Ben Chu: Securitisation poisoned the economy. Is it really a sensible idea to revive it?
In 2007, the party stopped. Investors finally realised that they had bought junk
Economic Outlook Exotic structured finance is making a comeback – this time sponsored by governments. In the boom years of the past decade, big banks set up off-balance sheet "Special Purpose Vehicles" to disguise their expansion of lending from regulators and shareholders. The Luxembourg-based European bailout fund, the European Financial Stability Facility, is effectively a Special Purpose Vehicle for eurozone governments – an attempt to keep an extension of national support to troubled eurozone member states hidden from taxpayers. And our own Treasury wants to restart the engine of "securitisation" in order to channel funds to small UK firms and start-up companies who are finding it difficult to get bank loans.
The Treasury plan has been called "credit easing" and details are due to be unveiled in the Chancellor's November statement. The basic idea seems to be for the Government, with the help of investment banks, to make loans to small firms, package together bundles of these loans, and then to sell the bundles to private sector investors.
Those details are probably enough to send a shiver up the spine of anyone who knows the recent history of securitisation. In the past decade, thousands of billions of dollars and euros worth of securities backed by the income streams of bundles of mortgages and loans were churned out by banks in Europe and America. Investors couldn't get enough of these assets, which paid attractive rates of interest and, according to the credit rating agencies, were almost entirely free of risk. The more investors – from pension funds, to provincial banks, to hedge funds – consumed, the more the investment banks manufactured. Global securitisation issuance peaked in 2006 at $4 trillion.
Bank analysts rhapsodised about a new paradigm of lending in which credit risk would be dispersed across the entire economy and held by those most able to bear it. Debt markets were said to be deeper, more liquid and safer than ever before. We were promised a bright future for global growth thanks to this explosion of cheap – and solid – credit.
Well it didn't exactly work out like that. Securitisation turned out to be poison for the global economy. US banks had started filling up the securities with home loans taken out by poor Americans, sometimes without jobs, who had no chance of paying them off. Credit rating agencies, rather than blowing the whistle on this malpractice, had continued to label these toxic securities as AAA rated. Investors, gulled by the stellar ratings, kept on snaffling them up. Then, in 2007, the party stopped. Investors finally realised they had bought junk, began to experience huge losses on their securities, and the market collapsed. As the two charts above show, it has still not recovered.
So is it a good idea for the Government to try to revive this market to help small businesses? The policy has some influential supporters. Adam Posen, of the Bank of England's Monetary Policy Committee, urged the Treasury to go down this road in a speech last month. He pointed out that, for decades, the securitisation of mortgages in the US, supported by large government-sponsored agencies, worked well and that it was only relatively late in the day, when regulation was loosened, that the market ran out of control.
The OECD is also in favour of restarting the securitisation market, which it believes is vital in supporting a global economic recovery. The Paris-based think tank points out that lending standards among European securitisation issuers never collapsed in the same way as in the US. A Standard & Poor's report shows that default rates on American securities from 2007 to 2010 was 7.7 per cent. For EU securities over that period it was just 0.95 per cent. The prices of EU securities fell dramatically in the credit crunch but that, argues the OECD, is because nervous investors stopped trading them, not because they were blowing up with losses.
But even if we accept the argument that it is possible to have "good securitisation", is it feasible that private investors, still traumatised by the experiences of the recent past, will be persuaded to buy them? Some monetary policymakers are sceptical. They point out that securitisation markets "worked" when investors believed, brainlessly, that one mortgage was worth exactly the same as another. Now that (one hopes) they know better, who is likely to invest in a bundle of loans or mortgages without knowing the quality of the individual borrowers? Surely no one is going to put their faith in the judgement of the credit ratings agencies again?
This is not an argument for doing nothing. There is plainly a problem with lending to small businesses. It is clear from Bank of England latest Trends in Lending report from last week that small firms and start-ups – which cannot issue corporate bonds – continue to find it extremely tough to get credit from their banks. But there is a simpler, and less risky, way of fixing this problem than trying to create an securitisation market for small business loans.
The Government controls the Royal Bank of Scotland and Lloyds who, between them, account for around 60 per cent of the small and medium-sized enterprise (SME) market. Why not simply mandate these banks to increase their lending to this sector? The Treasury argues that it would be wrong for the Government to tell banks how to do their job. But by exploring securitisation, the Treasury is already implicitly admitting that those banks are getting it wrong. The embarrassment of admitting that the much-vaunted Project Merlin, which was supposed to boost bank lending to small firms, has failed probably has something to do with the Government's reticence.
So where does this leave us? There are some who argue that if the political will is not there to force the banks to lend to small businesses, then it would be a disgrace to close the door on securitisation while it offers hope of alleviating the credit squeeze on small firms. Despite my reservations about the securitisation model, I find this compelling. We should not make the best the enemy of the good. Yet there is no reason why we should not push for more bank lending for small firms at the same time as supporting attempts to help them through securitisation. Credit where credit's due, should be the guiding star.
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