State-sponsored shadow banking system

You might be forgiven for thinking that the biggest single month ever for securitisation in Europe and Britain was sometime before we all realised that we were in a credit bubble, perhaps sometime like the sunny days of 2006.

In fact, the biggest month ever, by some margin, was December 2008, when more than €212bn euros of securitisations were issued in Europe. One small problem however is that there was almost no demand for them, with only about €8bn in public deals intended to be bought by actual investors wanting to take on actual risk. The rest were “retained” deals, almost always structured so they were eligible for financing by central banks under repo arrangements.

The numbers involved are staggering, with more than €750bn euros of these retained deals having been created in 2008, according to Unicredit Group data. Before the deluge, banks in Europe and Britain pursued risky strategies of either originating and distributing or relying on wholesale funding so they could grow their balance sheets beyond their ability to gather actual deposits from bona fide savers.

When that dispensation fell apart, central banks stepped in as “emergency” sources of funding, with the argument being that the banking system needed liquidity to get it through an unforeseeable storm. Central banks will repo, or finance, securities that meet certain criteria, applying a discount to the face value to protect them but exchanging good old cash for hard-to-sell securities.

That storm is now about 20 months long and what were once emergency measures are now, more or less, the business model for banking. Banks now lend money to homebuyers, businesses and consumers, turn those loans into securities, park the security with a friendly central bank and get cash back, thus allowing them to effectively take on more risk and continue lending despite balance sheet pressure.

This suits central banks, especially the ECB, as it keeps credit flowing and arguably supports asset valuations that would otherwise crush bank balance sheets and result in far more banking failures. But like what came before, it is an inherently unstable arrangement, however convenient or useful. “The structure-to-repo model is not sustainable. Repo-financing will be limited in 2009, or at least will not experience the same growth of 2008,” said James Zanesi, an analyst at Unicredit Group in Munich.

Who bears the risk, who holds the bag?
This strategy, which amounts to lending into a deteriorating collateral environment, is by definition riskier for the banks than originating and selling it on. After all, mortgage loans in Britain, where prices may fall another 15-20 percent and where unemployment is rising rapidly is probably not the world’s best risk right about now.

Bank investors will bear this risk, and you only need to look at the equity prices of European banks to see what the market thinks of it. It is also possible that people above equity holders in the capital structure could end up being hurt, though market orthodoxy now is that to hit bond holders would be suicidal.

The banks, for their part, are engaged in a Darwinian all-or-nothing bet. If they stop lending they are probably toast anyway, so may as well lend and hope that they are amongst the survivors and can then grow rich on fat margins.

Need I mention that there is a fair amount of moral hazard here. Banks have every incentive to make as many loans as ever they can, take on as much risk within the framework as can be managed and park as much as possible with their central bank.

The risk may bring with it the money they need to earn out of their problems and if things come apart, well then, the authorities have all the more reason to keep them alive if they are looking at an ugly loss if they fail.