Be happy about the lack of securitization

By Felix Salmon
October 7, 2009
Paul Krugman has a good response to Jenny Anderson's piece today on the woeful state of the securitization markets: isn't that a good thing?

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Paul Krugman has a good response to Jenny Anderson’s piece today on the woeful state of the securitization markets: isn’t that a good thing?

Here’s my question: why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets. Yet the assumption at the Fed seems to be that this isn’t an option — that the only way to go is back to the securitized debt market of the years just before the crisis.

Why? Are we still convinced that securitization is a far superior system to conventional banking, and if so why?

Another way to look at this is to ask what’s happening at the big institutional investors who drove the securitization market. If they’re insisting on underwriting loans all of a sudden, and actually wanting to understand who they’re lending to, that’s a good thing too. Here’s James Kwak:

The boom in securitization was based on investors’ willingness to believe what investment banks and credit rating agencies said about these securities. Buying a mortgage-backed security is making a loan. Ordinarily you don’t loan money to someone without proving to yourself that he is going to pay you back (or that the interest rate you are getting will compensate you for the risk that he won’t pay you back). The securitization bubble happened because investors were willing to outsource that decision to other people — banks and credit rating agencies — who had different incentives from them.

What’s more, it turned out during the crisis that a lot of the investors in the securitization market were banks — specifically, they were European banks and SIVs who, in a feat of regulatory arbitrage, managed to discover that it didn’t matter how much credit you were exposed to, just so long as it carried a triple-A rating. I think we can all agree that insofar as banks are lending, they should be lending directly to borrowers, rather than outsourcing what’s meant to be their core competency to investment banks in the modeling-and-repackaging business.

The stubborn refusal of the securitization market to participate in the current credit boom is one of the few chinks of light I’m seeing these days. It shows there’s still some common sense in the world; long may it stay that way.


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good point about the lack of revival of the securitization market. instead, we are seeing widespread enthusiasm for wholesale bank funding. clearly that was a wildly successful model. (esp because the USG was willing to bail out banks.)

Posted by q | Report as abusive

So are you saying,Felix, that there should be no secondary market for home loans?

What puzzles me is that the secondary market seems to have worked fine for at least 20 years i.e. 1980 – 2002 (including high ratio loan of up to 95% LTV with Private Mortgage Insurance — PMI).

(I understand “securitization” is another term for selling loans to secondary market.)

It seems to me that the system with PMI worked because the underwriting standards were sensible and followed. But we had both high LTV and securitization in that era and so I wonder if securitization is really the magic bad variable.

Securitization has enormous benefits as it allow the very lenders –e.g. small one-branch banks — who presumably might know the borrowers first hand to make loans far in excess allowed by their own ratios.

Getting rid of securitization sounds too pat.

To the extent that securitization is motivated by regulatory capital arbitrage, by all means kill it. If securitization has real economic benefits beyond the regcap gamesmanship it facilitates, let it live.

Securitization allows more money to be made available more quickly BECAUSE somebody has already used their business apparatus (staff and infrastructure) to vet the loans. This must be a good thing, not a bad thing, because it promotes efficient use of resources; the problem with the system as it stood (and stands for now) is that there aren’t good tools in place for investors to make decisions about the quality of the securities; there ought to be ratings on packages by companies like Moody’s, just as with municipal bonds, and companies which don’t maintain the quality of their product should suffer in the ratings so that investors can avoid them or demand higher percentages of their profit (in whatever form the agreement takes).

Taking a moralizing stance on these financial issues is the luxury of non-players who don’t fancy themselves involved in the economy and can sit on the sidelines wagging their fingers because they don’t have the vision to see how hard their own life will be when they can’t sell their own home in their golden years or can’t borrow money for anything because the credit system is too small and constipated (like their imaginations)…

Posted by Rich | Report as abusive

To the extent the shadow banking existed to enable regulatory arbitrage, eliminating the regulatory arbitrage eliminates the demand for SIV paper and banks reduce securitizations and lend directly and prudently instead.

But non regulatory arb demand for truly high quality bonds still exists and securitizations should exist to meet that demand.

Without a secondary market, loan risk is even more concentrated in the banks. Is this really a desirable policy goal

I think the Feds objective is to revive a legitimate securitization market so that it can drain those excess reserves as lenders step forward from outside the banking system.

I don’t think anyone thinks, in its current state, the secondary markets is a far supeior system, but it has its useful place. Krugman’s argument is facile and the cnclusion you’ve drawn from it overly simplistic

Posted by michaelc | Report as abusive

Urgh, Felix, your continued insistence on treating the securitization market as if it were a living, thinking being is just dumb. It’s a financing tool, one that got abused just like others have in the past. It’s equally asinine to believe that direct lending from banks to whomsoever automatically means credit decisions are smarter.

Based on your approach, we should have let the stock market die in 2000 because of the dot com bust and should have banned bank lending after god knows how many poor lending decisions they have made over the years – including in this crisis. Wachovia’s and WaMu’s option ARMs, for example? HSBC’s subprime lending losses? Hundreds, if not thousands, of banks’ poor commercial real estate loans?

That’s what happens in a bubble, Felix – people lose their capacity and even their desire to analyse risk properly. Securitization of subprime mortgages is where is showed up most obviously in this crisis. But it was pretty rampant across all products.

