With the Federal Reserve keeping interest rates higher for longer, most types of loans will have higher rates for the foreseeable future. However, there is a secondary market for loans in the form of debt securitization, or the process of packaging debt to be sold as securities to a single investor. What does this mean for investors' wallets and the broader US economy?
Structured Finance Association CEO Michael Bright breaks down debt securitization and how it impacts Americans caught up in higher for longer interest rates.
In terms of what this means for credit card rates, Bright states: "Without this, rates would be higher than they are right now, and they would be more volatile. If you don't have the securitization industry and if you don't have these types of bonds that can trade globally, you have something that's called procyclicality with lending. That means when the economy is good, banks are very willing to lend; if the economy slows down a little bit, banks pull back quite a bit. You see a lot of volatility, not only in the rate itself but whether or not you can even actually access credit under older systems."
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Editor's note: This article was written by Nicholas Jacobino
Video Transcript
BRAD SMITH: By now we've all heard higher for longer. Meaning interest rates for credit cards, mortgages, loans. Anything that requires you to borrow money as a higher interest rate for the foreseeable future. But in the background, get this. There's an entire secondary market packaging up loans and selling them to investors, which means a lower interest rate for you. That's called debt securitization. Packaging debts into a single security to be sold to investors.
To put it simply, if a bunch of my friends owe me some cash, I can bundle up the amount that they owe me which spreads out the risk from my reliable and less reliable friends, and sell it to investors as a security, which is a fungible and tradable financial instrument used to raise capital in public and private markets. So the win for traders, a new lower risk investment. And borrowers get a lower interest rate.
To break down what this all means for you and your loans, we've brought in the specialist here, Michael Bright, Structured Finance Association CEO here with us. Mike, first and foremost, why is this something that is in the markets? Why is this also beneficial to those who are seeking a loan?
MICHAEL BRIGHT: Well, thanks for having me. Enjoy speaking with you and your audience. I got to tell you I think you did a pretty good job just now. I'm not so sure you need me here today to talk about this.
BRAD SMITH: We need you, Mike. Don't go anywhere. Don't go anywhere.
MICHAEL BRIGHT: No. You basically captured it. But without securitization, without the structured finance industry, essentially, if you need a loan for whether it be a car, or a credit card, or a mortgage, you have to go to a bank, and the bank makes an individual decision just for you. And then that loan would sit on the bank's balance sheet.
And that's what we had in our economy really up until the Great Depression. And some countries that are developing still have that as well. But with the bond market being part of the equation, the securitization and structured finance industry being part of the equation, your mortgage may be owned by the Bank of Japan, it may be owned by a oil money in the Middle East.
And what that does is that brings all this global capital to bear. So that when you need to get access to credit for whatever it is you're attempting to borrow to purchase, you're not just relying on one or two banks to do it. The banks are actually facilitators of making you that loan.
But then bundling that loan, putting it into a bond, and then selling it off to an investor globally. So now, you have global capital that comes in that can be borrowed. And those investors can really model it using statistics because you have a large sample size.
BRAD SMITH: So how does this impact things like credit card rates?
MICHAEL BRIGHT: Without this rates would be higher than they are right now, and there would be more volatile. So if you don't have the securitization industry, and if you don't have these types of bonds that can trade globally, you have something that's called pro-cyclicality with lending. So that means when the economy is good, banks are very willing to lend. If the economy slows down a little bit, banks pull back quite a bit.
And so you see a lot of volatility, not only in the rate itself, but whether or not you can even actually access credit under older systems. If you have a global system where you have tens of trillions of dollars of investment money that can all facilitate lending to communities across the country, you have less volatility and net rates are lower than they would be. Now, I know you were talking about higher for longer. And the Fed having to increase interest rates. And that's true. But still by historical standards, we're still quite low.
BRAD SMITH: So it's interesting. When you've got a secondary market like this, some people might think about the Big Short, and ultimately, how we avert that reoccurring once again here, especially with us we've been staring down a recession with a likelihood of a recession for about 18 months, maybe even two years at this juncture. And still waiting for it to potentially happen, even though we see resiliency continuing to shine through. So all of that considered, how do we avert that happening with the secondary market like this?
MICHAEL BRIGHT: Yeah, so no matter how big the secondary market is, no matter how much global capital there is, no matter how much statistics you use, if the loan that's made at the front end is a bad loan, whether the underwriting was done properly, you know, someone was sold a loan that they probably shouldn't have been sold or couldn't afford, fraud, people flipping houses, all of these things that occurred in the years leading up to the great financial crisis of 2008 and 2009.
No matter how much global capital is there and how much statistics you use, if the loans themselves are not good, then it's all going to break down. And that's exactly what we saw. The good news is Congress passed some very meaningful reforms in the wake of the financial crisis. And so now, there's a lot more safeguards on what you need to do before you can give a borrower a loan to make sure that they can actually afford to repay it.