The Economist's 2009 Consensus Lunacy Tour


If you're like me, the phrase "18-Page Special Report in The Economist" is just slightly less chilling than "positive result on your biopsy." Nevertheless, if you're interested (still?) in the Great Credit Unwind, take a fistful of Dramamines, zoom on up to High International Neoliberal Orbit — where the people on the ground look like ants and you can pretend you're in smart company because they spell "securitize" with an ess rather than a zed — and enjoy this investigation of the "shadow banking industry." The nameless Author posits that the massive reduction in lending has come mostly from capital market lenders, not banks:

The really precipitous contraction in credit has come from non-bank lenders–the array of money-market funds, hedge funds, former investment banks, exchange-traded funds and the like that is sometimes called the "shadow banking system". These capital-market lenders are especially important in America–banks have supplied only 20% of total net lending in the country since 1993…but they play an increasingly important role elsewhere too.

In particular, non-bank lenders have been buyers of securitised products, loans that are bundled together into securities and sold on to investors. An estimated $8.7 trillion of assets worldwide are funded by securitisation. More than half of the credit cards and student loans originated in America in 2007 were securitised. Many European banks used securitisation to fund the expansion of their loan books in the boom.

The size of the contraction is daunting: A study by a consultancy suggests capital market lending contracted by $950 billion in the first three quarters of 2008, while banks' net lending in all of 2007 was only $850 billion. This seems to me a solution in search of a problem. Having finally squeezed the last plugged nickel out of the last deadbeat, the universe of hot-potato lending is getting smaller, as it should. Banks have been burned in the process, but hedge funds and investment banks have been incinerated, and if anything's clear it is that there were too many of those folks to begin with.

But beware. The Economist's tricky pal "Emerging Consensus" shows up later to explain how the state can solve the moral hazard in which "originators had less incentive to care about the quality of the business they wrote because they thought the risks were someone else's problem. By making issuers take the first loss on any defaults in the securitised pool of assets (and stipulating that they cannot hedge that exposure away), regulators will give them a clear incentive to think about asset quality."

You need a regulator to tell you that? If you're selling me a cluster of questionable debts, and we have both learned that an echo chamber of insurance policies against our mutual defaults will not in fact make us both richer if the original debts go bad, the lesson has already been learned, and you and I will make our arrangements accordingly (and our contract will specify either your taking the first loss, my getting a much higher return, or liberal use of meat hooks and power tools to encourage the debtors to keep paying). I'm not sure the lesson was that tough to begin with. But here's a bet I would take: Regulation that tries to assign responsibility in this way, or forbids the parties from hedging their exposure, will give rise to wider use of even more cockamamie derivative products within a decade.

Toward the end the Author does address the problem of solving a problem that's already solved, and throws in a weird but interesting operational question:

Government intervention in America and elsewhere to ease homeowners' repayment difficulties will shake investor confidence in future income streams. The prospect of court-ordered reductions in mortgage principal-or "cramdowns"-is particularly alarming. According to Anna Pinedo of Morrison & Foerster, a law firm, there is also fogginess around the tax status of securitisation trusts, the entities into which securitised assets are placed. For tax purposes, they are structured as "pass-through" entities, meaning that the servicing firms that administer mortgage payments have little scope to modify the terms of loans if borrowers get into difficulty. With servicers now given greater leeway to intervene, questions about how far they can go without compromising trusts' tax status hang over the industry.

But the real whopper comes at the end, with a science fiction vision of a pangalactic FDIC which will provide "institutionalised guarantees for buyers of securitised assets to sit alongside guarantees for retail depositors." 

I can't think of many ideas worse than a government-backed, or even government-implied, guarantee of securities whose whole point is that they offer rock-star-commando levels of risk. Whole article, with charts.