January 8, 2008 / 2:02 AM / 12 years ago

Shadow banking system down, credit out: James Saft

LONDON (Reuters) - Securitization, a key source of funding for the global economy, is crippled and no one knows when it will recover or what it will look like when it does.

Sometimes called the “shadow banking system,” because it rivals banks in importance as a source of credit, the business of bundling together debt and other assets for sale as complex securities and vehicles was cut off at the knees during 2007’s credit crisis.

And because banks need to buttress their own fragile balance sheets, the health of the securitization market will be important not just because it will govern companies’ and consumers’ ability to borrow, but as a driver of economic growth and the price of assets from stocks to real estate.

Securitization has been hit by a terrible combination. Investors no longer trust the value of ratings from third parties such as Moody’s and Standard & Poor’s, while at the same time losses first emanating from the U.S. subprime market have more or less destroyed one of the main buyers, off-balance sheet vehicles such as SIVs.

Structured investment vehicles, which borrow short term to buy higher yielding longer term debt, were typically set up by banks as vehicles to buy securitized assets.

“The problem with the shadow system doesn’t get fixed quickly at all,” said Emanuele Ravano, head of portfolio management in bond giant Pimco’s London office.

“We will live with a year where lending standards will be much tighter. The banks are not going to be able to do much of the lending.”

And indeed the hobbling of the securitization market leaves a gaping hole.

Whereas nearly $1.2 trillion of asset backed securities were issued in 2006 in the U.S. and Europe, according to Thomson Financial data, just over $90 billion was done in the fourth quarter of 2007, a stunning slowdown.

Barclays Capital is forecasting a 43 percent drop in European securitization and a 39 percent fall in U.S. issuance this year.

Pimco’s Ravano points out that in Europe, the three major buyers of securitized debt were SIVs, which he calls “now prehistoric”; banks, which have balance sheet woes; and mutual funds, which have seen a huge increase in redemptions and are unlikely to have much firepower any time soon.


So what does this mean for financial markets and economic growth?

In short, it is going to make an already bad situation worse. Securitization was not just a source of borrowing, it arguably allowed prices across a range of assets to inflate as borrowers and investors took advantage of low rates and easy terms to increase the size, and risk, of their bets.

Now, credit will be more expensive for those who get it, will tend to be offered to those who need it less, and the amount of equity borrowers put up will have to be higher. The self-perpetuating cycle that drove prices up will drive prices down.

“Securitization markets, as opposed to central banks, have been the major source of liquidity,” said Lena Komileva, economist at Tullett Prebon in London.

“The danger is that the credit crunch ... will become even better entrenched in 2008.

“You can’t have asset prices at historical levels, i.e. where equities are now, against a backdrop of lending constraints and deteriorating economic fundamentals.”

There has been a strong correlation between the growth of securitization and the growth of overall money supply in the economy, according to Meyrick Chapman, fixed income strategist at UBS in London. With securitization down, it is reasonable to expect money supply to fall as well.

“If you sink broad money, you get a recession,” he said.

It’s also important not to look at the securitization and banking funding crunch in isolation. They are part of a process of inflated assets deflating which started with American subprime lending but did not stop there and will continue to spread.

“Collateral quality looks set to deteriorate on a broader scale,” said Komileva.

“If 2007 was the year of fairly narrowly defined problems in subprime, 2008 is the year that collateral problems spread.”

Moves by central banks to lend against a wider array of capital have helped banks out of their immediate bind, allowing them to finance securitizations that were tough or impossible to sell through such loans. But banks are very unlikely to carry on making new loans with central bank finance.

So how is the mess resolved?

Both Chapman of UBS and Pimco’s Ravano see sovereign wealth funds, which control more than $2 trillion in assets on behalf of state investors, as potential new buyers, but also agree that they are unlikely to ride to the rescue in the near term.

The most likely outcome is that the price of funding will have to rise considerably, and deals will be less complex. The longer it takes, the worse it will be for markets and investors.

The credit crisis will get worse before it gets better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Editing by Ruth Pitchford

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