When Debt Securitization Blew Up So Did the EconomyEconomics / Credit Crisis 2009 Mar 04, 2009 - 08:32 PM GMT
"Nothing we do for banks is for banks. It's all for the benefit of the people that depend on banks -- the businesses, the families, the students -- that require credit in order to do things that are important to their future." Treasury Secretary Timothy Geithner PBS Jim Lehrer News Hour
One thing is certain, this isn't a normal recession. In a normal recession aggregate demand declines, economic activity slows, and GDP shrinks. While those things are taking place now, the reasons are quite different. The present slump wasn't brought on by a downturn in the business cycle or a mismatch in supply and demand. It was caused by a meltdown in the credit system's central core.
That's the main difference. Wall Street's credit-generating mechanism, securitization, has broken down cutting off roughly 40 percent of the credit that had been flowing into the economy. As a result, consumer demand has collapsed, inventories are growing, and manufacturing has contracted for the 13th consecutive month. The equities markets are in freefall and all the economic indicators are pointed south. The so called "shadow banking system" which provided wholesale funding for mortgages, car loans, student loans, and credit card debt, has stopped functioning entirely.
Journalist David K Richards describes the modern credit system in his article "Humpty Dumpty Finance":
"To begin, it is important to recognize how Wall St. has transformed the bank-based credit system, which existed in the 1930's and prevailed until the mid-1990's, into the 'modern' securities-based credit system we have today. Non-bank sources currently supply more than half the credit needs of businesses and consumers. This transformation in the way credit is supplied has made it difficult for the Federal Reserve to reignite credit growth through massive expansion of the Federal Reserve balance sheet, which was the supposed 1930's style antidote. The old-style banking system, in which banks kept the loans they made on their balance sheets, would have responded quickly to Bernanke's interest rate cuts and aggressive injections of excess reserves. But banks today no longer keep most of the credits they underwrite on their own balance sheets, nor do they keep them in the form of individual loans. Instead, banks gather credits together to form asset-based or mortgage-based bonds which they then distribute or sell to pension funds, insurance companies, banks, hedge funds, and other investors worldwide. ("Humpty Dumpty Finance" David K Richards, Huffington Post)
This new "securities-based" credit system emerged almost entirely in the last decade and had never been stress-tested to see if it could withstand normal market turbulence. As it happens, it couldn't survive the battering. The market for mortgage-backed bonds and other securitized investments disintegrated at the first whiff of grapeshot. As soon as subprime foreclosures began to rise, investors fled the market en masse and securitization hit the canvas. Now the wholesale funding for MBS and other consumer loans has slowed to a trickle. That means that housing prices will continue to crash dragging the stock market along behind.
The Fed and Treasury are determined to revive securitization. They're planning to provide $1 trillion for the so-called "public-private partnership" and the Term Asset-Backed Securities Loan Facility (TALF). The money is a taxpayer-provided subsidy for a deeply-flawed system which is inherently unstable. Consider this: subprime mortgages were only defaulting at a rate of 6 percent when the entire market for securitized investments folded like a house of cards. The Fed and Treasury are wasting their time trying to fix a dysfunctional system instead of focusing on debt relief for underwater homeowners and struggling working people. That's where the money needs to be spent
It's no surprise that the banks were big players in the securitization racket. Converting mortgages and other debts into securities has many perks including transfer of risk, a reduction in funding costs, lower capital requirements and additional liquidity. Banks can actually create a security and then sell it to itself at a profit in what amounts to an "in house" transaction. Nice trick, eh? There are also considerable benefits from maintaining off-balance sheets operations which--through the magic of modern accounting--allow loans to be held as assets that don't require the same capital reserves as conventional mortgages. All this sleight-of-hand increases the amount of credit that banks can balance on smaller and smaller morsels of capital.
The financial sector now represents 40 percent of GDP, which is to say that the exchange of paper claims to wealth is the driving force behind economic growth. The production of useful things, that actually improve people's lives and raise the standard of living, has been replaced by the trading of complex debt instruments and opaque derivative contracts. Securitization is at the very heart of Wall Street's Ponzi-finance scam. It creates profits by transforming liabilities into "cash flow" which can be sold at market. Bottom line: Factories and manufacturing are out. Toxic paper and garbage loans are in.
As ringleader of the banking fraternity, the Federal Reserve has a big stake in securitization and would like to see it succeed. Bernanke's job is to provide the liquidity and capital that's needed to put the credit markets back in order. To that end, Bernanke has spared no expense to underwrite all of the toxic loans which have presently brought the financial system to its knees. According to Bloomberg:
"The U.S. government has pledged more than $11.6 trillion on behalf of American taxpayers over the past 19 months, according to data compiled by Bloomberg. Changes from the previous table, published Feb. 9, include a $787 billion economic stimulus package. The Federal Reserve has new lending commitments totaling $1.8 trillion. It expanded the Term Asset-Backed Lending Facility, or TALF, by $800 billion to $1 trillion and announced a $1 trillion Public-Private Investment Fund to buy troubled assets from banks. The U.S. Treasury also added $200 billion to its support commitment for Fannie Mae and Freddie Mac…” (Bloomberg News)
There's literally no end to the Fed's generosity when it comes to providing for its friends on Wall Street. Only a small portion of Bernanke's largesse was bestowed with proper congressional authorization. Bernanke simply doesn't care if the public sees him as the unelected oligarch that he really is.
