Jump-Starting Securitization

Reviving the structured-finance market may do more to get credit flowing than fixing the banks

If there is a supreme irony in this financial crisis, it may be this: The complex money games that helped sink the U.S. economy are actually crucial to any sustainable recovery.

In March the Federal Reserve kicked off a $1 trillion campaign to resuscitate the securitization, or structured-finance, markets. This is where Wall Street firms pool and repackage all manner of cash-flow-producing financial assets—from mortgages to credit cards—into securities, which are then sold to investors. During the boom, Wall Street stretched to dangerous extremes the system of bundling mortgages and other loans into bonds for investors. The securities are still blowing up and damaging the economy.

While a lot of attention has rightly focused on the health of the U.S. banking system and its ability to lend, reviving the securitization market is probably even more important at this stage of the game. Bank lending is actually on the rise—if at a much slower pace than in the past. The securitization market, which once accounted for a third of lending in the U.S., is all but dead. Banks and other financial firms sold $152 billion in asset-backed securities last year, down from a high of $906 billion in 2006, according to trade publication Asset-Backed Alert. So far this year, only $16 billion of deals have been done. "The closing of securitization markets has added considerably to the stress in credit markets and financial institutions generally," Fed Chairman Ben Bernanke said in an Apr. 3 speech. The new plan "is aimed at restoring securitization."

No Cold Turkey

Success is far from assured. But if the Fed can fine-tune the details of its current program, the plan might just help thaw the credit markets, the lifeblood of the economy. The government needs to lure investors back into the market, pumping more money into the system. "The government can't let the economy go cold turkey on the securitization market," says Frederick Cannon, the chief equity strategist at investment bank Keefe, Bruyette & Woods (KBW).

The federal efforts to revive this critical market center on the inelegantly named Term Asset-Backed Securities Loan Facility, or TALF. Uncle Sam has promised to lend up to $1 trillion to private investors to buy newly issued securities. The Fed also intends to let investors purchase existing securities to help create a market for these moribund bonds—an expansion that could happen this summer.

So far, the impact has been minimal. Credit spreads have narrowed somewhat, a sign that the debt markets are improving. But the interest of hedge funds, private equity, and other big firms has been waning. Investors applied for only $1.7 billion in TALF funds in the second round of financing that closed on Apr. 7, a quarter of the amount in the previous round.

The tepid reaction is understandable. Many worry that asset prices will continue to tumble. Others fear the government will interfere in their operations, later deciding to recoup what's seen as excessive pay and profits or restricting participants' ability to hire foreign workers.

But TALF is also a work in progress, and the program may ultimately entice investors and jump-start securitization. Among the kinks: the list of eligible assets that investors can purchase. Under the current TALF rules, new securities backed by auto loans, credit-card debt, student loans, small-business loans, and other marginal loan categories qualify for government aid. But such asset classes have historically made up a small piece of the overall securitization market, so hedge funds and the like traditionally don't find those sorts of securities all that appealing.

Crucial Categories

Meanwhile, there aren't that many loans to securitize. Cars aren't selling, and consumers are cutting back on their credit cards. Plus, banks are tightening their lending standards, says Rod Dubitsky, an analyst at Credit Suisse (CS). "It's a new program; these things take time to work out," says one regulator involved with TALF. With one big deal, "the market could ramp up quickly."

To ensure that happens, the government is crafting TALF 2.0. The new incarnation of the program likely will include commercial and residential real estate debt. Those two categories are crucial, since they represent a significant part of the securitization market. There's also pent-up demand for those types of loans.

Consider commercial mortgages. Some $37 billion of such loans are due this year, with an additional $85 billion due by 2011. With the securitization market stalled, those assets can't be refinanced, leaving many analysts fearful the economy could suffer another blow if those loans aren't rolled over. TALF could help alleviate that looming problem by attracting more investors. "Over time, [TALF] will have a far greater impact," says Jean-Francois Tremblay, a vice-president at credit rating agency Moody's (MCO).

Money managers are gearing up for the new-and-improved version of TALF. NewOak Capital, an asset manager that specializes in commercial and residential mortgage securities, has created a TALF fund for big investors. Clients haven't signed on yet, but NewOak Managing Director Andrew Akers is confident there will be interest once the government tweaks the program. "We are ready to provide this for our customers," says Akers.

NewOak isn't alone. In the past month more than a dozen entities have been incorporated with "TALF" in their names, including the TALF Opportunities Fund and TALF Catalyst Partners. A handful of big banks, including Barclays (BCS), JPMorgan Chase (JPM), and Deutsche Bank (DB), are putting together investments pools that would allow wealthy clients to profit potentially from TALF. The banks are waiting for the Fed to greenlight the deals. Says KBW's Cannon: "If the stars line up, TALF will help."

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