Tuesday, June 19, 2012

Fed shocked to discover that restarting securitization necessary for monetary policy transmission mechanism

In his Wall Street Journal article, Jon Hilsenrath discusses how the economy isn't responding as economic textbooks say it should because the prime transmission channel for monetary policy is credit and that channel is blocked.

Your humble blogger would like to thank Mr. Hilsenrath and the Fed for confirming a prediction that I made in late 2007 has come to pass.  At the time, I said that the economy would be in a downward spiral until such time as structured finance provided current information on the underlying collateral.

To date, structured finance securities do not provide current information and the market for these securities is substantially smaller than it was pre-financial crisis.

This is important as banks have a limited capacity to hold loans on their balance sheets.  Naturally, the banks are using this capacity to hold loans to borrowers with the best credit ratings.  Due to zero interest rate policies, the spread between excellent and troubled credit is so small that the extra yield does not merit the risk to banks to hold the loans for troubled credits.

While the banks are handling the credit needs of the most creditworthy borrowers, the absence of structured finance means there is a huge shortage of capacity to handle the credit needs of the less creditworthy borrowers.  As a result, the credit channel for the transmission of monetary policy is blocked.

Opening this credit channel is simple:  require that all structured finance securities provide observable event based reporting.  Under observable event based reporting, each activity, like a payment, involving the underlying collateral is reported before the beginning of the next business day.

With access to observable event based reporting, market participants can independently assess the risk and value of each security and make buy, hold and sell decisions based on the prices shown by Wall Street.

With structured finance functioning closer to pre-financial crisis levels, the credit channel is unblocked.

Shrunken access among credit have-nots is triggering more than personal plight. It has weakened the influence of the Fed—one of the best hopes for spurring stronger economic growth—and raised doubts within the central bank about whether it is doing much to reduce unemployment. 
The debate is especially important now. Fed officials are weighing new steps at their policy meetings Tuesday and Wednesday, following a period of disappointing jobs growth and financial turbulence in Europe. 
The credit divide factors into their thinking. Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should. 
By reducing interest rates—the cost of credit—the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts. 
But the economy hasn't been working according to script. 
After surviving a crisis caused partly by loose lending, banks remain reluctant to extend credit to households with even a hint of financial problems. Fannie Mae and Freddie Mac, the two government-backed mortgage finance firms, tightened their own standards after the crisis. Banks worry Fannie and Freddie will return any troubled mortgages.


Anonymous said...

You're basic premise for a solution to restarting securitzation is off the mark. It really depends on the asset class that we are talking about. Mortgage-backed securtizations have more than 20 years of track record for providing holders with servicer level (details on individual mortgage payments) and bond level (information about payments made to various classes of bondholders) reporting. Obviously, mortgages pay once a month and that is when the data is gathered and reporting takes place. Credit card securtizations have similar characteristics but the details are slightly different. You could make similar comments about other asset classes as well.

You are absolutely correct that what is holding back the recovery is the absence of a robust securitization market. However, the absence of reporting is not the problem. Investors would like to jump back in but there is no product. That's because banks and other issuers are completely uneasy with the lack of clarity surrounding regulatory standard for new issuance and capital liquidity standards (e.g. Basel III).

Mark F. Ferraris
Managing Princial
Orchard Street Partners LLC

Richard Field said...

Mark, thank you very much for your comment.

Based on your comment, I expect that you will be happy to take the Brown Paper Bag Challenge (www.tyillc.com).

The challenge is quite simple. I have prepared a simple structured finance security. In this case, I took $100 and put it into a brown paper bag with a Prime Collateralized Securitization label on it at the beginning of last month.

According to a servicer report issued during the middle of this month, at the end of the month there was $75 still in the bag.

Your challenge is to value the contents of the bag today.

To make it worth your and my while, based on the price we agree on for the contents of the bag, you and I will exchange a payment.

If the price we agree on is less than the value of the contents of the brown paper bag, then I will pay you the difference times 100,000.

If the price we agree on is more than the value of the contents of the brown paper bag, then you will pay me the difference times 100,000.

The last thing you need to be aware of is that just like the Wall Street firms that own billing and servicing firms, I too have observable event based information and know what is in the brown paper bag.

Your opening bid is?

Or would you like to reconsider your opening statement about how once per month disclosure is adequate for knowing what you own?

By the way, observable event based reporting is the equivalent of putting the collateral into a clear plastic bag.

As you contemplate what you would like to offer for the contents of the brown paper bag please think of how much easier it would be if the contents were in a clear plastic bag.

Finally, what I am proposing with observable event based reporting applies to all asset classes. It also parallels how bank/servicer information systems track what is happening with the underlying collateral.

Given that the data is available on a current basis, there is no reason that market participants shouldn't have observable event based reporting (a view as if the collateral is in a clear plastic bag) and not a once per month or less frequent report (a view as if the collateral is in a brown paper bag).

Richard Field said...


I am not sure there is much ambiguity in what the regulators are proposing for the standards for structured finance.

It appears to me that the regulators have embraced:

If you are a financial institution and buy a structured finance security where you don't know what you own because the security does not provide observable event based reporting, you need to fund it with 100% equity.

If you want to issue a structured finance security and retain as little of it as possible, then you need to provide observable event based reporting so investors can know what they own.

I realize that observable event based reporting wipes out opacity in structured finance, but it is the appropriate place to restart the market. You will recall that the private label RMBS market stopped when BNP Paribas announced it could not value the opaque, toxic sub-prime mortgage backed securities.