THE BARRICADE

Thanks jeebus. I wonder as I got this chart from Milken if these are all the AAA securitizations created or just the ones S&P rated? Where are the trial lawyers when you need them? It is time for Barack to name Milken debt czar - as debt is the true national pathology from which we suffer. Thanks for your insight and your kind words.

Dark Space, the fundamental problem was the pricing of credit risk based on rising collateral values rather than on the borrowers ability to service the debt, compounded and reinforced by principal/agent issues. Tools whether they are a hammer or chainsaw can still be dangerous. Securitization is a tools. But when taken to extremes it became an enabler of fraud and added risk regardless of where they spread.
Simple securitization works fine, eg 100 similar conforming loans. But unless you are careful you end up with CDO cubed instruments - totally opaque and completely unreliable, subject to the interpretation of mathematical cons like applying gaussian statistics to non gaussian situations.
I think information asymmetry is the essential part of wall street’s modus operandi and is essentially the source of most profits. Securitization aids and abets this asymmetry to an unmanagable extent. Blaming securitization is wrong. People can misuse any tool or capability. In 30 years since the first MBS, securitization has lowered the cost of borrowing, reduced the systematic risk, and provided an easy way for companies to manage their balance sheets while increasing investor exposure.

Sure, the recent spate of assets blew the models, but that was not because the models didn’t work, it was because they didn’t adjust them for the correct assumptions. That isn’t the model’s fault, but the model user.

If we removed securitization the problem still would have occurred. If we removed the problem, securitization would have been just fine.

This has been a key element in the formation of asset bubbles throughout history, long before securitization, and it will be again, even if securitization is banned forever. The details change, but the underlying problem doesn’t.

Securitization is fine, provided that there is total, complete, and unadulterated transparency. The “bar” should be set fairly low for those who want to sue issuers of securities and the grounds that there was anything at all misleading in the information provided. Additionally, the “bar” on prosecutors to pursue criminal prosecution of people who issue securities should be sufficiently low so as to encourage full disclosure.

Securitization if done in a conforming, non complex, transparent way should work. Fannie created the idea of “conforming” loans in order to be able to sell secondary mortgage debt to obtain money to then push down into the mortgage system in the US. This form of securitization worked well, mostly because it INCREASED liquidity and commoditized mortgage debt.
What didn’t work well were CDO methods of securitization. Here, there was no “conformity” — there was an incomprehensible mish-mash of prime, sub-prime and derivative nonsense packed inside one security. These instruments served to DECREASE liquidity and de-commoditized mortgage debt. This was bad.

It’s easy to analyze the creditworthiness of an individual mortgage borrower. But when hundreds of different mortgages are lumped together to create a single security, a true credit analysis of the security would require analyzing each individual borrower’s creditworthiness. Consequently, the diligence required to do a true, thorough credit analysis of hundreds of individual borrowers underlying each security makes it unecomincal for an investor to buy a securitized “bond”.

So the investment bankers built in lots of protections for the investor. Each securitization was over-collateralized and credit enhanced (via credit default swaps). That gave investors comfort that even if some of the individual borrowers in the pool did default, they could look to the over-collateralization or the insurance protection to make them whole. Finally, to give investors even more comfort, they asked the credit rating agencies to rate the securities.

So the securities were over-collateralized, they’ve been analyzed by the credit rating agencies, and the credit is enhanced with credit default protection from a AAA rated insurance company like AIG or MBIA. What can go wrong? It’s clearly a no brainer investment.

I wonder how many individual $400K mortgages investors would have bought if they’d performed their fiduciary duty and done the credit analysis to learn the borrower behind the mortgage was a migrant strawberry pickers making $18K per year?

One of our working assumptions was that lenders would not knowingly, willfully make loans they knew would default.
The question in securitization seems to be this: Are the risks honestly described, so that “risk sharing” can be rationally participated in? In aircraft, yes. In high-risk mortgages, no. Andrew Cuomo began an investigation of Clayton Holdings, and the due diligence performed by Clayton for several large mortgage securitizers. Testimony revealed that when Clayton (now part of Bank of New York Mellon) found a bad mortgage, and notified the securitizer, the securitizer merely paid the wholesaler less for the mortgage, rather than rejecting the mortgage as unfit. Where did this investigation lead? But wait, there’s more! The defective mortgage information provided to the securitizers was not then provided by the securitizers to the bond rating companies. Massive fraud such as this is the natural first cousin of securitizing mortages which were in part fraudulently underwritten, in part products unpredictable as to their futures (option ARMS). NYT January 27, 2008 by Jenny Anderson and Vikas Bajaj.

