David R. Evanson
Present Value: Essays on Community Banking, Winter, 2005
The capital markets are like a giant sphere: A push on one side is surely felt elsewhere, often with unintended and sometimes undesirable consequences.
By analogy, consider the equity markets of the late 1980s to the late 1990s. Regulatory attempts to narrow trading spreads on equities — in the name of investor protection — were indeed effective. The process was rendered complete in April 2001, when securities on all exchanges and stock markets were required to trade in decimals. As a result, many securities were quoted in increments below 1/16th of a dollar — or a “teeny” — and trading costs for investors were markedly reduced.
On the other side of the sphere, consequences were at work. The regulatory-enforced reduction of trading profits drove some securities firms out of business. More fundamentally important, however, was the fact that many securities firms stopped making markets where trading was thin. And if liquidity and access to capital were not cut off for smaller enterprises, they were markedly atrophied.
Liquidity for, and access to, smaller companies carries a price: larger trading spreads. Their removal did more than lower trading costs; it removed opportunity. It is within this framework that securitization is examined.
Is the wholesale transfer of assets from bank balance sheets to the credit markets a net-positive or net-negative event? The answer is that securitization has had significant effects in the banking sector at large. None of these effects appear to be negative, although they are fundamental and far-reaching for banks at every strata, from money center banks to superregional, regional and community banks. Among banks in the upper echelon, securitization has changed bank balance sheets and reduced risk. At the regional and community level, securitization has focused banks away from consumer mortgage lending and toward commercial real estate lending. Because of this, risk may be increasingly concentrated for smaller regional and community banks, since their real estate lending is geographically concentrated.
In many ways, the evolution and revolution wrought by securitization are the result of a perfect storm. The elements of this storm consisted of the worst crisis in banking since the Great Depression; a rise in information technology, which enhanced the ability to issue a greater volume of securities; and a rise of information, which provided investors transparency with respect to these securities.
THE IMPACT OF INFORMATION TECHNOLOGY
Andrew Grove, a co-founder of Intel Corporation, had polished many pearls of wisdom during his storied career, but one of his favorites was: “What can be done, will be done.” Thus, if a process could go digital, it would go digital. This idea had a notable impact on the art and science of asset securitization. In the broadest sense, information technology enabled the pooling of many different types of assets that lenders had never considered before. These included auto loans, sub-prime loans, business loans, credit card receivables, sub-prime auto loans, and even royalty streams and structured settlements.
While “big iron” information technology allowed banks to select among a pool of loans on their books, the process was initially conducted by technologists, not bankers, and the end product was frequently delivered on “green bar.” Even inside the large banking organizations in the late 1970s and early 1980s, only highly skilled “MIS professionals” could access and extract usable information from the data warehouse. Moreover, the iterative nature of asset selection became awkward with the shuttling of information between bankers, technicians and ultimately the investment bankers, who structured deals and sold them to institutional investors. Securitization was retarded not because banks were lacking a pool of loans, but because the tools and processes at the time were awkward.
Information technology overcame another challenge on the issuer side: tracking. Within any pool of cash flows, a myriad of irregularities can and do occur. These include late payments, partial payments, defaults, prepayments, partial prepayments, and payments drawn on nonsufficient funds, to name just a few. However, the technology to track these irregularities and determine their effects on a pool of loans was not perfected at the dawn of securitization, and so the twin challenges of selection and tracking extracted a cost. Pricing reflected the fact that investors bore risks associated with these uncertainties and imperfections.
By enabling static pool analysis, information technology certainly helped issuers. But when information on loan pools became accessible to investors via a true relational database, rather than through the manipulation of spreadsheets, the landscape changed forever. It was as if suddenly there was a spotlight on pools of loans as well as other cash flows, where before there was only darkness.
The new transparency didn’t just create demand for asset-backed securities, it also unlocked it. Now, issuers had a story to tell about their assets, backed up with the analysis to prove it. The only comparable phenomenon in recent financial history was that of noninvestment-grade bonds. By demonstrating to investors that defaults on so-called junk debt were palpable and manageable, Drexel Burnham trader Michael Milken unleashed a torrent of demand for junk debt and in the processed altered the landscape forever.
FIG XXX shows the growth in mortgage-backed securities over the last five years. In large measure, this growth was predicated on investor demand.
Source: Inside Mortgage Finance
The growth in both mortgage-backed and asset-backed securities presents a challenge to banks that may, in a conceptual framework, alter or undermine their primacy as financial intermediaries for businesses and consumers. With more and more debt funded by the bond and fixed-income markets, are banks losing share? If so, can the trend be reversed? Should the trend be reversed?
FIG #XXX depicts some of the challenges and opportunities facing banks.
