Friday, November 14, 2008

Bad Debt

    Structural analysis of the US debt markets by M.C. Escher

Since nobody at the US Treasury Department seems to be listening to me, I'll re-iterate what I said yesterday.  Re-animating the system for securitizing consumer debt is not a solution to the problem.  The securitization of consumer debt is the problem.  The system can't be put back together because its fundamentally broken.

Two things have happened.  First, there was a systemic breakdown in the linking of risk and reward.  Securitizing mortgages allowed those who granted the mortgages to pass the risk to someone else via securitization.  Once securitized, the underlying risk of the individual mortgages was lost.  Its not just that investors sucked up securitized mortgages without looking at the underlying risk, its that they sucked them up despite being unable to look at the underlying risk.  That's not supposed to happen.  That it did is evidence the system itself was broken in ways only now coming to light.  The second thing was that global investors and US consumers used the broken system to throw a party.  Because there is no central exchange or clearinghouse for securitized debt, nobody knows the total amount out there.  US Consumers took on too much debt and there was no way to tell.  Had this information been available, alarm bells would have gone off long ago.  Everyone involved is guilty here.  The exchanges, the banks, the investment banks, the mortgage lenders, the consumers, the investors and especially the Fed and the Treasury Department.

OK, so now the system is broken.  What happens next?  The banking crisis will continue for some time.  One of the really bad things banks did during the boom was to securitize their loans and sell them off.  That took the loans off the balance sheet.  They no longer counted against the bank's lending ratio.  But who bought most of the securitized debt?  Other banks.  They bought the debt and put it on the asset side of the balance sheet.  Loans that should have counted against the bank's lending ratio were magically transformed into assets that increased a bank's lending ratio.  It is going to take years to unwind all twists and turns in bank assets.  In the meantime, banks are sensibly avoiding purchases of new securitized debt.  The debt market is thus frozen.  It doesn't matter how much money the Treasury Department throws at the banks, they are not going to turn on the taps again until the debt they already have gets figured out.

That brings up the next problem.  Because the risk/return relationship was disrupted by massive securitization, there is no way to know what the existing securities are worth.  The security is good until someone defaults.  Then its worth nothing.  Or more precisely, partly nothing since thousands of individual loans were combined into the securities.  In a theoretical worst case, you don't know that a batch of securitized mortgages is good until 30 years have passed and all the underlying mortgages are paid off.  In reality, modeling will tell you how good the pool is based on the performance of a small sample.  But the models depend on 20 years of historical performance.  They can't predict what's happening now, and they can't predict what's going to happen as a result.  Think of it this way.  20 years of data on a beach's wave action won't tell you when a tsunami is coming or how bad it will be.

Unfortunately, it gets worse.  Batches of securitized debt should have a consistent risk profile.  They should be just as risky today as tomorrow.  That's not the case anymore.  As US housing prices fall, and economic activity slows down, more and more of the underlying debts will default.  The gobs of securitized US consumer debt are getting riskier each day.  Again, no amount of government guarantees to the banks can change that.  As the crisis gets worse, more and more securitized debt goes bad.  It has now spread from the US housing market to the wider consumer market.  Securitized credit card debt, student loans and car loans are plunging in value.  As I said yesterday, US consumers have borrowed more than they can repay.  A clamp-down on consumer lending is inevitable and rational.  The entire system of creating wealth through selling securitized loans is broken.  The financial markets will have to either find new ways to facilitate debt or return to the pre-derivatives methods used prior to the '90's.  Either way, all the bad securities created in the last 20 years need to be undone, with un-foreseeable consequences.