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The Securitization Market Shifts Into Reverse


The conveyor belt that once moved assets off balance sheets is going in the opposite direction.

In the summer of 2007, the securitization market froze as credit deterioration in the subprime mortgage market became apparent and money market investors in SIVs and asset-backed commercial paper vehicles ran for the exits. And as a result, the speeding "originate for resale" conveyor belt used by lenders across mortgages, auto loans, and credit card loans came to a screeching halt.

In the absence of a liquid secondary market, loans began piling up on originator balance sheets, creating both capital and liquidity concerns. And between the TARP and the various "alphabet soup" programs enacted by the Federal Reserve, many of the ripple effects of the backup in assets were contained.

Talk with anyone active in the securitization market, however, and they'll freely admit that things are hardly back to normal. In fact, they'll tell you that the conveyor belt that once moved assets off balance sheets has reversed direction, and assets that financial institutions once thought were gone forever are returning like the swallows of Capistrano.

Unfortunately, it's the bad assets that are coming back to roost.

Over the weekend, the Wall Street Journal reported that Fannie Mae (FNM) and Freddie Mac (FRE) will be issuing as much as $200 billion in new debt to finance the purchase of delinquent loans which are held in pools of mortgage-backed securities that the Agencies guarantee. And this morning, the Journal reported that the Federal Home Loan Bank of Seattle is suing the underwriters of certain private mortgage-backed securities alleging that the firms misled investors about the underlying quality of the loans.

Where the securitization market once facilitated the movement of loan assets away from originators, the legal system is now moving financial claims the other way -- from investor to asset manager to underwriter or guarantor -- to "bundler" all the way back to the originator. And while we're just at the beginning stages of the litigation/warranty repurchase daisy chain, if the "settlements" so far are any indication, the final figures will be enormous. But let me emphasize two things:

First, the big dollar claims are likely to end up being borne by the big mortgage banks (Wells Fargo (WFC), JPMorgan (JPM), Citigroup (C), Bank of America (BAC), and GMAC (GJM)), by underwriters and/or by money managers (as was recently the case with State Street (STT), all of whom are far more deep-pocketed than the thousands of independent mortgage originators around the country -- most of whom will quickly declare bankruptcy).

Second, the resolution process is largely circular in nature. To the extent that the government (Fannie, Freddie, the FHLBs, the SEC, etc.) goes after financial institutions for remedy, the cumulative impact could end up increasing the need for further bank bailouts -- particularly as banks are just beginning to reserve for their "representation and warranty" exposures. (And the resolution process is likely to become even more interesting as both the banks and the government wear many conflicting hats. For example, Morgan Stanley (MS), Merrill Lynch, Bank of America and Wells Fargo are all members ("owners") of The Federal Home Loan Bank of Seattle.)
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