Posted by Murray | Report as abusive

It’s scary that Krugman won a Noble Prize, the guy is a bit of a nutter these days. He can’t let go of his ideas because (I think) he has some superiority issues. His bottom line message is scary: let’s spend our way out of this mess and doing via the USG. YIKES! I’m not saying government is any better or worse than the XYZ mega-corp but corporations can come and go, the government stays forever. Sorry if I’m a little off-topic, but I since this article is essentially a defense of Krugman, it’s important to weigh his words… like if Rush Limbaugh starts attacking someone for being addicted to drugs, or overweight, or a loud-mouth, etc.

Posted by the Shah | Report as abusive

@David, securitization is not the same as a secondary market for loans. There’s nothing wrong with re-selling loans, but securitization packages up a whole bunch of them into one package, so the buyer doesn’t really know what they are getting, unlike when investors buy individual loans. It’s kind of like buying ground hamburger meat, you have no idea what it was originally like, nor do you know if there was e coli in any of the meat before it was added to the mix. If you just bought a chunk of meat, it could be tested for it, but not the ground up stuff. For that, like the loans that are combined into a giant package of loans, you have to depend on a third party rating organization – and that’s where things break down.

People have died from eating meat contaminated with e coli, because the buyers of ground up meat (which comes from many different sources) had no way to grade all of the components of the ground meat. Similarly, businesses have failed because they bought ground up loans when they had no way to grade all the components of the bonds.

Posted by KenG | Report as abusive


Perhaps I am mistaken but I am pretty sure that the secondary market for loans does (or did, anyway) always bundle loans together. In fact I don’t think you could ever go out and buy ONE loan from Fannie Mae or Freddie Mac.

You can buy individual DOT or Real Estate Contracts but that owner-carried paper makes a whole different market and I doubt (since they have no PMI or conform to any particular standards) you could rate a package of them.

I thought people just invested in fannie mae and freddie mac, I didn’t realize they actually bought collections of specific grade loans from them (sub-prime, different tranches, etc.)? did they sell bonds in specific collections of mortgages? If they did that, then they wouldn’t have lost so much money, as the people who bought the CDOs were the ones who lost $$ (unless you then bought CDSs that the government was willing to cover).

Posted by KenG | Report as abusive

In my opinion, not restarting the securitisation market can only be a very bad thing. I admit that it’s good that predatory sub-prime mortgage lending, to people who could not afford to pay their mortgage loan, has now stopped. But does that mean the whole market should close down?

Do you think it a good thing that financing for small to medium sized businesses, commercial properties and consumer loans should also be shut down or severely restricted? Do you think it is a good thing that mortgage loans will cost perhaps three times as much as they used to for pristine borrowers?

Personally I think not – you and I will suffer along with everyone else. I am the first to admit that things went to far at the peak of the market and it needed to be reined in.

Check and balances are required to prevent another mess like this from re-developing. But, at the same time, it is also clear that, unless the primary securitisation market is restarted (and by that I mean bank issuers selling securitised debt to real investors) then we are in for a very long, drawn out and nasty recession which will bring out the worst in our society.

Economists reckon that unemployment will plateau next year. Personally I don’t think it will unless vital financing gets through – and that means the securitisation market needs to restart.

To put it in context, since the crisis began, banks have been unable to sell their securitised debt and (in Europe) there is around €1.3trln of securitised debt that is now sitting on bank balance sheets which is eligible for repo funding with the European Central Bank.

If this debt was pushed to the ECB in one go (unlikely, but not impossible) the whole financial system would go into meltdown. You think I am being a bit melodramatic but the fact of the matter is that the ECB does not have the balance sheet to provide that sort of financing. It’s a bit like a hundred people trying to hold onto a rubber ring.

So, I beg to differ, we really do need to get this market back on its feet, if only because its too big and the consequences too damaging – to ignore.

We need more people to write about this market with more understanding.

Point taken, William. But I think some of the skepticism toward securitization on the part of Felix, myself, and many others is driven by the view that the securitization market never functioned properly in the first place. The grand idea, as I take it, was that securitization was supposed to bring liquidity to various classes of illiquid assets like mortgages et al by the following mechanisms: aggregating risks, centralizing the analysis t.

What say you to these concerns?

Why do you state that the securitization market never worked well?
So far as I understand, it worked quite well between 1980 – 2002 for single-family home loans..
And farther back of course for FHA and VA loans which I believe were also packaged but because the initial underwriting was strict, had very low default rates.

It seems to me that the securitization market didn’t work well when it was not well-managed and well-regulated and that sums it up.

Yes, David. I overreached with “never”. I also neglected to finish before posting my comment. I’ll try again.

My skepticism is driven by the view that the securitization market (or at least large parts of it) ceased to function properly some time early this decade. The grand idea, as I take it, was that securitization was supposed to bring liquidity to various classes of illiquid assets like mortgages et al by the following mechanisms: (a) aggregating (and in many cases tranching or otherwise reorganizing) risks, (b) centralizing the analysis those risks at credit rating agencies, and (c) transferring those reorganized risks and rewards to those better suited (than originators) to bear them.

I think what we came to terms with in 2008 was that there had been problems in that chain of logic all along. By aggregating and tranching risks, originators discovered new-found demand for what would have previously been considered imprudent loans. By centralizing risk analysis in the hands of the ratings agencies, investors grew complacent in their own due diligence. And the hope that securitized products would end up on the balance sheets most tolerant of the risks turned out to be spectacularly flawed. The demand was ravenous for the seventy-some-odd percent of the securitized structures granted AAA ratings. Whether this demand was due to investor appetites for low risk or merely for the appearance of low risk (and for the lower capital charges that come with that appearance) remains to be demonstrated.