further reduce risk. Trading of securitized products and the ability to hedge them and make levered bets on them through the use of CDSs (the bigger "shadow" system) transformed corners of this market into trading markets as opposed to long-term ownership and investment markets. Hedge funds became the audience of choice for new debt issues of this type. As a result of all the factors mentioned above, pricing (the risk premium over treasuries required by investors) of securitized loans narrowed significantly, versus the pricing for an individual loan that would have been made by a bank (I wish I had empirical data to back this up, but suffice it to say that few banks still make auto loans, credit card loans etc. and hold them on their books as price competition from the securitization markets squeezed them out).

The production pipeline of securitization led to a moral hazard. The underwriting function was seperated further from the origination function and the ultimate ownership of the risk. (I know a lot of this is review for our many savvy readers, but bear with me). Underwriting standards, which normally move in cycles due to competition, simply disintegrated in the most recent up cycle.

The sub-prime implosion and subsequent chain reaction margin call impacting the securitization insurers, CDS dealers, and originators initially shocked the securitization market and drained liquidity from it. The subsequent severe economic downturn laid naked the poor underwriting that took place and excessive use of leverage across several sectors.

Having lost faith in the quality of securitized product and being made acutely aware of the hazards of the securitized debt manufacturing process, investors are highly unlikely to return to buying new issues from this market quickly. The new $200 billion Term Asset-Backed Securities Loan Facility (TALF) may facilitate liquidity for banks and financial services firms in the securitization business and it may even help forestall a refinancing crisis of certain maturing securitized products, but in my opinion that is the best that can be expected. You see, even if the securitization market became liquid again tomorrow, the risk premiums on these securities would trend much closer to the pricing of the underlying loans of these types than they did in the past. This is because the benefits of diversification and insurance wrappers have been shown to be smaller than previously believed and the fundamental underwriting issues are now well known.

Don't expect traditional banks to be able to rush in and fill the voids either. In many cases banks no longer participate in the markets where securitization became dominant. In segments like auto loans, they simply left the business and much of their underwriting and local customer expertise was dissipated over the years. In some cases, like commercial real estate, banks still made loans despite heavy competition from securitization (CMBS), but they were conservative and became cherry pickers only competing where price was not the determining factor.

When you look at the 400 basis point plus spreads that portfolio lenders to the real estate market are now demanding from borrowers.... and getting, it becomes apparent that even a new revamped, regulated and re-populated securitization market, will be charging much higher risk premia for its product. This, while banks will continue to tighten up underwriting considering the runaway losses they are experiencing, which I highlighted in my piece Bad Loans: Going to Extremes. In fact, as shown above, banks have not yet begun to really cut back on lending. I believe that is still ahead of us (but that's the subject of another piece). According to the American Securitization Forum, "banks may fail to meet approximately $2 trillion of demand for credit origination globally over the next three years in the absence of well-functioning securitization markets."

Mort Zuckerman, Chairman of the Board of Boston Properties, Editor in Chief of U.S. News & World Report and, until recently when he got caught holding Madoff funds, considered no dummy, views the outlook for the shadow banking market this way: Business Week

"This shadow banking system of money-market funds, investment funds, private equity funds and hedge funds that has been largely unregulated - that is no longer going to be possible."

Now he was referring to the uber uber shadow banking system including all non-bank regulated financial players, but his point is well taken. Fraud, mis-representation, over-the-top risk taking and out and out thievery have ruined the party for everyone and resulted in the obliteration of trust in the origination market and much of the buying community (funds etc.) for securitized product.

The securitization egg cannot be unscrambled! Hedge funds were a significant source of liquidity in this market, as were SIVs and other off-balance sheet vehicles. Crippled investment banks were the aggregators of product which was sourced by brokers nationwide and underwritten by small outsourcing firms. These firms are all in various states of implosion and now they will begin to bear the costs of finally being regulated. In fact, the busted securitization system is choking on its own feedback loop. According to Richard Watson, managing director of the European Securitization Forum, "banks that used to buy triple-A MBS tranches at 50 basis points (bp) over LIBOR can't or won't buy them today at a spread of 200 bp or wider, even though the annualized rate of return would be 25% based on a capital requirement of 8% against the position. We need to recapitalize the banks to get carry investors back into securitizations that provide cash to the real economy."

Hold onto your hat though, because here's a real shocker. I am not even sure any of this matters. My partner continues to rib me that no one has ever seen me and Paul Krugman in the same room together, but along with lots of things I don't agree with, he recently gave us all a simple, yet wise, reminder when he wrote "Everyone talks about the problem of the banks, which are indeed in even worse shape than the rest of the system. But the banks aren't the only players with too much debt and too few assets; the same description applies to the private sector as a whole."

Savings%20Rate.jpg As you all know, and this graph hauntingly illustrates, the savings rate in the United States has collapsed and dis-saving is likely to pick up in the near term due to lower compensation and increased unemployment. It is, of course, not a surprise, then, that people are not in the mood to borrow or consume. The trend towards thrift that I pointed to a few months ago in my piece Trading Down: It's Cool to be Frugal is likely to accelerate as Americans work double time to increase their savings rate.

I know there is not a huge amount of new news in this piece, but it was meant to persuade rather than inform. By stringing together information we have all been hearing in a coherent fashion (hopefully), I wanted to lead you to a conclusion.

When a market or industry cycle ends, "Everything Works in Reverse." We are in a credit cycle and we have most definitely shifted out of neutral and into reverse.

A year ago, my firm Guild Partners, made the rounds to commercial real estate clients and prospects with a presentation on the coming de-leveraging cycle. I sincerely hope it helped a few folks to be better prepared for the environment that has ensued. I am currently updating the presentation to take into account all that has happened in since. If you or anyone you know would like to hear our new presentation please feel free to contact us. I am more confident than ever that we are in a de-levering cycle that for a host of reasons will run its course despite whatever small measures can be mustered by our government to ease it. Those who are prepared for it will survive and maybe even profit.