Wednesday, October 03, 2007

Martin Wolf on Securitization

Securitization - or written with an s instead of the z, as the Brits do - was all the rage in the financial world, until the sub-prime markets slipped. Companies like the idea of bundling loans or receivables into financial instruments that they can sell to investors, gaining cash and spreading risk around (otherwise known as getting it off their books). Martin Wolf, writing in the Financial Times, had an interesting column on the topic that started with a John Maynard Keynes quote:
A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.
How unfortunately true. The risk that appears all too often to interest them most is the risk of embarrassment, not the risk to capital. The problem here is that bankers made bad loans that they figured they'd move on to someone else - in any other circles called a con job. According to his figures, and an interesting chart, US "asset-backed paper contracted by 21 per cent between August 8 and October 1." A brutal ouch. Wolf was taken aback:
What I am surprised by is how toxic securitisation of subprime mortgages has turned out to be for the financial markets. I admit that I thought securitisation had attractive features: it should allow banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books; it should allow banks to transfer those risks on to investors who want longer-term, higher-yielding assets; and, in the process, riskier borrowers should have access to more credit than before.
And he was right in theory, I think. As he notes, there were two main reasons for the crash. One was "all-too-familiar euphoria," as he puts it, though I'd term it historic and economic ignorance. Depending on rising prices to make everything work out, and to let people get out of the trap of credit priced too high for them, is as foolish as thinking that any type of market has an infinite size and can allow unlimited growth as long as someone might like.

The other reason, which I'd call duplicity and naivete, both in borrowers, lenders, and investors, comes about because of a change in the relationship between borrower and money source:
As Robert van Order of the universities of Aberdeen and Michigan points out, securitisation necessarily creates a chain of transactors where bank lending interposes just one institution between the borrower at one end and the depositor at the other. Such chains depend on trust or, as he puts it, "reliance on originators and servicers to originate good loans and service them properly". The trust proved misplaced and has duly vanished: credit means "he (or she) believes". Alas, he no longer does.
There are still some advantages for everyone if the system works well, but if it depends on trust, it could be years before it comes back. How long did it take for people to consider junk bonds after their time of dalliance in the 1980s?

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