Monday, September 8, 2014

Blueprint Needed to Rebuild Structured Finance

By Roy C. Smith

While the corporate side of global finance is recovering well, another side that suffered in the crisis is still ailing so badly it is a drag on the US economic recovery as a whole. Mortgage-backed securities may have got a bad name in 2007-2008, but some way to revive the structured finance market must be devised to get the housing market out of the doldrums.

Corporations around the world issued $2.1 trillion dollars of new bonds in the first half of this year, according to Dealogic, setting a record.  The issues included corporate investment grade, high yield and financial industry bonds. Corporate new issues of stock (including a big increase in IPOs) also increased over the first half of 2013, to $489 billion, a 20% improvement.  So global capital markets are on track to provide about $5 trillion of corporate finance in 2014.

Banks also provide global syndicated loan facilities (including bridge and other leveraged loans, and refinancing) to corporate clients. For the first half, the volume of all such loans was $1.7 trillion, up 8% on 2013 and the highest since 2007. 

The main difference in capital market activity since the crisis, however, has been the plunge in global “structured finance” (securitised debt). In 2006, $2.8 trillion of global structured finance issues were sold.  By 2013, volume had dropped 70% from its peak, to $790 billion, and at a pace of $356 billion in the first half of 2014, it appears to be drifting even lower. Most of the decline in structured finance has been in mortgage-backed securities, especially those issued without US federal agency guarantees.

In the US, banks make mortgage loans based on credit scores, then sell the loans to federal housing finance agencies (the Federal National Mortgage Association, Fannie Mae, or the  or Federal Home Loan Mortgage Corporation, Freddie Mac) that guarantee the loans and package them into mortgage-backed securities to be sold to the market.  The banks recover their investment and repeat the process, providing a continuous, relatively low-cost flow-through mortgage finance system that greatly aids the real estate industry.

A Serious Structural Problem

The collapse of the mortgage finance system has left a serious structural problem. The system is now being squeezed at all its vital points.

The federal mortgage agencies are not playing the flow-through role they were. Before the crisis they were aggressive, overleveraged and devoted to expanding home ownership by lending to weaker credits. But  since being taken into federal “conservatorship” in 2008, they have deleveraged, become more cautious and been made to run a tight ship.

Under conservatorship (which lasts indefinitely) the agencies have had to rebuild their balance sheets, repay the government the $187 billion of bailout funds they received, and distribute all free cash flow to the government, not to investors. In the process, the agencies have cut back their purchases and securitisation of mortgages from pre-crisis levels; in 2013 these were 13% less than the year before,  and down a little more in the first half of 2014.

Non-agency credit sources have disappeared; the agencies now guarantee nine of ten US residential mortgages.

Banks, addressing their own balance sheet problems, have pulled back on loans to borrowers with lower credit scores. But the pace of the pull-back has accelerated. In the first half of 2014, total mortgage lending declined by 53% from 2013 levels, according to Inside Mortgage Finance, and non-bank mortgage lenders among the top 30 originators accounted for 23% of the market, up from 11% in 2012.

Partly this decline is because the largest US mortgage lending banks (Wells Fargo, Bank of America, JP Morgan and Citigroup) are wary of doing business with the federal agencies. The banks have complained of the massive government lawsuits over technical breaches and failures that occurred long after the loans were made, but felt they had to settle rather than face the risk of losing at trial. 

Fed chair Janet Yellen said in June that this concern by the banks has substantially dampened the recovery of the US housing market. Sales of existing homes in July  were 4% below the 5.4 million-unit level of July 2013 and sales to first-time buyers remain historically low, according the National Association of Realtors. House sales are still about 25% below what they were in 2006.

Restoring housing activity is a key, but still missing, component of the broad economic recovery that the government says it is seeking.  A drying up of mortgage credit has continued to be a drag on the housing market.  It may get worse before it gets better.

In August, John Stumpf and Jamie Dimon, chief executives of Wells Fargo and JP Morgan, respectively, warned (separately) that unless the government offered a “safe harbour” from such litigation, based on clearly defined rules for handling the business, they would hold back from making new loans to the millions of people with lesser credit scores that are looking for mortgages.

Resuscitate the private sector

The Treasury tried to get out in front of the housing finance problem in February 2011 when it announced a plan to wind down the housing finance agencies over time to be replaced by private capital that would be appropriately disciplined by Dodd-Frank’s enhanced regulatory umbrella.

The Treasury has done little since then to support the plan or to explain how it might happen. A bi-partisan effort in the Senate was made this year to bring a bill to restructure the housing agencies. This much anticipated bill, which endeavored to get rid of the federal agencies but preserve the government guarantee of mortgage loans and a commitment to “affordable housing” ,disappointed just about everyone when it was revealed in March, and is now permanently stalled in committee.  

The best hope for restoring mortgage finance activity is to rethink ways to get the private, non-government guaranteed portion of structured finance market restarted. Surely a new set of more conservative and transparent mortgage backed securities that would appeal to institutional investors (especially in this low interest rate environment) can be created, but it will take a combined effort of the banking industry, credit rating firms and public regulators to make it work. They will have to cooperate to establish a new set of standards for what goes into the securities, how they are to be analysed and rated, and how regulatory safe harbour rules will work to enable the issues to be underwritten.

This is really a job for old-fashioned investment bankers to take on, one that requires a lengthy series of patient negotiations with the various parties involved to produce a workable prototype for a whole new market to develop. Sigmund Warburg and his partners created the first Eurobond through such a process in 1963.

A similar effort is now essential to redesign the global structured finance market.

From Financial News, 8 Sept., 2014

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