Proposal: Limit securitized banking to special banks

Securitized banking is worth saving, and that can best be done by creating special banks to buy the securities, say Yale professors Gary Gorton and Andrew Metrick, early proponents of the view that the financial crisis of 2007-2008 was a bank panic.

 Securitized banking is Gorton’s term for the combination of the repurchase market and securitization – that is, using repurchase agreements to finance the business of securitizing loans. Securitized banking was the site of the financial panic in 2007-2008.

In a September 10 paper, “Regulating the shadow banking system,” Gorton and Metrick would bring securitization under the oversight of regulators by restricting sales of asset-backed securities to special banks, “Narrow Funding Banks,” that would finance themselves with repo loans and other debt.

 These Narrow Funding Banks would have capital requirements and discount window access, just like commercial banks, but they wouldn’t be able to do anything except buy asset-backed securities. Anyone else that wanted to buy asset-backed securities would buy Narrow Funding Bank debt instead. In other words, Narrow Funding Banks would be regulated collateral creators, or repo banks.

 Anyone other than Narrow Funding Banks and commercial banks that wanted to repo would have to be licensed and regulated. Any unregulated repurchase transactions would not receive the special “safe harbor” treatment currently given repo agreements in bankruptcy court, where repo lenders get to keep the collateral and do not have to share with other creditors.

 From the paper:

 Repo and securitization should be regulated because they are new forms of banking, but with the same vulnerability as other forms of private bank-created money. Like previous reforms of banking, we seek to preserve banking and bank-created money, but eliminate bank runs.

 Our proposals are aimed at creating a sufficient amount of high-quality  collateral that can be used for repo safely. Narrow Funding Banks are to be overseen to assure the creation of safe collateral, and repo is to mostly be restricted to banks. Our proposals are built on the idea that these activities are efficient, in part, because of safe harbor from bankruptcy, and the maintenance of this safe harbor is the incentive for agents to abide by the proposed rules.

 The vulnerability of bank-created money to banking panics has a long history, and also a long history of attempts to eliminate this problem. Historically, collateralization has been one successful approach. Off-balance sheet banking has become the source of collateral and needs to be overseen. We propose that Narrow Funding Banks become the entities that transform asset-backed securities into government-overseen collateral. Repo then can be backed by high-quality collateral.

 See RepoWatch’s Finding a Fix for a discussion of other proposals to reform securitized banking. These include:

 -assess companies that securitize and use those premiums to insure asset-backed securities.  Fannie Mae and Freddie Mac might play a role here.

-create a repo resolution authority, with access to the Fed’s discount window, that in the event of default by a repo borrower would repay the repo lender, liquidate risky collateral, pay out claims and force the parties to take a financial hit. 

-have the Treasury Department issue Treasury securities as needed for repo collateral  or insure riskier collateral by selling credit default swaps on it.

-eliminate the “safe harbor” status for repurchase agreements, so repo lenders will have skin in the game.

-require banks to securitize in-house, not in off-the-books businesses.

-Require shadow bankers to use only top-quality collateral. Let repo downsize to fit existing bullet-proof securities.

-Permit securitization of standardized, proven mortgages only. Let non-standard mortgages stay on the books of the company that made them.

-Limit the use of repurchase transactions to extremely well-capitalized banks.

-Levy a tax or fee on all short-term instruments like repurchase agreements and ABCPaper, to discourage a financial institution from using them to buy or finance longer-term assets.   

-Require shadow bankers who are increasing their dependence on short-term money  to hold more capital and more easily-sold assets.

-Require repo lenders to charge a minimum fee or haircut, the way mortgage bankers sometimes charge a down payment, to limit leverage.

-Eliminate rehypothecation.

-Require companies that pool loans and issue securities to produce more detailed prospectuses and quarterly financial statements that enable repo lenders and investors to accurately judge them.