Can We Have Economic Recovery Without Securitization?

Today, Fed Chairman Ben Bernanke said in Congressional testimony that the recession could end some time in 2009 if the financial system were stabilized. Although Bernanke cautioned that a full recovery could take two or three years, this statement helped to spark a stock market rally, with the Dow Jones Industrial Average rising 236 points, or 3.32%.

This is nice to know, but there's a rather big "if" in the statement. Chairman Bernanke prefaced his prediction of recovery on stabilization of the financial system. By now, we all understand that the financial system won't be easily stabilized. The front end of the problem involves trillions of dollars of bad debt from the real estate mess and American economic downturn, along with a growing crisis in Europe and Asia--Russia and the nations on its perimeter are, in particular, becoming increasingly problematic. Just stabilizing the formal banking system (i.e., those institutions legally chartered as banks) by removing toxic assets and recapitalizing will take trillions from the government.

Then there's the back end of the problem of stabilizing the financial system: securitization. In the last 30 years, a shadow banking system evolved through the securitization market. A wide variety of loans, ranging from mortgages to consumer loans to corporate debt. were bundled into investment vehicles that were financed by investors who, for the most part, took the risk of loss on the bundled loans. This was a wonderful financial innovation for banks, since they could earn fees making, selling and administering loans, while not bearing the risk of losses from those loans. Securitization seemingly came to be viewed by bankers as one good thing there couldn't be too much of.

Well, just as there is no such thing as a free lunch, there's no good thing that you can't have too much of. Since securitization appeared to generate vast earnings for banks with minimal risks, they securitized early, often, over lunch breaks, after office hours, on weekends and even while in the shower. They defied contemporary social trends by setting aside multitasking in order to concentrate on securitizing. Generating the profits that would allow CEOs and other executives to earn tens of millions in bonuses required that the banks make more and more loans. There are, however, only a finite number of borrowers with good credit ratings. After that, in order to get more loans to securitize, you have to make loans to increasingly poor credit risks. Thinking that they could continue foisting the risk of loss onto investors, bankers kept the profit making party going by exercising increasingly poor credit judgment.

Today, we know how the story ended: today's economic mess. A rather under-publicized aspect of today's mess is that the securitization market is dead. Good riddance, one might say. It was a monster that Wall Street created but couldn't control. But the cash used to make trillions of dollars of loans came from the securitization process. Without it, banks have to use their capital and deposit base to make loans, and they are now stuck holding the loans they make. From one perspective, this is a good thing. If banks have to eat what they kill, they will be careful about what they aim at. However, today's bankers aren't like the bankers of yore. There's nary a J.P. Morgan among them. They don't really want to be responsible for the loans they make. We can analyze this as a Baby Boomer, Gen X, Gen Y, Millenial, all of the foregoing, or whatever problem. It remains a problem and, as a result, banks have cut back on lending.

The conventional discussion about fixing securitization revolves around requiring the banks that make the loans to "keep some skin in the game" by retaining some of the risk of loss on the loans they sell. This is the way securitization is sometimes down in Europe. But such a concept assumes two things: (a) banks are willing to retain risk; and (b) investors remain willing to invest in securitized assets. Both assumptions are questionable. Retaining risk takes away much of the advantage to banks of securitizing. Sure, the banks get to spread some of the risks around. But increased loan loss reserves, expanded risk management systems and other drags on earnings will get in the way of $50 million executive bonuses. Moreover, investors now profoundly mistrust the banks that underwrote the securitizations. Lawyers could draft elegant Indentures of Trust for securitization transactions that would make abundantly clear that underwriting banks bear some risk of loan losses. Yet, investors wouldn't fork over their money. A cat that walks on a hot stove top doesn't care who's legally liable for its veterinary care. It simply won't walk on that stove top again.

Thus, to get the banks lending again, they and the government need to deal with the loss of the securitization market. More precisely, the securitization market was the very large, unregulated segment of the banking system that collapsed last year. This loss must be replaced somehow, and eliminating toxic assets, recapitalizing banks, and tweaking the securitization concept probably won't take us the whole distance.

At the moment, the federal government has substituted itself for the securitization market. Mortgage loans are still being securitized by Fannie Mae, Freddie Mac and Ginnie Mae. All of these investments are guaranteed by the U.S. government, so investors will buy them. The Federal Reserve is buying or will buy bundles of consumer loans and corporate loans, in order to free up bank capital for more loans. In essence, the Fed is providing the funds for more consumer and corporate loans. The Fed guaranteed money market funds and bailed out auction rate securities (a money market fund equivalent). If you deposit your cash the right way into a bank, you can have unlimited federal deposit insurance, at least until the end of 2009 (hint: amounts over $250,000 should be placed in a non-interest bearing acccount). Our financial system has been de facto nationalized, although no senior federal civil servant will admit to it.

But we can't have financial markets that are all government, all the time. No one wants that, not the President, nor Congress, nor Democrats, nor Republicans. The federal government has only blunt instruments to combat the economic crisis. The Fed, in a variety of different and innovative ways, has flooded the banking system with printed money, which has kept the hounds at bay but with serious potential for inflation. The Obama administration has secured the passage of a $787 billion stimulus package, an impressive accomplishment for a rookie President, but it doesn't replace the loan funding formerly provided by the securitization market.

As we know from the mortgage crisis and credit crunch, a lot of the financial system's problems involve the fine details of the plumbing system. Just as the substance pipes are made of (copper, not polybutylene), and the washers and gaskets used, can be important to a home's plumbing, the structures of mortgage backed securities, CDOs, special purpose entities, credit default swaps and myriad other financial esoterica can make a great deal of the difference in the viability of the financial system. The federal government can't solve this problem. Federal civil servants can be far more creative and effective than popular culture would hold. But they can't develop new funding mechanisms for Wall Street, not if Wall Street wants to be privately owned. This is one for the private sector. Wall Street is fortunate to exist in a nation that believes in free enterprise and which will provide the funding to recapitalize banks after they have effectively collapsed through many faults of their own. If the major banks do not want to remain wards of the state, they must develop new funding mechanisms. Most likely, this will require sharing with investors some of the profits from securitization banks used to keep for themselves. That wouldn't be a bad thing. Investor confidence isn't going to come back by itself, or because the President tonight made one of his typically eloquent speeches. It's going to come back when investors get a better deal.