Bank Market Share & Growth in Nonfinancial Sector Debt
Source: Federal Deposit Insurance Corporation
Banks that once held one-third of all debt to businesses, governments and households now hold something less than 20 percent. The decline of the banks’ market share coincides with the rise of information technologies. What started as the pooling of loans by government-sponsored entities, such as Fannie Mae and Freddie Mac, has given way to an entirely new way to fund loans, which in the aggregate has fundamentally changed bank balance sheets.
This decline is all the more striking considering that the overall credit pie in the United States has increased dramatically during the last 20 years. Following World War II through the 1980s, nonfinancial borrowing grew at about the same rate as Gross Domestic Product. The ratio of the two was so stable that economists accepted it as a fact associated with the growth of an industrial economy. However, as FIG #XX indicates, the ratio began to change dramatically as the 1970s came to a close. Analyses of market shares by various intermediaries show that commercial banks did not appear to participate in this expansion.
Source: Federal Deposit Insurance Corporation
Where banks lost ground, in particular, was in the arena of home mortgages. The same technologies that gave rise to improvements in securitization were also having an impact on the consumer-mortgage business. These technologies “commoditized” the home mortgage business.
Once loan pricing became the primary driver, the mortgage business lost its luster. For almost all but the largest institutions, the business was no longer sufficiently attractive to merit the bank’s best efforts. Community banks simply could not compete. Once the underwriting was written to the standards of government agencies and the standards of a growing number of conduits established by money center and super regional banks, the community banks lost their “information advantage.” Whatever these institutions knew about these borrowers personally was irrelevant.
CHART TITLE: Holders of Mortgage Debt by Institution Type
Source: Federal Deposit Insurance Corporation
Today, government-sponsored entities and related federal-mortgage pools now fund close to half of home mortgage debt, up from just 10 percent in 1983. Much of this growth has come at the expense of saving institutions, which have seen their share decline from 50 percent in the early 1980s to about 13 percent. Bank market share has dropped from 20 percent to 18 percent.
To some degree, the Internet finished off the commoditization of home mortgages that had been initially brought about by securitization. When the process became digitized — from initial customer contact to sale in the credit markets — the opportunities for a bank to add value to the process were even further diminished.
The same trend has occurred in consumer credit, although the market arrived here by a different route. Initially, from the 1950s through the 1970s, commercial credit shifted away from retail and manufacturing firms to depositories and finance companies. The conferring and management of credit became for all but the largest manufacturers and retailers the kind of “non-core” activity that was better off outsourced on a private label or direct referral basis. Today, 97 percent of consumer credit is provided on an intermediated basis. Bank market share, once more than half of the total, is now just one-third of the market; securitized pools now fund another third of consumer credit, while finance companies, credit unions, and savings institutions account for the remainder.
NEW TITLE: Holders of Consumer Debt by Institution Type
Source: Federal Deposit Insurance Corporation
Taken in total, the conclusion is inescapable: When looking at balance sheets, bank market share is lower than it was 20 years ago. This reduction in share has come about primarily because of the increasing use of, and demands for, securitized pools of assets. It suggests that that the current trends may continue unabated.
When the question is posed, “What has securitization wrought?” the answer becomes, in part, that it has introduced a host of new competitors to banks. It has done this by establishing a funding mode that challenges the primacy of banks and depositories as the source of intermediated credit. It has also bifurcated the credit markets in ways that have reduced risks. Regarding this competition, the threats that bankers face today would be all but unimaginable to the bankers of 50 years ago.
THE NEW COMPETITION
First, government-sponsored agencies and federally related mortgage pools have taken a significant share of the home mortgage market. But this change has been positive. After the experience of the last 30 years, it would be hard to argue against the notion that funding long-term mortgages with demand deposits is a dangerous proposition. In this regard, mortgage securitization has removed this risk from bank balance sheets and placed it in the capital markets, where investors with longer investment horizons -– such as pension fund investors -– now hold mortgage-backed assets.
A second, less obvious form of competition now comes from the mutual fund industry. Here again, the rise of information technology — associated not with issuance but with transparency and static pool analysis — created important new changes in how asset-backed securities were received by the market. Rather than an oddity or a one-off investment opportunity, securitized home loans, business loans, or credit card receivables entered the status of an “asset class” once they could be analyzed by fiduciaries.
This elevation in status meant that there were marketing opportunities for mutual fund complexes. Specifically, investor portfolios could achieve a new level of diversification with asset-backed securities. This fit in well with the trend among individual investors over the last 25 years of holding fewer securities directly and more securities indirectly. Today we find the mutual fund industry holding assets that not long ago would have been on bank balance sheets.
