Saturday, November 29, 2008

Cause of the credit crunch and how to fix it - I think.

I wonder if the investment banks could actually save the day by creating some new securities. That's (partly) what created the mess, so it'd be only right...
I just read that securitizing residential & commercial mortgages, car loans, credit cards, and other consumer debt dropped 75% from last year.

That number seems like the best evidence of the credit crunch I could find. That's trillions less available money to be borrowed The people who would have bought those securities seem not to have found a place to put that money yet.
For one thing, a lot of them were bought by banks,pensions, or insurance companies for reserves . Since most of those securities were AA/AAA, they were bought by people who needed something conservative. Most of that money seems to be going to treasury bonds or AA commercial paper (30-90 day) stuff.

The banks continue to need reserves since their reserves were depleted. They're not loaning out their excess cash.
The insurance companies and pension funds just want to wait things out. They're filling their reserves or underfundings too. And they don't want to fill up with the same stuff that broke them (even though a lot of the structured securities are very secure and have very low losses).

I actually think the solution might come from structured finance. Chopping up and repackaging the consumer debt into bonds has three main parts.
Arbitrage (create bonds that are worth more than the collateral). That only works when the yields you have to pay out for the resulting bonds are low compared to the yields paid on the collateral (on average). Without arbitrage, no one will create the new securities. Extremely high yields on these securitizations (if they sell at all) are the big reason they've dried up.

Liquidity (chicken/egg with the arbitrage. You pay lower yields on the bonds partly because they're more liquid than the collateral. Also more secure, and maybe more desirable for regulatory reasons.)

Security: The bonds have credit enhancement structures. The simplest example is a "B" pool of collateral that is drawn on if there are defaults on any of the main A pool. What's left of the B pool is the "residual." Fancier structures also throw off excess interest and such to the B pool (or draw on excess interest from the B pool).

SO: Liquidity and Security are two of the HUGE objectives of structured finance. Since the banks, credit card companies and such have all this collateral building up and blocking their ability to do business, they will sell it for cheap (relatively), which normally would create a big arbitrage opportunity. All the investment banks have to do is come up with a new credit enhancement structure that isn't too expensive and that their customers will have some faith in.

Probably that's where the Treasury could actually do some good. They could make credible guarantees on bonds that (even without the guarantee) would be strong enough to get a legitimate AAA from overfunding, diversification, or some other means. (Not credit default swaps, probably).

So far, the treasury has guaranteed existing structured bonds. The TARP collateral purchases.
I think they should guarantee new bonds instead. That is what's needed to get the credit markets going again.
And it would be cheap. They'd be guaranteeing new bonds with new standards. Good enough to earn a AAA now (a lot harder than a year ago).

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