The modus operandi of securitization is in essence not compatible with banking. Who is the borrower, what is the collateral, who owns it and what is the principal loaned? These questions’ answers confound our current debt collapse. Since World War II we have seen a steady barrage of loosening banking standards by crony capitalists and their partners in crime….lobbyist politicos. We’ve had 70 years of monetary stimulation pumping the fiscal. The monetary pump is now running like Niagara Falls. The reason to keep banking simple stupid is that someone needs to be able to sound an alarm on a bank heist. Securitization was a long process of white collar criminals mapping the bank, taking down the alarm, confusing the books to amounts taken and bribing the regulators, the cops, the judges, the senate, the congress and ….Do we really think that Warren Buffett was lost to his Moody’s lying about credit standards? If a bank falls in the woods and no one hears it is it a bank robbery? The system was gamed by Wall Street wise guys. It’s the perfect bank heist.

I think his point is that securitization induces leverage. If a bank doesn’t have to hold it’s loans, but sells them and then lends out more money in a continuous cycles, it is basically lending out a lot more money than it took in deposits, thus getting around the reserve ratios that it is supposed to maintian. Yes, the bank still has the required ratio, but there are a lot more loans owned by somebody floating around than the reserve requirement called for.

Essentially, you have fractional reserve lending with a multiplier limited only by the amount of securitization the bank can perform, creating an incentive to make risky loans and sell them off and creating a bubble.

securitization enables the entity creating the package to hide risk. This is essentially a fraudulently activity, whether or not intentional (and in the home mortgage market, it was generally intentional in my view), aided and abetted by really lousy risk analysis by the ratings agencies (mostly negligence and stupidity, not intentional). In the particular, in the home real estate market, it enabled lenders to pawn off huge risks it knew existed in the loans it was making to unsuspecting third parties.

So, while securitization may not necessarily be bad, it has so many opportunities to go bad that the best way to prevent future pain may be to shoot the process. I really don’t think regulators or ratings agencies or any other third party can devise a system that will prevent the gaming of securitization that we have seen in the last decade

Securitization is the finance industry’s application of the concept of instant gratification i.e., why hold on to an asset that slowly drips cash flow to you and eats up capital when you can simply capture a quick gain-on-sale through securitization?

Stockholders want earnings growth – securitization was a nice vehicle that enabled banks to deliver that and yes, securitization enabled much greater credit growth for the entire economy than would have otherwise occurred, but it had other ‘benefits’ as well for the banks (access to more sources of funding, capital management tool, distributing risk to those better suited for it (sub tranches), etc.)

but once home prices actually fell, all those models behind the MBS that said that could never happen went bust and the resulting crash of the economy combined with a generally over-levered consumer meant that the problem that started in the MBS world spread to even ‘safer’ classes like credit cards, autos, etc.

the problem now is, in the last few years securitization provided about as much credit to the economy as simple bank lending did – so with securitization dried up, you have three choices - either:
– allow it to stay dried up, and suffer a 30%-ish contraction in credit extension/the economy
– infuse the banks with enough capital so that they can make enough loans to replace the capacity lost from securitization
– or try to re-create the securitization market

Securitization has worked just fine for more than 30 years. It has functioned well, lowered borrowing costs, and provided companies a good way to finance themselves and their activities. People got crazy and shifted how they underwrote business, that isn’t securitization’s fault. Undoubtedly, things need to change, however, securitization itself doesn’t need to change.

I think some of you are naive. Wall Street used mathematicians and indescribably complicated formulae to construct and deconstruct these securities specifically in order to obfuscate the underlying collateral and potential risks. The point, in fact, was complication. You see, if you could construct something that nobody could actually understand, they couldn’t dispute what they were told or what they read in black and white. Then, combined with the vaunted AAA rating + a high yield, and people, in their greed and desire NOT to know, became willing believers. People can understand a whole loan. Not much issue there. But, these securities were designed to be beyond analysis. All you needed to know was that there was a lot of math involved and that there was a AAA rating. That’s it.

“Risk diversification” was nothing more than “risk concealment”. Hide lots of bad under a little good

All these post are a compilation of discussion of securitization from the big picture - they had a great debate on the topic and here are the best posts discussing the pros and cons of securitization.