With household debt -– mortgages and consumer credit — getting funded through securitization in the capital markets, banks are increasingly funding commercial mortgages. While consumer mortgages conform to standardization relatively easily, business mortgages do not. Therefore, an important outcome of securitization is that it has caused banks to focus on creating assets where their infrastructure of loan creation and monitoring adds significant value.
NEW TITLE: Business Mortgages Held by Institution Type
Source: Federal Deposit Insurance Corporation
Competitive and market forces are fostering a renewed and perhaps necessary focus on commercial real estate lending, particularly by community and regional banks. But there’s potential for significant risk. Community banks, by their very nature, are geographically focused. Thus, a buildup of commercial real estate assets on their balance sheets exposes them to regional economic shocks or recessions.
Perhaps the best example of how the variance in regional economies can affect banks comes from the experience of the energy-producing states of the Southwest during the mid to late 1980s. Rising oil prices produced a vibrant and robust regional economy. Texans, used to talking in “units,” which in regional financial vernacular refers to $100 million, found themselves talking about scores of units. All the trappings of a growing economy — rising incomes, employment and real estate values — were attendant in this regional oil boom.
But when oil prices fell from its 1985 high of $30 a barrel to something just north of $10 in 1986, it was as if the first domino had been knocked over. Incomes, in terms of wages and net profits, dropped. Defaults increased. Real estate values plummeted. The financiers of the regional economy — in many instances luckless and hapless S&Ls — were hit hard. Insolvent institutions took their place alongside empty office buildings, unfinished real estate projects, and dormant oil rigs.
So, what has securitization wrought? Hopefully, a generation of bankers and regulators are more cognizant of the risks that banks face and more willing to face them proactively. The fear is that the pain of taxpayers, bankers, bank employees, depositors and borrowers may already be forgotten and that a repeat, though not on the same scale of the S&L crisis, could be in the offing.
What else has securitization wrought? Perhaps a redefinition of banking. Not in the popular sense, but in the technical sense. In the same way that for consumers, a five-year-old laptop computer looks very similar to a new one, for the technicians, engineers, manufacturers, marketers and salespeople, it’s a whole new product.
While the rise of securitization has challenged banks and driven assets from bank balance sheets, it has also, perhaps, sharpened the focus of banks. Going back to Andrew Grove’s belief that “what can be done, will be done,” the application of securitization technology enabled the unbundling of credit services.
REDEFINING THEIR ROLES
This unbundling has led to a redefinition that has been organic in nature: Banks have assumed a leadership position in certain aspects of credit provision that appear best-suited to their natural strengths. At the same time, they’ve jettisoned those that seem to be inconsistent with what a bank balance sheet can withstand. The results are the rise of business mortgage lending and the decline in the number and value of home mortgage and consumer loan assets on bank balance sheets.
While unbundling has led to a decline of loans on bank balance sheets, it may have increased a bank’s essential role in providing credit services. No other players on the intermediation food chain can match a bank’s ability to allocate and monitor credit. There are several reasons for this.
First, even the lengthiest of bank loans -– outside of mortgages -– are relatively short-term in nature. By sheer numbers alone, banks are constantly reevaluating the creditworthiness of businesses.
Second, the demand deposit relationship that a bank has with its borrowers gives it inexpensive and unparalleled access to a borrower’s financial behavior, health and well-being. This access and insight is often bolstered by other aspects of the relationship –- such as cash management — that provide a detailed picture of the borrower’s health and behavior. With this specialized insight might come superior knowledge of the value and alternative uses for collateral that backs the loan.
These two factors enable banks to originate and monitor credit much more efficiently and inexpensively than the other sources of capital that now fund loans. Said differently, the infrastructure that banks provide in the provision of credit would have to be built and installed in the absence of depository institutions.
Testimony to the evolving yet undiminished roles of banks can be seen by looking at bank income statements as carefully as balance sheets. Macroeconomic data collected by various government agencies presents a number of challenges in understanding bank profitability vis-à-vis their competitors. However, an analysis by the FDIC of a pool of publicly traded finance companies, which includes banks and their competitors, provides a proxy for the standing of banks since the shift of assets off of their balance sheets took hold.
FIG XX? makes clear that banks have maintained their share of profitability despite the onslaught of changes they have faced. In fact, it appears that bank profitability — relative to that of other financial services firms — has remained at approximately the same level as it was in 1984, prior to the rise of information technology that led to the unbundling of credit services. Finally, the data seems to suggest that profitability could be tied more closely to the volume of intermediation services rather than the volume of assets held on a balance sheet.
Ultimately, securitization has wrought a new era in banking. And although it’s virtually invisible to retail customers, for bankers themselves, it’s a force for fundamental change in every aspect of the profession.