Securitization survives the fall

September 11, 2009

A year after the government’s seizure of Fannie Mae, Freddie Mac and AIG , not to mention the bankruptcy of Lehman Brothers that sent the global financial system into a tailspin, very little has changed to prevent debt from being sliced and diced, again and again.

This is a mistake. Although there were many factors contributing to the downfall of the global financial system, the repackaging of toxic debt into esoteric financial products was at the heart of the credit crisis when it erupted in 2007.

It’s easy to forget, particularly when many are focused on anniversary tick-tock accounts of the last days of Lehman Brothers, how nasty CDOs — or worse, CDO squareds — became so incredibly popular in the first place.

Yet, after all the damage, the trillions of dollars lost and the biggest state intervention in financial markets since the Depression, there has been no movement to ban their creation.

Securitization in its broadest form — taking underlying collateral, bundling it together and selling it as tradable debt — is still hailed as an important 20th-century invention that has helped worthy borrowers get the credit they need to buy a home, car, or education that would otherwise be out of their reach.

Policymakers, understandably, are anxious to get it started again after the market snapped shut last year. Wall Street, and investors taking advantage of generous financing from the Federal Reserve, are happy enough to oblige.

And it has worked. As of last week, new bonds backed by consumer debt reached $100.5 billion for the year, according to Barclays Capital. While a fraction of the pre-crisis market, that deal volume represents a healthy revival of a near-dead business. Three-quarters of the new deals are eligible for Fed financing.

The problem is phase II — when these securities are then repackaged into something else. At the margins, it’s already under way. Banks are repackaging problematic bonds backed by residential mortgages and the current disaster zone, commercial real estate loans, so they can slice off a new piece that can be resold with better protection.

The amounts are still small, but it’s a reminder of the temptation to shift around a problem asset so investors can feel better about risk.

Although securitization has been around for more than 30 years, the housing and credit boom combined with the computing power of the 21st century gave rise to the proliferation of these repackaged goods filled with bad home loans.

Home loans, though, were just the most bountiful fodder to be found. The next go-around could involve using, say, bonds backed by life insurance policies — the resurfacing fad among Wall Street banks — as the building blocks for a new product.

In the name of simplicity and transparency, the repackaging of securities should just be banned, as I’ve argued before. This will ensure that junky debt doesn’t get cut into so many pieces that understaffed regulators, rating agencies, investors and bank executives lose track of just who is left holding the bag should things head south.

Much of the public outcry and regulatory fervor has been focused on the banks and their reluctance to give up big bonuses for a job well done, or done badly as the case may be.

This is understandable, given the hardship banks and their creations have caused, but this won’t necessarily prevent creative innovation from running amok.

Keeping banks from creating new products out of old ones will go a long way to make sure we’re not right back where we started when the next crisis unfolds.

The Year Since Lehman — related columns:

A year after Lehman, the good news

Banking? Keep it simple, stupid

A year on, it’s still a housing story


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