THE EXTENSION OF MONEY WITH DISINTERMEDIATION

Direct Financing and Hedging of Risk

Since the Reagan era of the 1980s, under the influence of Milton Friedman and other economists from Chicago, deregulation coming from an over-regulation due to past wars being necessary became the motto, if not the Holy Grail. The refinancing of economies was no longer limited to bank financing, as we have already seen when describing financial depth (Chapter 2). Securitization granting equivalent guarantees to paper holders was the main engine, and the deficits of both trade and budget the fuel for it. Financial instruments, including mortgage-backed securities becoming monetary instruments, were moving faster and outside the boundaries of the banking system.

REPLACEMENT OF BANK LOAN FINANCING BY SECURITIZATION AND THE IMPACT OF PRO-CYCLICAL EFFECTS

[1]

The Origin of Securitization

A primary reason for debt securitization was to allow banks not to carry the risk of loans they produced or were rewarded for. This objective was enabled by ongoing evolution in economic conditions. These included deficit spending by governments or industry, and the matured savings (albeit dwindling) resources of an aging population. Thus, a new form of monetary sourcing and leverage was available on financial markets. This in turn opened the window for widespread sales of new financial instruments, both from within originating monetary jurisdictions and in a cross-border international context. Moreover, as the administration of loans is not specifically a banking activity and can be subcontracted to specialists, effective externalization of associated expenditures and financial risks served to reduce banking overheads. Ultimately, this overall strategy of debt securitization was intended to reduce banks' balance sheet liabilities, and as a consequence enhance return on equity for banks.

Over the past 35 years, financial engineering options have also increased in sophistication, and the impact of their implementation has fundamentally changed the financial structure of the economy. Concurrently, the traditional oligopolistic sources of commercial bank financing have progressively been supplanted by the role of markets and securitized debt instruments. In the USA, the most active players on these secondary markets have been financial institutions with total assets that exceeded those of traditional commercial banks, particularly as of 2007 Q3.[2] One example of such secondary market instruments are mortgage-backed securities, which have enjoyed a historically disastrous upsurge, due in part to the massive pre-crisis expansion of the housing sector – a key contributor to the domestic US economy. This occurred in parallel with another trend, namely the progressive transference of US manufacturing capability to foreign nations that offered low-cost offshore production environments.

This dynamic provided players in the securitization sector with a false sense of abundant and rapidly accessible liquidity. However, economic history showed that such hubristic liquidity presaged a coming crisis, one which was heralded most recently by a massive rise in household debt coupled to mortgage-backed securities, a wave that by mid-2001 had already reached a domestic value of $11 trillion for the US housing sector.

Alongside these real-estate-sector securitization options and trends, the facile financing of heavy infrastructure and transportation capabilities (rail or sea, and aircraft) was also facilitated in the context of reducing the required scope of government participation. Such financing was enabled through the sale of receivables, the management of which could also be subcontracted. The role of bank financing was increased by the sale of loan portfolios, and by the release of corresponding hedging equity that was available for new credits (under Cooke and Basel ratios). By capping the ratio between loan commitments and available core equity, Basel II regulations actually favour the securitization process.

This process is not a very recent phenomenon – that is, many years of growth in the US home construction sector (that contributed to the set-up of the 2008 crisis) had long been “pushed” by government-chartered agencies set up for the purpose of warranting fiscally compromised loans, and then allowing their direct or secondarily securitized sales on organized financial markets – or by artificially clearing such loans from the ledger sheets of commercial banks that were previously saddled with such failing loans.

We note that this evolution of factors accelerated the disintermediation of lending activities, which were subsequently reduced to redistribution activity, and thus escaped from the need for refinancing internal to a given commercial banking institution. In turn, this pattern influenced direct central bank interventions, for instance in response to negative assessments on the capabilities of various commercial banks to self-finance their internal loan portfolios. Not surprisingly, under such conditions “interest spreads”[3] have emerged as a determinant factor. If spreads are high and allow coverage of the default rates, this induces banks to lend. Conversely, if spreads narrow and become too low, banks abstain from accumulating additional lending risk.

