Thursday, November 13, 2008

Asset-backed securities and the future of consumer lending

So... no buying of mortgages from banks in the TARP. What are they doing?

On the same day they pulled the rug from under our banking system, Treasury announced they would be "exploring" programs to improve liquidity in the AAA-rated asset-backed security (ABS) market. Although securitization has in many ways been a big part of the problem, revival of the ABS market would make a big difference.

Remember the covered bond idea? Its a structure used extensively in Europe where a bank pledges a pool of mortgage loans to "cover" a piece of debt. In theory, the bank enjoys a lower interest rate on such debt because it is both a general obligation of the bank as well as "covered" by the mortgage loans.

In July, the Treasury proposed covered bonds as an alternative to the traditional securitization markets. It never really got going in large part because the corporate bond market continued to deteriorate, and thus was not receptive to new products. But the idea was sensible enough. Covered bonds better align the bank's incentives with the investor, because the bank remains on the hook for the debt no matter what. This is in contrast to a straight securitization, the bank off loads all the risk to investors.

From a macro-economic perspective, a vibrant covered bond market would have allowed banks to lend knowing there was a ready source of cash. Banks will not lend until they are confident in their sources of cash. If the covered bond idea is dead, for now anyway, perhaps the ABS market can pick up the slack.

Historically, ABS have typically been backed by consumer loans, including credit cards, auto loans, home equity, and student loans. ABS were typically structured with a senior/subordinate credit enhancement, meaning that certain tranches of the deal would take losses first and only once those tranches were wiped out would other tranches take a hit.

Of course, there have been numerous problems with the ratings agencies allowing too little in subordination in certain deals. But there is nothing inherently wrong with the senior/sub concept. In fact, if its kept as a simple sequential loss structure, analyzing the credit of an ABS deal becomes relatively straight forward: its just losses versus available subordination. Sounds a hell of a lot more transparent than trying to decode a bank's balance sheet!

So what if the ABS market could be revived? Lenders who could not access the unsecured debt markets could access the ABS markets, raising loanable funds. If the lender also kept a sizeable residual on the deal, the result would be similar to the covered bond idea.

Many companies would benefit directly from an improved ABS market. Credit card issuers, such as American Express, Citigroup, and Capital One. Student lenders such as Sallie Mae. Even the autos would benefit, although obviously the GM and Ford situation is much deeper, Toyota and Honda would also benefit.

It wouldn't solve all our problems. I still wish they were buying mortgage assets. But this is better than nothing.


PNL4LYFE said...

It's not obvious to me why banks would be much more willing to lend even if covered bonds were an option. It seems like it just moves assets off the balance sheet much like the guarantee portfolios of the GSEs. Would the main benefit be that it would allow long term debt issuance rather than relying on the short term funding from various Fed programs?

Credit Cruncher said...

Isn't this also somewhat different because once the bad mortgages are gone, they are gone. Improving liquidity in the ABS market (or more likely the ABCP market) on the other hand, would require real investors coming in at some point to take up the slack, which is somewhat of an assumption at this point. Otherwise, is this really any different than lending to the banks through any other of the many liquidity programs?

Accrued Interest said...

How effective this is depends entirely on how its structured. If the government offered term financing for the life of the instrument, it would be wildly different than existing programs.