Since the credit crisis began, I have frequently found myself in agreement with Paul Krugman. Not everything, but for the most part, especially on many major points, we are sympatico: He has been correct about Moral Hazard, about the folly of these many bailouts, about the advantages of nationalizing the banks. And, I suspect he is right that the economy would benefit (short term) from a bigger rather than smaller stimulus.
Where we part ways is on his criticism of Securitization. I simply do not see it as a proximate or even secondary cause of the crisis and collapse. It is a tool, and whether it is used for good or evil is a function of too many things beyond what its purpose is.
First, lets go to the professor’s Friday column, then see where we part ways:
“Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.
But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.
Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed . . .
A quick definition before proceeding further:
“Securitization is a structured finance process that involves pooling and repackaging of cash-flow-producing financial assets into securities, which are then sold to investors. As a portfolio risk backed by amortizing cash flows – and unlike general corporate debt – the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.¹
Under normal circumstances, securitization works fine. But the 1998 – 2008 period was filled with all manner of aberrational issues. Much of that era terribly skewed financial activity. Consider:
-Fed Chair Alan Greenspan took rates to 1% — so low as to cause an enormous credit bubble;
-The Fed refused to supervise/regulate the new “innovative” mortgage lenders. Hence, millions of ill advised loans took place;
-For most of history, credit transactions were based on the borrowers ability to sevice the debt (i.e., repay the loan); For a 5 year window (2002-07), that no longer mattered. What dominated the lending decision was the lenders ability to sell the loan to Wall Street; Hence, the lend-to-securitize model was born;
-These firms sold mortgages to Wall Street with an unconscionably short warranty: They guaranteed these mortgages would not default for a mere 90 days. This removed the lenders incentive to find qualified borrowers.
-AAA: The major rating agencies (Moody’s, S&P and Fitch) failed to perform their functions. These firms were wholly corrupted by their new business model of getting paid by underwriters, as opposed to the bond buyers. This pay-to-play model is little more than good old fashioned “Payola.” They slapped a Triple AAA rating on pretty much anything they could get a fee on.
-Without these AAA ratings, most of this paper could not have been sold to the various funds, central banks, and SIVs that bought them;
-Credit Default Swaps on the securitized products were wholly unregulated.
All of the above is painfully detailed in to Bailout Nation.
Do not forget that Securitization had been around for decades without major problems. And over the entire period of time in question, credit card loans, auto financing, and student loans were securitized without incident (other than expected cyclical recessionary downturns).
The same can be said about derivatives. Handled properly, they are tools that serve a function. Let loose with no regulation/supervision/transparency/reserve requirements, you have the making of a disaster . . .
We can even say the same about Mortgages. Would you draw the conclusion that because the lending industry made so many bad loans, that mortgages were the problem, and therefore we should do away with them? You have to look at the context in which the loans took place.
Securitization is no different.
Under normal circumstances, it works fine. And if we tweak a bit around the edges — make sure that securitizers cannot shed liability as easily as they have, and adjust incentive compensation away from the current hit & run style of faux profits but real bonuses, Securitization will work just fine.
The Market Mystique
NYT, March 26, 2009
1. Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford U Press, 2003, p. 103 via wikipedia