As we pass the anniversary of the Lehman meltdown, policymakers and the media continue to mark the event with a repetition, yet again, of the question, “why didn’t economists see this coming?” Beyond the mere point – made by many economists in response to Paul Krugman’s recent New York Times Magazine – that there are many different types of economists, a vast minority of which specialize in the combination of financial markets and macroeconomics necessary to make such an observation and even fewer who understood securitization prior to the crisis (a set that excludes Mr. Krugman), is that those few who did see it coming also know how it ends.
You see, rather than just indicated by macroeconomic or financial market imbalances, this crisis is really just a boring rerun of crises repeated on a lesser scale over the past several decades of securitization market development. Recall the subprime automobile securitization crisis of the mid-1990s, the subprime credit card crisis of the mid-late 1990s, the high-LTV mortgage crisis of the late 1990s, the subprime home equity crisis of the early 2000s, and the aircraft lease and 12b1 fee securitization crises of the early-mid 2000s. All involved new untested asset classes whose performance could not be adequately predicted by investors. All involved warehouse funding that evaporated quickly when the ability to fund long-term through securitization markets was removed. And all resulted in a substantial decline in securitization of the collateral asset class after the crisis.
That decline is what is before us today. While the economy could continue to grow more or less unhindered in the face of a reduction in subprime automobile loans, subprime credit cards, niche high-LTV mortgage loans, or second-lien home equity loans, each crisis was economically more disruptive than the last. Eventually, reasoning that each successive crisis still had not had a significant macroeconomic effect, regulators and markets scaled the industry even larger until we finally did have a macroeconomic impact – called a recession – that resulted from the necessary credit disruption.
So now the question is how do we grow without subprime and pay-option first lien mortgages? Moreover, given the disruption to first-lien mortgage securitization markets overall, how do we grow without securitization? This is not an academic question. At its peak prior to the crisis, securitization (including that from the GSEs) was funding roughly $9 trillion of consumer lending. Comparing that with insured deposits of roughly $6 trillion, it is easy to see that securitized funding is crucial to the banking industry and that expecting to grow with roughly a third of pre-crisis bank funding is not going to be easy.
So while we can sit and continue to wonder why the crisis happened and why nobody noticed, it makes more sense to look at parallels from similar crises. Using those observations, the asset class of (at least) subprime and pay-option mortgage lending will be a mere fraction of its pre-crisis importance, not because of government restrictions but because of the natural limits of investor demand. Of course, government policy can skew the outcome, either artificially suppressing the sector to the detriment of economic growth or artificially supporting the sector through subsidies that will encourage the sector to re-bubble and pop more violently than recently witnessed in the name of homeownership.
I would propose a middle ground: support continued development of sound securitizations while allowing fringe applications to experience the throes of development. Subprime first-lien and pay-option loan securitization was uneconomic, and needs to retreat before occupying its appropriate (small) niche in the mortgage world. The Alt-A and prime loan categories beg for regulatory classification, and mortgage lending to those segments begs for regulation to determine conformity with those classifications to avoid the category arbitrage that resulted in “stealth Alt-A” and “stealth prime” infiltrating the core of the securitization world.
Securitization has contributed significantly to capital deepening in financial markets and concomitant economic growth. It is not necessarily wise to throw that out because of recent market disruptions. Nonetheless, securitization markets need to be protected from misuse in order to provide economic benefits. Hence, a better way forward might be to protect the integrity of securitization markets, while realistically seeing their limitations. So while two years into the crisis some remain curious about the “why,” it is more important to focus on the “lessons learned.”
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: [email protected]; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.