As we know, the above description is problematic. During the starting phases of the 2007-2008 crisis, the liquidity erosion within the financial markets would not have been readily perceived, particularly if observers' viewpoints were limited to the classical analysis of cash money and bank credits to the economy. In other words, not all the intermediary financial institutional parties (including commercial banks, whose public customer deposits do not cover the entire scope of operational refinancing capital requirements) inevitably engage in large-scale borrowing on the financial markets. However, unlike the precarious position of pure brokerage houses, whose operating reserve liquidity rapidly eroded during the crisis period, diversified “multi-activity” banks cross-retained liquidity resources to allow for continued operational stability. That is, multifunctional mega-banks with sizable commercial operations or mainstream commercial banks exert a so-called protective “bumper role” – as the sheer size of their balance sheet can cover the marginal effects of defaults, at least in those instances where banks do not surrender to the market sirens of unrestrained proprietary capital trading or whose organizational structure is heavily skewed away from maintaining a sizable commercial banking operation.

The pro-cyclical effect of market refinancing and interbank deposits (REPO)[4] reveals a major reason for the brutal credit crunch and resulting novel aspects of the 2008 crisis. As suggested by knowledge gained during that crisis, future doubts about overall macroeconomic accounting-level reconciliation between “values of debts” in the banking system (including sovereign debts and the projected global capacity of economies to eventually reimburse those debts) are unlikely to be ameliorated by mere application of “stress-testing” parameters. In other words, new and potentially misleading accounting standards may not provide more than a distorted picture of individual or grouped banking status, since the economic link between such financial institutions (including their fiscal vulnerabilities) has assumed a historically new pattern of interdependence – one that remains largely undefined with no accepted, crisis-tested or proven formula for its global analysis. Moreover, “stress test”-defined and capital requirements-driven accounting standards have, to date, not adequately considered accounting-induced microeconomic “book elfects” which can result from the impact of how securitization trends are analysed or inadequately considered.

Thus, the potential for banks to experience instability as a consequence of pro-cyclical market behaviour will not be reduced by links to such accounting standards – at least not in the absence of wide-reaching intrinsic reform. Without such far-reaching fundamental reform, central banks would have to provide substitute liquidity in future crisis settings where a focal lack of liquidity could emerge in the financial sector, and for which a replacement monetary supply would not exist outside the central banks themselves. This potential scenario remains a major challenge for today's central banks.

With securitization's global role extending far beyond the intent of any original design, a financial Excalibur emerged – a double-edged sword with the potential to drive future transactional flow in the face of an uncertain and potentially deleterious outcome. A suitable analogy might be a football championship with sizable quantities of pre-reserved tickets, subject to potential cancellation on the basis of non-predictable inclement weather. Such financial uncertainty for both organizers and ticket holders would, in turn, be compounded through insurance premium liabilities for the organizers and inflated ticket costs for football fans.

It may be said that securitization has been a victim of its own success. Through the securities sorting phenomenon, stakeholders were separated from immediate fiscal impact and remained largely concerned only with the financial health of underlying primary warrants and their owners. Little concern was directed towards the impact on the larger population of retail-level public market investors – in essence, the citizens who were potentially most vulnerable to variances in the financial health of underlying warrantees.

In a real sense, securitization allows for de facto transformation of a “receivables portfolio” into a new secondary (derivative) financial instrument, which becomes independently tradable on public markets. Prior to the 2007-2008 crisis, this had been allowed to occur even if primary “receivables” warrants underlying the new financial instruments were of uncertain long-term stability. In this manner, an entire market sector (in this case real estate and the credit industry) could be exposed to non-sector-applicable market-driven variations in value, without links to the overall economic situation or that of the impacted sector (e.g., real estate and credits).

The challenge of maintaining balance in this macabre new financial reality involved offsetting the greed of the financial world against the weakness of prevailing accounting standards.

  • [1] See further, note 88 in D'Austra and Schlessinger (1993) regarding securitization alongside a parallel banking system, as well as our previous book.
  • [2] $17.6tn for market institutions (including $4tn for ABS issuers) and $12.6tn for banking institutions. Source: US Federal Reserve.
  • [3] Difference between interest rates for borrowing money versus the lending rate applied to borrowers.
  • [4] Contractual sale and repurchase agreement by which two parties agree to the sale by one of them of a proportion of securities (that will be used as collateral for the other buyer against a loan of lower value), with both parties agreeing to subsequently reverse the transaction by a repurchase transaction at some later date.
 
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