Securitisation markets also need structure, perhaps an exchange-like setting, to provide the sort of standardisation and rules that help trading of stocks and options.
For better or worse, stress tests of the 19 largest US banks are done. Investors and the government feel they have a better handle on banks’ financial health and can move on.
That gives officials room to address another pressing task on the financial crisis to-do list: Fixing the so-called shadow banking system, or non-bank lending markets.
At the heart of this market is securitisation, which in recent years provided about 25 percent of the funding for consumer loans and 50 percent for mortgages.
Securitisation is a process in which banks or other firms package loans into securities. The securities are sold to investors, giving lenders money to make new loans. While helping to increase credit, the process fuelled the financial crisis by passing dodgy assets from banks and others to investors.
Although industry groups have been trying to bring this market back to life, those efforts aren’t enough. The government has to get involved, setting rules that restore confidence among investors and possibly even helping to create a more formal market structure, perhaps along the lines of a stock exchange.
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Unless that happens, securitisation will continue to rely on government backstops. Yet the economy needs this process to function again on its own.
To get an idea of how much lending capacity is at stake, consider that between 2005 and 2007 more than $8 trillion in securitized products were issued globally.
With securitisation markets paralysed since August 2007, banks have to pick up the slack. Any expansion in lending requires more capital, though, putting pressure on banks.
Securitisation started in the 1970s and initially was used in mortgage markets. By moving loans off their balance sheets, or securitising them, banks were able to lend more.
The process created securities that were supposed to be less risky because they were based on a large pool of debts. A few loans might go bad, but not thousands or tens of thousands. They were also sliced and diced to offer investors varying levels of return and risk.
For years, the process worked fairly well, helping to lower borrowing costs for homeowners and consumers. The process went off the rails earlier this decade as shoddy lending practices, inadequate disclosure, a lack of monitoring and flawed ratings allowed banks and others to unload increasingly toxic debts through securitisation.
At the same time, the securities being sold became mind-numbingly complex. Collateralised debt obligations, which were pools of securities that themselves packaged thousands of loans, were the epitome of the problem.
When the housing bubble popped, investors realised they didn’t understand what they owned. That caused them to refuse to buy any packaged loans that weren’t backed by the government or mortgage giants Fannie Mae and Freddie Mac.
So what can be done? For starters, the government, not just industry, needs to get involved. “Given the profound breakdown in the market, I’m not convinced that an industry-run solution will work,” said Rod Dubitsky, director of asset-backed research at Credit Suisse Group.
Next, the government needs to insure that investors can get a real sense of what it is they are buying. That means making the system more transparent.
Proposals on this front are wide-ranging. Richard Field, founder of financial consulting firm TYI LLC, advocates real-time disclosure of the performance of debts underpinning securitised products. Without this, he says, investors are given a brown paper bag and told there is a $100 bill inside, yet aren’t allowed to look inside to see if this is true.
Some worry daily disclosure would result in information overload, though there is broad agreement that investors require more standardised information about key elements of securitised loans, as well as a clearer picture of actions taken by those who service the debts.
Investors also need to know that someone is monitoring this information flow and gauging its reliability. In the past, there was no policing of the system, no enforcement mechanism, Dubistky said.
Changing that might require some sort of audit function, or an independent clearing house for information provided by banks. In addition, the government would have to mandate that institutions provide information.
“This market needs a stick, it doesn’t need a carrot,” said Ann Rutledge, a principal at R&R Consulting, which specialises in structured finance.
Securitisation markets also need structure, perhaps an exchange-like setting, to provide the sort of standardisation and rules that help trading of stocks and options.
None of this will make enough of a difference, though, if investors don’t feel that they can once again trust ratings companies. That makes a revamp of the way the raters operate— a question under debate by legislators— a top priority.
Yet any change has to go beyond the question of who pays rating companies’ fees, R&R’s Rutledge added. Ratings for securitized products should be dynamic, changing as more information is gathered about the performance of underlying loans, she said.
Finally, it may be necessary to see that folks who create securitised products have some skin in the game. Already, some regulators and international organisations are proposing that banks hold on to a chunk of whatever they sell to investors.
With such changes, and government guidance, investor trust just might return.
(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)