In recent years the debt securitization market was the source of roughly 60 per cent of all credit in the United States. Now securitization is on life support—whatever securitization is still happening largely occurs because of government programs. This makes credit hard to come by for everyone from consumers to businesses.
Jenny Anderson tells the tale of the woeful state of securitization in today’s New York Times.
Enormous swaths of this so-called shadow banking system remain paralysed. Depending on the type of loan, certain securitization markets have fallen 40 to 100 per cent.
A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.
The market for securities backed by commercial real estate loans is in worse shape. No new securities of this type have been issued in two years.
Paul Krugman this afternoon responded by asking why banks can’t just lend like they did in the old days.
Here’s my question: why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets. Yet the assumption at the Fed seems to be that this isn’t an option — that the only way to go is back to the securitized debt market of the years just before the crisis.
Why? Are we still convinced that securitization is a far superior system to conventional banking, and if so why?
We think Krugman means this as a rhetorical question. He certainly doesn’t attempt to answer. Let’s suppose for a moment that Krugman really wants an answer to his question.
The reason why we need securitization to get banks lending is that the international Basel capital requirements reward securitization and punish bank lending.
Under Basel, a well-capitalised bank was required to hold $4 for every $100 in individual mortgages—a 4% reserve requirement. But if it held the securitized the AAA and AA tranches, the bank only had to hold $1.60 in capital. Similar formulas apply to corporate loans and consumer debt. To put it differently, asking banks to hold on to loans because there is no securitization is asking them to set aside an extra $2.40 for every $100 they put into the markets.
The immediate effect of this is to contract credit. The higher reserve requirement means that banks cannot make as many loans. A bank with $4 billion in reserves could invest in $250 billion in debt securities. But that same $4 billion could instead be used to make only $100 billion worth of loans. That’s a huge contraction. And avoiding this contraction is exactly what regulators are trying to avoid in their attempts to revive the securitization market.
The contraction may actually be worse than described above. Banks operating under the higher capital requirements are unable to achieve market returns adequate enough to attract new capital. The higher capital requirements threaten to lower profitability—banks can put less of the dollars they have to work in the markets—which means that investors will shy away. This means that ailing banks will have trouble attracting investors, which could create another round of bank failure.
This also explains why banks are depositing their excess reserves with the Federal Reserve rather than lending them out. They know that capital will be scarce if the securitization market doesn’t return to boost their profitability. What’s more, they want to have dry powder if the securitization market revives.
Right now we’re avoiding this contraction—or at least diminishing its effects—by having the Fed recycle the deposits by buying debt-securities. But if we ever attempt to get the Fed out of this business, we’ll be facing a huge credit contraction.
So what policy should we adopt in the face of this credit contraction? Probably the best policy is inaction—we really shouldn’t be hell bent on reviving a securitization market that was, in large part, driven by regulatory arbitrage. If a new, healthier market for securitization springs up once we have better capital requirements in place, we might see credit begin to expand again.
“The stubborn refusal of the securitization market to participate in the current credit boom is one of the few chinks of light I’m seeing these days. It shows there’s still some common sense in the world; long may it stay that way,” Felix Salmon writes.
He may well be right about that. But we hope he realises the consequences of the death of securitization.