One of the dead bodies in plain sight that generally goes unremarked upon in polite company is the buyers’ strike in the securitization market. Issuance of private label (as in non-government guaranteed) residential mortgage backed securities has collapsed, with government entities insuring 96.5% of all home mortgages in the first quarter 2010. The commercial mortgage bond market is a shadow of its former self.
One could take the view that the moribund state of the private mortgage securitization market is a side effect of the government’s aggressive efforts to prop up the housing market. In other words, the terms private uninsured investors would require are sufficiently far away from what the authorities are willing to offer that they are not competitive.
Would that that were true, but the state of play is even worse. Starting in 2004, many traditional “real money” private mortgage investors began pulling back. In 2005, derivatives players started colonizing the residential mortgage market, with disastrous effects. Private RMBS were increasingly sold not to arm’s length investors, but to collateral managers of CDOs (who got funding from dealers), and to conduits.
The problem, fundamentally, is one the Fed recognized in 2008: banks needed to raise a tremendous amount of equity. From an April post:
John Dizard, in “Fed plan is spoilt by its backing of hypocrites,” returns to a notion he has brought up in some recent Financial Times articles, namely, that the amount of funds that banks need to rebuild their balance sheets is so large that it cannot be obtained without some form of government sponsorship. Note that that does not necessarily imply explicit payments or subsidies; it could take the form of calling in favors (assuming we have any left), guarantees, or other forms of intervention.
Dizard provides more support for his view by dissecting the Fed’s plan to save the finance business. And what is that plan? Banks must raise $200 billion in the next two quarters.
Dizard treats this fantasy with more dignity than it warrants, puncturing the notion that this goal is even remotely attainable. Moreover, that delusion presupposes that financial concerns are even willing to seek more equity right now. Many are asserting that they don’t need more dough, thank you very much, because sales of stock-linked paper would be highly dllutive. Hhhm, wonder if this point of view has anything to do with the prevalence of option-based incentive comp. It couldn’t possibly, since pliant boards will no doubt re-issue the options at more favorable strike prices. Dizard also points out that shrinking balance sheets to conform with shrunken capital bases isn’t very workable either.
Dizard uses this discussion to make a broader, more disturbing observation: despite the nasty dose of reality inflicted by the markets, regulators and central bankers are still co-opted by the industry and are acting as enablers rather than seeking real solutions, no doubt because they might inflict pain on their charges.
Yves here. Fast forward to 2010. Central bankers seem unwilling to confront some fundamental problems, all of which point to the politically unacceptable conclusions:
1. Chris Whalen of Institutional Risk Analytics contends that large banks, in real, risk adjusted terms, are destroying value. That means they must do a combination of cut pay, which is the biggest expense (which no one at these organizations is even remotely prepared to consider), and/or shrink their balance sheets so as to improve their returns on capital
2. Securitization volumes increased in significant measure due to bad practices: poor due diligence, misratings, the ability to camouflage risk and dump it on unsuspecting parties. Some of the once-critical outlets for risk, namely AIG and the monolines, have been blown up, plus investors have smartened up and are unlikely to be fooled a second time, at least on anything remotely approaching what took place in the bubble years. But all the things that investors want, such as better underwriting standards, having parties in the securitization pipeline retain a meaningful piece of the deals, would make the economics of securitization much less attractive.
So the result is a much smaller securitization market, with much more costly credit.
The real problem is that this is the end state after credit excesses: a return to healthier practices means more costly, less readily available debt. As Gillian Tett describes in the Financial Times today, the authorities stepped in to prevent that outcome, yet appear unwilling to accept the fact that there is no going back to status quo ante, circa early 2007, nor should they want that outcome.
From the Financial Times:
In the first seven years of the past decade, the securitisation sector expanded at a stunning pace…But since the onset of the financial crisis, these markets have collapsed…
So far, few non-bankers have really noticed this collapse, largely because governments have stepped into the breach, papering over the gaping hole. In the US, for example, the Federal Reserve has bought $1,250bn of mortgage-backed securities. In Europe, the Bank of England and ECB have gobbled up mortgage-backed bonds, and other securitised assets, via repo deals. Before 2007, eurozone banks sold more than 95 per cent of their securitised products to private sector investors; now it is under 5 per cent – with the rest going mostly to the ECB.
The crucial question is: how long will this pattern continue? Unsurprisingly, all western central banks are deeply uncomfortable about the fact that they, in effect, have replaced, or become, the securitisation sphere. They are thus looking for exit strategies and urging the banking industry to restart the securitisation machine…
In 2007, when bankers were guzzling champagne, a large source of the demand for securitised bonds came from quasi “invented” buyers – that is, banks and bank-funded vehicles that were developing investment strategies to take advantage of regulatory and rating agency loopholes, fuelled by artificially cheap loans.
Cheap funding has since vanished and governments are determined to close all those loopholes. As a result, those invented buyers have disappeared.
That need not spell the end of securitisation, per se. After all, there are still real money investors out there, such as pension funds, which could buy securitised bonds. But if these real investors reappear, they will demand much better returns. That means the market will be smaller in future, and funding costs will rise.
That leaves G20 leaders with an unpalatable choice: either the government continues to replace the securitisation market indefinitely, to maintain credit growth, or it must adjust to a world where credit is far more rationed and costly. That first option is hated by most central bankers. However, the second is disliked by most politicians, too.
Yves here. So far, political expediency is clearly prevailing.