John Dizard, in “Prepare for return of a direct lending world,” argues that central bankers believe that securitization is not coming back in any meaningful way in the foreseeable future, and banks will therefore have to roll up their sleeves and do old-fashioned lending in much greater volumes than before.
That may seem like a very bland statement, but it is tantamount to saying that a comet has wiped out most of the mammals and the dinosaurs will rise again.
The dinosaurs may indeed have been written off prematurely, but a reversal of the financial services industry pattern of the last 30 years away from balance sheets towards market intermediation will have profound implications. Due to space limitations, Dizard only alludes to them; I’ll tease them out.
The first is a shrinkage and radical reformation of Wall Street. The industry’s revenue model has shifted from a mix that varied from firm to firm of investment banking (underwriting and M&A), equities, fixed income, and asset management, toward one heavily skewed towards fixed income, with some leavening from prime brokerage (the big profit item here is lending to hedge funds) and asset management at certain firms.
Cyclically, employment on Wall Street peak to trough usually falls about 20%. But a lasting repudiation of the securitization model could lead to even deeper, permanent cuts, although the investment banks may be in denial over its change in fortune. For example, investment trusts, the speculative vehicles that led to the stock market bubble that culminated in the 1929 Crash led to a distaste for pooled vehicles of all kinds, even though some of the trust had been honestly and conservatively managed. It wasn’t until the 1950s that memories had faded enough for mutual funds to become a growth industry. It might take that long for bad memories of the damage inflicted by securitization to fade.
Banks have been losing market share in financial intermediation to investment banks since 1980. If banks have to keep more assets on their balance sheets due to a lasting reduction in securitization, it will require a massive increase in bank equity. And where will that come from? The Anglo-Saxon nations that have historically dominated finance have been profligate borrowers and have had low savings rates for many years. The only places that can fill the void are the high-savings nations: China, Japan, the Gulf States, Taiwan. There has already been tooth-gnashing and worries about foreign influence due the investments made by sovereign wealth funds in faltering investment banks.
If the central bankers’ forecast is accurate, the shift in financial gravity will be more rapid and complete than observers and industry members anticipate. Even if London and New York nominally remain leading financial centers, the natives will no longer call the shots.
From the Financial Times:
At the beginning of the year I floated a deliberately heretical thought: that it would be impossible to recapitalise adequately the US banking system with new investments of actual cash. Instead, I suggested, it would be necessary to return to a discarded 1980s concept. Not padded shoulders for power suits, though that might help as well, but “supervisory goodwill”. That was an accounting tool used by US regulators to allow weak and reorganising depository institutions to meet their capital requirements by using a sort of pretend equity. By the end of the decade, supervisory goodwill, at least under that name, was prohibited by an act of Congress.
I was hoping for a blast of angry mail from readers, particularly those at regulatory agencies and central banks. It never appeared, since it turned out that there was a lot of re-thinking about bank capital adequacy being done by the official and semi-official world. Heresy and irresponsible suggestions were, at least for a moment, allowed.
In the space of just three weeks, though, forced writedowns of asset values, surprising disclosures and the consequent market reactions are forcing a new consensus within the central banking world. There isn’t a lot of time to play with what-if’s. The “ifs” happened.
Wall Street and the City have been waiting for a series of magical events that will allow the securitisation machine to re-start. Recapitalising the monoline insurers, one-time injections of new equity for banks from sovereign wealth funds, a revival of stock market confidence; all those were, collectively, supposed to revive off-balance-sheet lending.
That’s not what the central banking world is thinking. The official world, and those close to it, are anticipating that we’re going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.
The problem with putting credit on bank balance sheets is that those balance sheets aren’t big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders’ equity and reserves aren’t there, at least in the necessary size.
Very true, the central bankers will say. So we’ll just have to get some new shareholders. The “real money investors” are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: “A banker is a soldier in the service of the state.” So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.
New money will come in to recapitalise US banks, and perhaps eventually the European banks, but it will demand seniority to existing shareholders. And it will get it. The central banks do care about the capital adequacy of the institutions they oversee and to whom they grant cheap funding. But if mistakes were made under an old regime, then the people who bet their money on that regime are just out of luck.
It won’t be enough, of course, to simply assign existing bank shareholders to the role of cannon fodder. The new shareholders have to be given some assurance that there will be sufficient operating cash flow to take care of them, and to finance any further write-offs for, say, losses on leveraged buy-outs or credit cards.
What follows, I believe, will be steep yield curves for some time. Net interest margin, not deal fees, is in the end what the banking business is all about. The central bankers are less comfortable talking about this implication, but it would seem inescapable. The steepness of the yield curve has to come more from low rates at the short end than high rates at the long end, or those McMansions will be underwater for a lot longer than the political system can bear.
During the transition to a new set of shareholders, who will profit from the on-balance-sheet world, the central banks will probably be willing to have case-by-case exceptions to the rules on capital adequacy. They are opposed to black-letter, across the board, permanent changes in capital adequacy rules. Write-offs can be stretched out a bit, or ratios allowed to run a bit thin, but there is not the intent to adopt the let’s-pretend style adopted by the Japanese banking system in the early 1990s.
As for the rating agencies . . . there will be a quiet demotion, rather than a purge. Central bankers believe the agencies will not have the same significance in an on-balance-sheet world. During securitisation’s heyday, they enabled the other participants in the obscuring of risks. Structured finance isn’t over, but the lack of transparency effectively allowed by the abuse of the ratings system has been noted. We’re not going back to the pre-structured finance world, but it will be much simpler, and subject to much better disclosure.