In my previous post I commented on Ben Bernanke’s recent communication of the Fed’s exit strategy for getting its balance sheet and daily operations back to historical norms. I suggested that one necessary ingredient to convince the public that we will see a return to a stable monetary regime would be a credible explanation of how the United States government will be able to meet its enormous current and implicit future fiscal obligations. Today I’d like to discuss a second element that I feel is missing from the exit strategy articulated by Bernanke, and this is a compelling vision of what a healthy financial market not propped up by the Treasury and the Fed would look like.
Let me frame this issue using as an example one of the ongoing Fed-Treasury initiatives that troubles me the most, which is the Term Asset-Backed Securities Loan Facility, or TALF as it is affectionately known. According to the Fed,
The TALF is intended to make credit available to consumers and businesses on more favorable terms by facilitating the issuance of asset-backed securities (ABS) and improving the market conditions for ABS more generally.
Let’s see if we can start by agreeing on some basic facts. First, the process of securitization was unquestionably enormously successful in the early part of this decade in attracting huge sums of capital from all around the world to fund loans to U.S. households and firms. Without securitization, it is inconceivable that we would have seen anything like the $4.3 trillion in new non-agency household mortgage loans issued between 2004 and 2006.
Second, surely we can agree today (though some may have still thought otherwise as recently as May of 2007) that this success was absolutely not
spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks.
I hope that instead we would agree today that the success of securitization in 2004-2006 was due to (1) misperception on the part of the buyers and raters of the ABS of the degree to which aggregate risks could be diversified by pooling disparate loans, and (2) a misplaced confidence in the implicit or explicit guarantees provided by the securitizer, by derivatives used to hedge ABS holdings, or by the U.S. government, the latter in particular introducing a moral hazard component that rendered the system seriously unstable. And I hope we’d further agree that these factors resulted in a profoundly malfunctioning credit market that caused an unsustainable run-up in U.S. real estate prices and household debt that are the primary reason we’re in such trouble today.
A successful exit strategy requires a vision of where you want to go, and how it’s going to be different from the place from which you just came.
So the natural questions are, do we believe that problems (1) and (2) above have been resolved, and what persuades us that securitization could succeed on anything remotely like its previous scale in the absence of features (1) and (2) above?
I’m worried that Bernanke’s answer for why these problems won’t recur may be that underwriters, investors and rating agencies have learned the lesson from previous mistakes.
I guess I’m looking for evidence that the Treasury and the Fed have learned the lesson from previous mistakes.