Securitization Hibernation

The credit crunch of 2007-2008 is going to last for quite a while longer. It also will have a major impact on real estate even after credit becomes widely available again.

Globalization has changed the nature of capital availability and flows, both within and outside of major economies. This trend became evident when the Niagara of capital flooded real estate markets from around the world and eventually led to the credit crunch.

National governments cannot fully control the availability and use of capital within their borders, nor can they isolate their money supply from the effects of foreign capital. If Wall Street were to become so heavily regulated as to discourage foreign capital from entering the U.S., many financial institutions would shift to stock exchanges in London, Tokyo, Frankfurt, Paris, or Hong Kong.

No matter who wins the White House, the new administration in 2009 will surely regulate Wall Street and mortgage lending more than in the recent past. But because of global competition, that government will be limited on how much it can reshape the U.S. financial sector.

Crisis of confidence

The U.S. banking system has been weakened by large losses of capital. Even the nationalization of Fannie Mae and Freddie Mac will not end the credit crunch for private borrowers. It will take years for banks to rebuild capital bases and to be willing to readily make loans. Meanwhile, borrowing from banks to finance real estate deals will be tough.

Tax advantages or other incentives might emerge to encourage private investment in banks. But most foreign capital sources will be reluctant to underwrite our banking system's deleveraging because of its weaknesses from losses past and future.

A central problem facing the U.S. financial sector is a global lack of confidence in U.S. rating agencies. A basic function of securitizing loans was to permit faraway investors to invest in properties about which they knew little.

This capital inflow was possible because major U.S. credit rating agencies and some banks assigned quality ratings to securitized issues. Foreign investors felt protected, if what they were buying earned high ratings. But the experiences of many foreign investors have left them bitter because of the failure of our credit rating agencies to recognize the riskiness of securities they initially rated AAA.

Most foreign investors are in no position to perform due diligence on distant properties. So once they lose confidence in our rating agencies, many will not accept U.S. securitized instruments.

Bold solutions needed

How can worldwide investor confidence in our securitized instruments be restored? We need to invent a new type of credit rating system not subject to the same inherent conflicts of interest that plagued the previous system.

That means rating agencies wouldn't be paid by the security sellers trying to sell bonds. If new private institutions could fill that void with sound regulations, then confidence might return. But it will take time.

Private equity funds are another casualty of the credit crunch. These funds will not be able to raise tons of capital at low interest rates and capture high fees. Why? Intense competition among lenders has vanished, causing each investor to demand more due diligence about how his funds are to be used. Greedy money has shifted to opportunity funds.

Real estate owners and operators who need funds to roll over debts, buy more properties, or upgrade properties will have to find ways to borrow money not so dependent on securitization. Another alternative would be for securitizers to retain at least 10% of their own issues, taken from the lowest-ranking tranche.

Other options include forming joint ventures with funding sources, issuing preferred stocks and convertible bonds, and even selling off major assets.

The days of easy borrowing at cheap interest rates with minimal loan covenants are gone at least until enough time passes for investors to forget their bad experiences. You might recall that by the time 2000 rolled around, investors had all but forgotten the painful memory of 1990, the height of the S&L crisis.

Anthony Downs is a senior fellow at the Brookings Institution. He can be reached at [email protected].

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