How securitization really works
In the winter of 1997, musician David Bowie issued $55 million worth of bonds backed by royalty revenue from 287 songs he had written and recorded before 1990. The bonds had a 10-year maturity, a Moody’s A3 rating, and a 7.9% interest rate (at the time, the 10-year Treasury yield was around 6.5%, so the spread was relatively modest). “Bowie bonds” were no accident: by the late 1990s, the U.S. financial system had evolved to the point where virtually any payment stream could be securitized.
The success of U.S. securitization – as an alternative to bank finance – is a key factor behind the current push of euro-area authorities to increase securitization. The other key driver is the concern in Europe that many borrowers will remain starved for finance. Because finance is predominantly bank based in Europe – and banks faced heightened capital requirements – governments and potential borrowers are anxious to shift at least some financing into capital markets (including bonds and equities). European policymakers are fond of noting that European finance is 80 percent bank based and 20 percent market based, while the U.S. pattern is the reverse. (This may be a slight exaggeration: recent World Bank numbers for the euro area are closer to 60/40, while the U.S. pattern is indeed about 20/80.)
Yet, emulating American securitization may require doing something most Europeans don’t realize. It probably means providing government guarantees at a scale that people currently do not envision. The reluctance of the financially healthiest euro-area countries to forge a euro-area banking union suggests that they also will resist large collective guarantees for a securitization market.
To see what we mean, we can look at a few numbers regarding U.S. securitization. According to the Federal Reserve’s flow of funds statistics (the Z.1 release), total securitization stood at $9,360.4 billion as of end-March 2014, the latest reading (see chart below). But government-backed securitizations – these are mortgages, student loans and the like – accounted for $7,721 billion of this total (shaded in blue in the chart). That is, only 18% of U.S. securitization – primarily auto loans and credit card debt – are free from government guarantees! Even at the peak of private-sector securitization in mid-2007 – before the financial crisis grew intense – the government-backed share exceeded 60%.
Securitized Liabilities in the United States (U.S. Dollars in Trillions)
Source: FRB Z.1 (flow of funds) and authors’ calculations. Government-backed securities include GSE credit market liabilities, agency- and GSE-backed mortgage pools, and securities of budget agencies. Other securitizations include the liabilities of ABS issuers and open market paper issued by chartered depositories.
To put these numbers into perspective, we can look at another part of the U.S. financial system: insured bank deposits. You may be surprised to learn that (again, as of end-March 2014) only $6,094 billion out of $9,922 billion in bank deposits are insured. That is, 61% of bank deposits are government backed (see chart below) versus 82% of securitizations.
Share of Deposits in Domestic U.S. Bank Offices Insured by FDIC
Source: FDIC Quarterly Banking Profile (balance sheet) time series.
We believe that U.S. government backing of securitizations can (and should) be scaled back to allow for greater private participation in the mortgage market. Indeed, and in contrast to current U.S. policy, we generally share the view that the U.S. government-sponsored enterprises (GSEs) should be wound down within a few years.
Nevertheless, it also seems difficult to jumpstart a large-scale securitization market in Europe without sizable public support. To be sure, the federal backstop for the U.S. GSEs became explicit only when these organizations faced a run on their liabilities in the summer of 2008. Previously, it was the credibility of the implicit backing from the U.S. federal government that allowed the GSEs to borrow at low cost despite massive leverage. Yet, achieving such credibility without explicit agreement is more difficult in the euro area precisely because core euro-area governments wish to limit the financing burdens they share with the governments in the financially fragile periphery.
The bottom line: If the euro area wishes to get securitization going in a big way, it will still need more of the mutual insurance among nations that has been so difficult to achieve. That doesn’t seem to be in the cards for now.