Capital Markets: Forest and Trees

Today is a time to step back from the trees and see the whole forest. Then to focus in on one of the main problems.

One of the purposes of the capital markets is to facilitate the movement of capital to companies (corporate bonds) , individuals (car loans & mortgages) and governments (municipal bonds) so they can continue to grow our economy.

Before there were mortgage-backed bonds, banks and savings & loans made mortgages and kept them. Because they kept the mortgages in their own portfolio of mortgages, each mortgage application was carefully screened before a mortgage was granted. After the creation of the mortgage-backed bonds, the bank or savings bank could sell the mortgage and then with the proceeds from the sale of the mortgage start the process all over. This changed everything as now the originator of the mortgage no longer needed to be as careful about who they gave a loan to as they would be selling the loan anyway. The next step was that the mortgages were bundled and converted from many mortgages into a series of mortgage-backed bonds. The bonds were then rated by the rating agencies and then sold to investors, individuals and institutions, by the investment bankers. The system broke down because the ratings of these bonds did not reflect the risk they carried. When the real estate bubble burst, or was near bursting, the Wall Street mortgage-backed bond traders started to back away from bidding on these mortgage-backed bonds.

The original intent of the bailout money, the $700 billion, was to buy up these distressed bonds from the major players, the banks, so they could get them off their books. Because of something called “mark to market”, these banks and insurance companies saw their capital requirements failing. The first thing that needs to be done, even before the Federal Government buys up all this distressed debt paper, is to correct the situation with regards to the rating agencies. Without making this needed correction, more of the same is highly likely as far as structured financing is concerned. The only other thing that they could do is require that the originators of mortgages take on a percentage of the bonds that they present to be bundled into mortgage-backed bonds. In other words, putting their feet to the fire along with the eventual investors that buy these mortgage-backed bonds. But, that, in my opinion, just short circuits the whole idea of having mortgage-backed bonds in the first place. The real problem is making a correction in the rating agencies and that means turning that function over to the US Treasury or the Federal Reserve Bank. There is no way a system where the investment bankers are paying the rating agencies for structured finance bond ratings is going to be free of “shopping for ratings”.

Until the best and the brightest of the Obama administration figure this out, the longer the recession is going to last. Stimulus is all well and good. But stimulus is like having gas in the tank, but the distributor is not firing because the distributor cap is laying on the ground. When surgery is needed, whether it be a person or the capital markets system, there is no substitute. The sooner the rating agency fiasco is corrected the sooner the movement of capital can take place again.

Investors must have confidence in the bond ratings on structured finance instruments. Without that confidence, we do not have a dynamic capital markets system. The movement of capital is as essential as the existence of capital. The strength of the U.S. Government permits us to borrow from around the world. There is no question that U.S. Treasury debt obligations are AAA in the minds of investors around the world. That part of the equation is good for now. Now we need to get the capital in the hands of those that need it to build the economy. That piece of the equation needs work. As soon as they, those well dressed politicians in Washington, figure this out, the sooner the recovery can begin.

Stay tuned.