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Lawrence G. McDonald Headshot

It's Securitization Stupid: One Big Fix Needed in our Banking System

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I remember it like yesterday, it was the Autumn of 2006. I was on the Lehman Brothers trading floor where I traded distressed debt, bonds of companies in trouble. One of the brightest analysts in the firm came up to me with an interesting piece of data. He showed me a chart of "shadow banks" going out of business. I remember doing a double take and then looking at the data long and hard.

To explain, here's an excerpt from my 2009 New York Times Best Selling book, A Colossal Failure of Common Sense -- The Inside Story of the Collapse of Lehman Brothers:

The process began in the offices of large US mortgage brokers, particularly in California, Florida, and Nevada, where the prospect of a fast buck has never antagonized the natives. This was the start of a lending twilight zone, the advance of the Shadow Banks, places with no depositors, no customers filing in and handing over their paychecks to carefully run commercial banking organizations. The Shadow Banks would lend, finance, and provide capital for house purchases, but they had to borrow the money in the first place, from proper banks, mainly because they didn't have the money themselves. Presto! We have a lender who's not really the lender, a lender who had to borrow the money in order to make the loan. Huh?

All over the United States companies like Own It Mortgage, New Century (NCBC), and NovaStar were dropping like flies.

What does this mean to you, financial reform in the Dodd Frank Bill, our economy, and the Federal Reserve today?

The math is simple, since the Fall of 2006 more than 380 of these shadow banks have gone out of business. The big ones like New Century and BNC/Aurora Mortgage (owned by my former employer Lehman Brothers) were lending close to $5 billion a month of Subprime and Alt-A mortgages. $5 billion times 380 now-defunct shadow banks would be $1.9 trillion a month of lending power, which doesn't exist today. But not all shadow banks were lending at this insane pace. The average was more like $600 million times 380 now-defunct shadow banks, which equals $228 billion a month, or $2.7 trillion of annual US lending power, which does not exist today. There were more than 500,000 mortgage brokers in California alone; now that's a distribution system!

You must thoroughly understand this 21st century lending power. This isn't some government-sponsored Highway Works Project or some stimulus money the Obama administration and Congress are throwing at the economy to try to get things cooking again. This money doesn't go through the hands of a million bureaucrats and eventually end up in the US economy. This lending power was like taking a syringe filled with liquid cocaine and placing it right into the jugular vein of the US economy. I stress the word was.

Most economists didn't understand the multiplier effect of the securitization process described above in 2006; they called it "Goldilocks" out of ignorance and they still don't understand it today. The multiplier effect of this amount of capital oozing through our economy is and was nothing short of jaw-dropping. Every time someone buys a home in America hundreds of jobs are created. Carpets, appliances, electronics, cement, and wood. It goes on and on, money is spent and the money gets spent over and over again in the economy.

Which brings me to quantitative easing, the now infamous QE1 and QE2. Our Federal Reserve is taking almost $2 trillion and buying US Treasury securities to suppress interest rates, create cheap money in the hope US consumers get out and spend. The problem is this is like giving an ill patient a colossal blood transfusion with veins running through the body that are completely clogged. They're flooding the engine with gas with no spark plugs.

I've delivered more than 35 keynote speeches this year in more than 15 countries on the failure of Lehman Brothers and financial reform. I've had one-on-one meetings with people like Charlie Munger and I've been advising the financial crisis inquiry commission. I've been working with the team at DC Tripwire to stay up-to-date on all the latest moves coming out of Washington on financial reform and the long implementation process of the Dodd Frank Bill. I consider myself an expert on this subject.

I'm here to tell you I'm disgusted with the fact that very little has been done to fix our critical securitization process. I say critical because it needs to be fixed as soon as possible. In commercial real estate there was more than $260 billion of securitized lending in 2007 versus less than $10 billion this year. Imagine the jobs and lives this is impacting.

The most appalling focus point I see is that the Dodd Frank Financial Reform implementation process has securitization on the back burner, I mean the left field or Siberian-type of back burner. It's the last priority. To understand Dodd Frank, picture in your mind an eight-lane highway with some cars moving at 90 mph, some 50 mph. Securitization reform is more like 15 mph. Take residential mortgage-backed securities, for example RMBS. Where's the system of registering mortgage brokers? Stock brokers and financial advisers have a rigorous registration and regulation infrastructure known as the Financial Industry Regulatory Authority FINRA but we still have nothing in mortgage origination. There's a buyer's strike right now in securitization of mortgage-backed securities. Investors around the world who once flocked to mortgage-backed securities like drug addicts chasing their dealer aren't buying because they don't trust the origination process at the street level. This must be fixed before another round of quantitative easing or we get another stimulus package out of Washington.

We're in a row boat and Congress has the oars going one way and the Fed the other, let's right this ship!