Everyone has heard stories about how much credit is being reduced. Most anecdotes are about banks that are reluctant to lend, but in fact most banks are extending loans, even if they're demanding more information about their customers. The real reason credit seems tight is that the so-called "shadow banking system" appears broken.
The shadow banking system refers to hedge funds, investment banks and investment vehicles known as conduits. They use a process known as securitization, which means taking individual debts and then bundling them with other loans and selling them to investors and using the proceeds to make more loans. According to Bill Gross, who runs PIMCO, the world's largest bond investor, securitization overtook conventional bank lending as long ago as 2004.
But as Gross also points out, the shadow banking system was largely unregulated, which helps explain why few people were aware of the size of the problem. "Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever," Gross wrote.
Flash forward to 2008, and the shadow banking system ground to a halt. "A lot of the shadow banking system has collapsed," says NYU economist Nouriel Roubini. "We have essentially destroyed a good chunk of our capital market. We want to rebuild it. It is going to take time."
Faced with the disappearance of credit, the federal government has stepped in to try to revive lending in the securitization market. It introduced the Term Asset-Backed Securities Loan Facility, or TALF, in an effort to get the shadow banking system moving again. Under TALF, lenders such as hedge funds put up a relatively small amount (five to 16 percent) of cash, which is then matched by a larger loan from the Federal Reserve. That money is then used to buy securities made up of such assets as bundled credit card debts or student loans.
The government had high hopes for TALF , but they're still largely unfulfilled. It initially set aside $200 billion for TALF loans, then raised that to $1 trillion. Back in March, when the plan was launched, only about $4.7 billion in TALF-backed securities were sold, and then declined to only $1.7 billion in April. That grew to $10.6 billion in May, but that's still relatively little considering how vast securitization used to be in the marketplace.
The use of TALF has been so slow that Barney Frank, head of the House Financial Services Committee, wrote to Treasury Secretary Timothy Geithner and Fed chairman Ben Bernanke with "some questions and concerns about the implementation of the program." He asked for an explanation of why the plan did not seem to be working as expected.
One clue came from William Dudley, president of the Federal Reserve Bank of New York, who noted that investors weren't upset with TALF's terms, but were concerned that Congress might change the rules. "Some investors are apparently reluctant not because of the economics of the program are unattractive, but because of worries about what participation might lead to," Dudley said. He added that the tougher scrutiny of firms that took money under the Troubled Asset Relief Program -- such as limits on executive pay -- had essentially scared investors away from TALF.
The Congressional Oversight Panel last week released a report on TALF that found several reasons investors were steering clear of the program. For example, there are restrictions on the sale of securities, so investors are locked in for a number of years. And the interest rate on TALF loans may be higher than investors can get from other lenders. "With these uncertainties, and the fact that so far there have been fewer issuances under the program than expected, it is not yet clear that the program has been well designed to meet its purpose." That's Washington's way of saying the program isn't working.
The Obama Administration needs to consult with Congress and immediately adopt legislation, including protections for firms against retroactive legislative rule changes, that will make the TALF plan more acceptable to lenders and get lending flowing again. The shadow banking system needs to be fixed in a hurry.