When Securitization Blew Up, So Did the Economy

USDeptOfTreasurySeal-2003Bill

This isn’t a normal recession. In a normal recession aggregate demand declines, economic activity slows, and GDP shrinks. While those things are taking place now, the reasons are quite different. The present slump wasn’t brought on by a downturn in the business cycle or a mismatch in supply and demand.

It was caused by a meltdown in the credit system’s central core. That’s the main difference. Wall Street’s credit-generating mechanism, securitization, has broken down cutting off roughly 40 percent of the credit that had been flowing into the economy. As a result, consumer demand has collapsed, inventories are growing, and manufacturing has contracted for the 13th consecutive month. The equities markets are in freefall and all the economic indicators are pointed south. The so called “shadow banking system” which provided wholesale funding for mortgages, car loans, student loans, and credit card debt, has stopped functioning entirely.

Journalist David K Richards describes the modern credit system in his article “Humpty Dumpty Finance”:

To begin, it is important to recognize how Wall St. has transformed the bank-based credit system, which existed in the 1930′s and prevailed until the mid-1990′s, into the ‘modern’ securities-based credit system we have today. Non-bank sources currently supply more than half the credit needs of businesses and consumers. This transformation in the way credit is supplied has made it difficult for the Federal Reserve to reignite credit growth through massive expansion of the Federal Reserve balance sheet, which was the supposed 1930′s style antidote. The old-style banking system, in which banks kept the loans they made on their balance sheets, would have responded quickly to Bernanke’s interest rate cuts and aggressive injections of excess reserves. But banks today no longer keep most of the credits they underwrite on their own balance sheets, nor do they keep them in the form of individual loans. Instead, banks gather credits together to form asset-based or mortgage-based bonds which they then distribute or sell to pension funds, insurance companies, banks, hedge funds, and other investors worldwide. (“Humpty Dumpty Finance,” David K Richards, Huffington Post)

This new “securities-based” credit system emerged almost entirely in the last decade and had never been stress-tested to see if it could withstand normal market turbulence. As it happens, it couldn’t survive the battering. The market for mortgage-backed bonds and other securitized investments disintegrated at the first whiff of grapeshot. As soon as subprime foreclosures began to rise, investors fled the market en masse and securitization hit the canvas. Now the wholesale funding for MBS and other consumer loans has slowed to a trickle. That means that housing prices will continue to crash dragging the stock market along behind.

The Fed and Treasury are determined to revive securitization. They’re planning to provide $1 trillion for the so-called “public-private partnership” and the Term Asset-Backed Securities Loan Facility (TALF). The money is a taxpayer-provided subsidy for a deeply-flawed system which is inherently unstable.

The full article originally appeared at Dissident Voice. 

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