I recently wrote an article on the merits and dangers of creating a secondary market for small-business loans.
After reading the bill introduced on July 1 to promote economic growth and credit formation by facilitating the development of a secondary market for business, commercial, and community development debt and equity investments and for other purposes, I was again struck by the naive posture taken by legislators toward the financial services industry in general and the extension of credit in particular.
The bill claimed that the creation of a secondary market will solve all the ailments of our society and its economy. The bill is expected to do the following:
* Stimulate an increased flow of funds from financial institutions.
* Revitalize the economy.
* Increase the availability of credit at reasonable rates.
* Increase investments in emerging technologies in new businesses.
* Spread the risk associated with new ventures, thereby attracting more venture capital. Encourage investments by pension and insurance funds
* Increase the availability of credit for new and expanding minority- and woman-owned businesses.
* Stabilize and absorb cyclical downturns in business and real estate cycles.
* Be a highly effective tool to multiply government funds dedicated to community and economic developments.
* Capitalize community development financial institutions. Stabilize the commercial real estate markets.
* Enhance the value of real-estate-backed collateral.
Presented as a Cure-All
This bill is touted as a cure for every major issue facing our country and economy, with the exception of some terminal illnesses. I am still struggling with the legislators' logic.
I am discouraged to note that they have not learned from history. Although securitization is a great invention that facilitates the efficient flow of funds from savers to borrowers, the technique has its downside.
Securitization creates shrinking margins and reduces profitability and, with it, creates insufficient compensation for the credit risk incurred by the institution lending to small businesses or for higher-risk purposes, some of which are described directly in the bill.
A securitization market, with or without the involvement of government-sponsored entities, could temporarily increase the liquidity available to financial institutions for credit extension to institutions and borrowers who are not credit worthy enough for standard loans.
However, in the long run it will make the origination of these loans economically unfeasible and as unprofitable as the conforming mortgages being originated today.
Further, commercial banks and other depository institutions have been in the business of intermediating credit risk for generations. Introducing a securitization vehicle for nonstandardized loans or for poor credit risks would not eliminate the exposure.
Risks Spread Around
It would still require someone, in this case the investor or the credit enhancer, to absorb the risk and try to get compensated for the intermediation.
Securitization simply changes the distribution of risk and allows different institutions to hold it.
Last but not least, securitization is not going to be the ultimate healer of all economic woes. It cannot stabilize business and real estate cycles. It cannot guarantee the stability and enhancement of value of real-state-backed collateral.
I am surprised that the legislators make such sweeping statements without substantiation.
Securitizing nonstandard loans will help create liquidity in an illiquid market. That is the primary benefit of securitizing any asset class. But the price for that liquidity can be heavy and it can backfire on the financial system in significant ways never envisioned by the legislators.
Corrective laws such as the reform and restructuring bills of 1980 and 1991 were intended to fix systemic problems, yet resulted in more problems and in massive institutions' failures, which were not anticipated.
I'm greatly concerned that the continuing push for the securitization of commercial loans will result in similar adverse and unanticipated consequences.