Securitization describes a form of financing in which a
bank or other lender wraps up a package
of assets--car loans, for example, or mortgages or credit card receivables--and issues securities
against that package. (The securities are traded as bonds; hence the "securitizing.") Investors
such as money market funds and pension plans buy those securities. That provides cash that
lenders can recycle in another round of car loans, mortgages and credit card charges.
Such financial alchemy keeps America's buy-now-pay-later consumers swimming in credit. It
helps explain why, despite two years of layoffs and 401(k) disasters, people are buying cars and
houses at a furious pace. Securitized lending has its antecedents in Ginnie Mae, created in 1968
to package home mortgages. In the past decade it took off, having climbed to a staggering total of
$6 trillion, most of it to finance consumers. For comparison, all household debt in the U.S. totals
$8.3 trillion.
With the right attention to detail, the lender securitizing its book of car loans or credit card
balances gets both the stream of income from assets (that is, the consumer loans) and virtually
all the liabilities (the securities issued to investors) off its balance sheet. The investors are thrilled
with the arrangement. They can look to a predictable stream of consumer loan repayments to
back up the debt securities they have purchased; if the lender gets into trouble, they get first dibs
on that cash stream. For lenders, keeping these assets and liabilities buried in footnotes rather
than on the balance sheet is vital. Consolidate them and some lenders would look dangerously
leveraged.
Securitization is a big business for some finance companies. Citigroup has $204 billion of asset-backed debt outstanding, J.P. Morgan Chase $75 billion. Credit-card issuer MBNA has $73 billion--compared to on-balance-sheet assets of $45.4 billion and a comparative sliver of
shareholders' equity, $7.8 billion. Ford Motor Credit was able to save
several hundred million dollars over the past 18 months using off-balance-sheet financing. GMAC
is another big player. Without securitization you might not see as many 0% car loans.
What could stop this happy arrangement? Enron-wary reformers are agitating to have some or all
of the $6 trillion mess consolidated on the balance sheets of lenders. Some lenders are fighting this
tooth and nail. It would force a lot of them to raise the price of consumer credit or drastically cut
back on it. It could, if you believe the people lobbying against the reform proposal, stop the
economic recovery in its tracks.
Investors are already hesitant to provide all the credit this economy needs, says bond manager
Paul McCulley, who has 5% of the Pimco Short-Term Fund parked in asset-backed securities.
"A period of rising risk aversion is the worst time to tighten the rules," he says. A worst-case
outcome of the accounting change: a credit meltdown, with "everyone trying to sell at the same
time."
Andrew Smithers, chairman of Smithers &Co., economic consultants in London, warns, "If they
have to put the debt back on their balance sheets, it will violate the debt covenants of leading
banks." If banks' balance sheets lard up with the extra debt, "banks will have less propensity to
lend in similar size and pricing. It will diminish the return on equity," says Michael Malter, head of
asset-backed securities at J.P. Morgan Chase.
Forbes Magazine – August 12, 2002
Notes:
Initial Transaction:
1. Firm A issues $100,000 in long term debt
2. This generates $100,000 in loans (Accounts Receivable)
3. With an allowance for non-recoverable loans of 10%, this creates a stream of cash
payments of $90,000 + net interest of say 5% for a net recovery of 95%
4. This stream of cash is “securitized” and sold to Firm B (or marketed to
individuals) much like a bond that provides a guaranteed stream of interest and
debt repayment.
5. If the present value of the stream of cash is $90,000, this generates a second
source of income to Firm A.
6. Firm A can now enter into a second round of accounts receivable securitization.
This has the same effect as the factional banking system where banks generate loans
based on holding only a portion of deposits in reserves.
The same formula applies:
In the banking system, the loans multiplier is the reciprocal of the reserve ratio.
In the securitized cashflow example, the loan multiplier is governed by the allowance for
bad debt and the net present value of the loan repayment cashflow.
Therefore, the initial long-term borrowing of $100,000 can generate loans totalling:
$100,000 x 1/.1 = $1,000,000 |
