Introduction and summary
Credit performs the essential function of moving funds from the savers who want to lend to the investors and consumers who wish to borrow. Under ideal conditions, this process ensures that funds are invested by the most skilled and productive individuals, thus improving efficiency and stimulating growth, and that consumers can get funds when they need them the most to satisfy their consumption needs.
Many different instruments of borrowing and lending have emerged to better address the needs of borrowers and lenders. Examples are trade credit, banks, stocks and commodities markets, and an enormous variety of financial institutions.
For many years, banks and financial institutions were collecting and lending funds while keeping the resulting loans on their books until they were repaid. Regulations and the need to follow sound and prudent lending practices were generating a need for collateral, thus tightly linking the amount of funds collected to the amount of loans created, even in the presence of more profitable and productive lending activities. For example, a bank generating lots of mortgage loans, which are typically financed by short-term deposits, had to keep a significant share of collateral to ensure that they could repay their depositors in case they wanted their money back at short notice.
To alleviate firms' need to hold large amounts of collateral and allow investors and institutions to share risk, asset-backed securities products were introduced in 1970. Asset-backed securities (ABS) are bonds backed by the cash flow of a variety of pooled receivables or loans. ABS can be securities backed by any type of asset with an associated cash flow, but are generally securities collateralized by certain types of consumer and business loans as opposed to mortgage-backed securities, which are backed by mortgages. Firms issue ABS to diversify sources of capital, borrow more cheaply, reduce the size of their balance sheets, and free up capital.
For example, a bank holding consumer loans on its books could pool a large number of loans together and issue bonds with specific income streams generated by this pool of loans. In addition, the bank would transfer the loans to a separate entity. Selling the loans would generate cash flows that could be used to issue additional loans on the market.
ABS issuance grew steadily, increasing liquidity and reducing the cost of financing. From an annual issuance of $10 billion in 1986, the ABS market grew to an annual issuance of $893 billion in 2006, its peak in the U.S. (1) This growth was accompanied by expansion in the ABS market investor base from banks and institutional investors to hedge funds and structured investment vehicles (SIV).
The growth in ABS came to a sudden end with the financial crisis that started in 2007, which was characterized by a global credit crunch. The crisis began with a decline in house prices and an increase in mortgage defaults, particularly on subprime mortgages (high-risk loans to borrowers with poor credit). Uncertainty quickly spread to other consumer loan markets, such as those based on car loans, credit cards, and student loans. In July 2007, ABS issues backed by residential mortgages dried up. The failure of Lehman Brothers in October 2008 was a big shock to the financial markets and to investor confidence, and yields on ABS skyrocketed. (2) In this new high-yield environment, there was no economic incentive for lenders to issue new ABS. Consumer ABS (auto, credit card, and student loan segments) and commercial mortgage-backed securities markets (3) issuances vanished. The intermediation of household and business credit between investors and borrowers stopped.
[FIGURE 1 OMITTED]
This credit crisis was in many ways also a credit rating crisis. Given the difficulty for investors to evaluate these structured financial products, most relied on ratings of ABS bonds by the major rating agencies. …