Securitization soared between 2003 and 2006 when US current account deficit skyrocketed to nearly $800 billion per year. That's when "America's banks discovered that they could borrow money cheaply from Asia and lend it out in higher-yielding domestic mortgages while using sophisticated financial engineering to wall off and strictly control their risks."(Brad Delong) The US was consuming $800 billion more per year than it was producing, but the damage remained invisible because foreign governments and investors were recycling their savings back into US Treasurys, GSE bonds (Fannie Mae), and mortgage-backed securities (MBS). It was a windfall for Wall Street that put the investment banks and hedge funds deep in the clover.
A number of economists sounded the alarm, saying that the burgeoning account imbalances were unsustainable, but the business media just brushed them off as Chicken Littles. Now, foreign investment has slowed, the credit markets are frozen, real estate is retreating and $40 trillion of wealth has drained from the global equities markets. The tremors from Wall Street's mortgage-laundering swindle have rippled through the broader economy causing an unprecedented contraction in retail, imports, durable goods, transports, high tech, electronics, and cyclicals. The unemployment roles have mushroomed while asset prices have continued to plummet. The Dow has dropped 54 percent from its peak and is sliding inexorably towards 6,000. Pessimism abounds.
The economy is now caught in a deflationary downdraft. The sharp decline in asset prices is making it more difficult for businesses to roll over loans. Without financing, tens of thousands of businesses will default. Bernanke assumed it would be easy to reflate the bubble economy by increasing the money supply. Now he knows he was wrong; the printing presses haven't worked. The Fed's trillions are sitting in stagnant pools on bank balance sheets rather than churning through the credit markets. Monetary policy has failed; velocity is down and capital injections have not stabilized the financial system.
The TALF and "public-private partnership" is just more grasping at straws; another attempt to stop the debt deflation by trying to rev up securitization. It won't work. Bernanke and Geithner still don't understand the main problem, which is the explosion in private debt. Consumers are tapped out and easy credit won't help. Homeowners just lost 28 percent of their home equity in the last two years and more than half of their retirement (401K). They are much poorer than they thought and they need to increase their savings fast. What they really need is a reduction in the face value of their mortgage and a write down on their other main debts. Otherwise they will be forced to curtail spending and circle the wagons. That will trigger an even more precipitous decline. Have Bernanke and Geithner even considered how long the recession will last if the savings rate continues to rise at its present pace?
Until the two Bears Stearns hedge funds defaulted 19 months ago, securitization had been Wall Street's most reliable source of revenue; a real cash cow. It was the main reason that total mortgage debt jumped from $4.5 trillion in 1999 to $11 trillion in 2006; more than double in just 7 years. At the same time, the asset-backed securities (ABS) market, which packaged other types of business and consumer debt into securities, shot up by more than 500 percent to $4.5 trillion. Securitzation turned out to be the Mother Lode. The torrent of surplus capital from the savings glut in the Far East (as well as "yield seeking" insurance companies, retirement funds and investment banks) turned mortgage-backed securities and other structured investments into a multi-trillion dollar industry.
The process recycled revenue to mortgage originators where low interest rates and lax lending standards kept the volume of MBS high, but the quality low. It's clear now, that securitization created incentives for fraud by transferring credit risk from the originator of the loan to the investor. The originator makes his money on the volume of securities sold; the quality of the underlying mortgages is secondary. This week, the Wall Street Journal reported that 7 out of 10 subprime mortgages vintage 2006 will default. The failure rate proves that the system had deteriorated into little more than a scam.
It was securitization and the 25 to 1 leveraging of toxic assets at the hedge funds, investment banks and private equity firms, that brought on the current financial crisis. When trouble broke out in the subprimes, the secondary market shut down, and the flow of credit from nonbank financial institutions dried up. Unfortunately, the real economy has become addicted to easy credit and sky-high asset prices. Now that the bubble has burst, the phony prosperity of the Bush years has been wiped out in one fell swoop. The stock market has plunged to its 1996 level and housing prices are returning to the mean. The question now should be, do we really want to restore a crisis-prone credit-generating system (securitization) by providing a $1 trillion subsidy to profit-oriented hucksters who are largely responsible for the current recession?
As Barak Obama stated last week, "Credit is the economy's life-blood". It should distributed through government-owned and regulated financial institutions that operate as public utilities. Credit is everyone's business. It shouldn't be controlled by speculators.
By Mike Whitney
Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.
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