Credit Creaks into Gear

Wall Street's great credit machine, which once provided more than $2.5 trillion to consumers and fueled a long economic expansion, stalled when Lehman Brothers failed in September 2008. But this giant financial engine, known as the shadow banking system, may be sputtering back into gear. With traditional bank lending contracting, any new money from private investors should help get the economy moving.

The difference now is that the government is supplying much of the grease to get these markets running. That's not likely to change anytime soon: For the foreseeable future, the feds will be a fundamental part of the new credit reality.

FASTER REFINANCINGIn normal times, Wall Street bundles mortgages, credit cards, auto loans, and other debt into bonds and sells them to investors. The process, known as securitization, then frees up banks to make new loans. It's the lifeblood of the economy.

Slowly, Wall Street is reprising its critical role in the credit markets. In the third quarter investment banks sold nearly $20 billion worth of car loans, six times as much as in the same period of 2008. The yields on bonds backed by credit-card payments have fallen drastically, a sign that investor appetite is back. And the volume of mortgage securities, the largest segment of the credit market, is on track this year to nearly match the peak levels of 2005. "The core consumer finance sectors seem to be reasonably intact," says Joseph R. Mason, a finance professor at Louisiana State University.

The improvement in the securities market is helping the likes of Brian Mayes, who runs a publicity firm outside Nashville. The 36-year-old tried for four months to refinance the $430,000 mortgage on his four-bedroom brick house. One lender he'd lined up went bankrupt before the paperwork on the loan was processed. In August his new application with F&M Bank, a small Tennessee lender, went through in just 10 days. "I'm relieved and surprised," says Mayes, who cut the rate on his loan to 5.25% from 6.5%. "I thought that I was never going to get this thing refinanced."

To be sure, the credit machine isn't operating anywhere near full capacity. Securities stuffed with student loans amounted to just $15.5 billion in the first three quarters of the year, down 45% from the same period in 2008. And investors won't touch a mortgage deal unless it has the backing of the feds. That makes it nearly impossible for borrowers to get exotic subprime mortgages and other risky loans. To land so-called prime jumbo loans above $729,000, borrowers have to pay a premium. Those sorts of mortgages once accounted for nearly $900 billion of investments.

LENGTHY SHAKEOUTBut some of that credit should never come back. During the boom times, consumers borrowed way beyond their means, often betting home prices would go up forever. At the height of the market, for example, home equity loans accounted for more than 60% of asset-backed securities, not including traditional mortgages. A decade ago, that piece represented about one-third of the market. With home values at record lows, there are barely any home equity deals today.

What's happening now is a rationalization of credit. In essence, the market is trying to find the right balance between too much and too little. "It is a really tough question to untangle, and it is one that is crucial to economic growth," says LSU's Mason.

The process, which is happening along the entire food chain of credit, from borrowers to lenders to the government, will take years and ultimately reshape the debt markets. Lenders, for example, are trying to figure out how to dole out money prudently. Rivermark Community Credit Union, a small lender in Beaverton, Ore., made 442 auto loans in September, 33% more than the previous year. "I think peoples' confidence is returning, and they are feeling a bit more secure," says Gayle Rust Gustafson, vice-president for financial services at Rivermark. Even so, Rivermark is tightening lending standards: It's cutting the amount of items, such as the unpaid balance on a trade-in vehicle, that a borrower can roll into a new car loan.

Meanwhile, parts of the credit market are beginning to inch toward self-sufficiency and away from government subsidies. Consider the auto and credit-card segments. The first big spark of interest in such securities came from a $200 billion federal initiative started in March. Under the Term Asset-Backed Securities Loan Facility, or TALF, the U.S. agreed to help finance purchases by private players. The incentives have persuaded so many investors to scoop up auto and credit-card securities that deals are now being sold without federal aid. "The program has been very successful," says Theresa O'Neill, a credit market strategist at Bank of America Merrill Lynch Global Research. The volume of auto securities is on pace to hit $50 billion this year, up from $35 billion in 2008, according to the Securities Industry & Financial Markets Assn., an industry trade group.

Housing, which is being entirely propped up by federal funds and programs, will be trickier. This year government-backed loans have accounted for 99%, or $1.5 trillion, of mortgage securities. Banks and other private firms have issued a mere $15 billion. The breakdown has been more like 80/20 in the past. In addition, the Federal Reserve and Treasury have spent nearly $1.25 trillion buying those bonds to support the housing and broader credit markets. "The government is literally plowing trillions of dollars into the U.S. mortgage market to keep it afloat," says Guy D. Cecala, publisher of Inside Mortgage Finance.

The Fed has said it intends to quit buying mortgage securities by the end of March. Whether it does stop at that point may well depend on whether private players plunk down more money. That could take awhile. At the moment, says Sam Khater, a senior economist at First American CoreLogic, investors "are waiting for stability in home prices and the economy"—just like everyone else.

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