They were the “financial weapons of mass destruction” which blew up the world economy, yet perhaps surprisingly, they are poised to make a comeback – and what’s more, it is with the active encouragement of Europe’s new generation of central bank governors.
Ever since the financial crisis, “securitisation” – the bundling up, then slicing and dicing of loans into packages that can be sold to investors – has been something of a dirty word best not mentioned in polite company. Securitisation was the phenomenon that spawned “collateralised debt obligations” (CDOs) and all the other financial instruments that underpinned America’s sub-prime lending boom. If any one thing can be blamed for the banking crisis, it is surely the bonus-driven frenzy of CDOs and other forms of asset-backed securities issuance.
How odd, then, that all of a sudden everyone is talking about how to get these markets going again. Could we so soon have forgotten the damage that these fiendishly complex instruments inflicted on the world? How could we be even thinking about inviting them back into the fold?
Well we are, and the reasons for it are sounder than you might think. Indeed, I would go further, and say that there is in fact very little chance of a broadly based, market-led recovery taking hold in Europe without a revival in securitised lending to give it legs.
But before explaining why, here’s a little context. In the run-up to the crisis, securitisation was one of the main mechanisms by which banks expanded their balance sheets and facilitated abundant credit. New lending, whether for mortgages, credit cards, car loans, commercial property or even straight SME finance, would be routinely packaged up and sold off to investors, thereby freeing up capital for yet more lending.
At the time, most commentators regarded this growth in the so-called “shadow banking” system as a generally benign and even healthy process which enabled credit risk to be spread far and wide amongst a much bigger pool of investors than had ever been possible in the past. Securitisation had made the system safer, it was thought, not riskier.
So much for perceptions. The reality was that the risks were becoming progressively concentrated, through securities trading operations, on bank balance sheets, or in vehicles connected to banks, so that when the sub-prime crisis hit, and many “asset-backed securities” were found to be worthless, they undermined confidence in the entire banking system.
Why on earth would you want to bring back such collective madness? Some of the answers to this question are provided in a newly published joint paper by the Bank of England and the European Central Bank, a front runner to a more detailed consultation due to be issued next month on how to remove some of the blockages to a resurgent securitisation market.
Amusingly, the paper regurgitates many of the arguments in favour of securitisation that ahead of the crisis had lulled banking regulators into thinking it not just safe but, positively beneficial. The following sentence could have come straight from the mouth of Alan Greenspan circa 2006; a revival in asset-backed securities (ABS) issuance “could translate into a diversified funding source for banks and potentially transfer credit risk to non-bank financial institutions, thereby providing capital relief that could be used to generate new lending to the real economy”.
But my intention is not to mock; rather, it is to praise. There is nothing wrong with securitisation per se, provided it is kept simple and transparent, and the wretched credit rating agencies are kept well away from the game, so that investors themselves can make up their minds about the risk, rather than abdicating responsibility to corrupted outside analysts.
As things stand, we live in a kind of Alice in Wonderland where ABS issuance has not entirely gone away, but great chunks of it are not for private sale at all any longer, but for collateral to central banks for the funding that markets will not provide. This is particularly the case in continental Europe, where credit is still shrinking along with deposits. For Europe to stand any chance of getting back to financial and economic health, it requires the market to step back into the fray and take over from official, central banking sources of funding.
Ironically, some of the “unconventional” monetary policies that central banks have put in place to counter the crisis may be impairing the rehabilitation process. For instance, one of the effects of the Bank of England’s “Funding for Lending” scheme was to kill off anew any hope of a revival in ABS markets, since it offered an obviously cheaper source of funding. The same was true of the European Central Bank’s Long Term Financing Operation, and will probably be true of anything it might do by way of “quantitative easing” over the months ahead. Market funding is being crowded out by zero interest rate, central bank lending.
In any case, a resurgent securitisation market is the obvious solution to weaning banks off the central bank printing press. This is particularly vital in Europe, where the underdeveloped nature of capital markets has long been a key reason for sclerotic economic performance.
On the one hand, the ECB demands that European banks increase their lending to the real economy, on the other, it insists that they reduce their leverage. Securitisation provides one way of reconciling this apparent contradiction. By getting loans off their books through securitisation, banks both decrease their leverage, and free up capital for additional lending, producing a virtuous circle of credit expansion.
Don’t get me wrong. We plainly don’t want to go back to the pre-crisis world of having too much of a good thing. For the moment, however, that point is frankly so far away as to be not worth worrying about. In any case, the European ABS market as it stands is too small, and well buttressed, to pose much of a systemic threat. Unlike the US, where mortgagees can walk away from their debts by simply handing back the keys, mortgages in Europe are a full recourse market, making default much less likely.
Of the global losses on structured finance since the financial crisis began, around 60pc relate to US sub-prime lending, and just 0.2pc to European residential mortgage-backed securities. The UK is similar to the rest of Europe, with low levels of residential mortgage forbearance and default. There are many causes of the financial crisis; UK mortgages were not among them. Even Northern Rock will eventually yield a substantial profit to the taxpayers that kept it afloat.
So what’s holding things up? The stigma of the crisis, together with still poleaxed financial confidence, are the main constraints, but as ever, regulators scarcely help. Central bankers get it; Brussels doesn’t, with Solvency II regulation raised as a new barrier to insurance and pension fund participation in securitised debt markets.
Europe desperately needs to develop new sources of market-based finance, but it remains too suspicious of the City’s Anglo-Saxon alchemists to give them a decent chance. Properly contained, these “financial weapons of mass destruction” are key to unlocking renewed growth and a well functioning economy.
Jeremy Warner, assistant editor of The Daily Telegraph, is one of Britain’s leading business and economics commentators.