Leverage Limits Won't Kill Securitization

Over on his Reuters blog, Felix Salmon has a fantastic assessment of a looming problem for the securitization market brought to light by a Wall Street Journal piece today. The gist of it is that, if leverage requirements are imposed on European banks, then that will have negative consequences for U.S. banks looking to securitize their assets and sell the resulting bonds to those European banks. Salmon essentially asserts that this isn't really a bad thing. I agree.

Here's the key paragraph from the WSJ piece:

A global leverage cap would eliminate the principal source of regulatory arbitrage that fueled the securitization boom, Citigroup notes. U.S. banks have been subject to a leverage ratio all along, making them keen issuers of securitizations to offload assets, but reluctant holders of triple-A-rated assets, which used up balance sheet for little return. European banks, on the other hand, faced no gross leverage constraints but were regulated according to the Basel II capital rules, which encouraged them to load up with triple-A-rated assets because these carried a very low risk-weighting.

And Salmon's response:

The one thing which is absolutely clear is that banks should never be in the business of securitizing loans and selling them to other banks. If you want to sell loans to other banks, just do so directly, by syndicating or participating out the loan. Going the securitization route is expensive enough that the only way it makes sense is if there's some kind of regulatory arbitrage going on, and we don't want that.

Exactly right.* Leverage requirements won't hurt the good kind of securitization -- when auto loans, credit card loans, mortgages or any other cash flow are packaged into bonds and sold to investors. They would affect the regulatory arbitrage driven securitization, which is undesirable anyway. That would shrink the size of the securitization market, as the WSJ warns. But that would be okay, considering what would be lost is unwanted anyway.

*As a friend brought to my attention, "exactly" might have been a bit of an exaggeration. Syndicating giant pools of loans actually isn't cheaper than securitization. Other than that, I agree with Salmon's analysis. Remember, banks can still buy and sell securitized bonds even with leverage requirements. They just wouldn't be able to take advantage of any regulatory loopholes in doing so.