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5 "Tells" that the Stock Markets Are About to Reverse

The Securitization Boondoggle

Interest-Rates / Credit Crisis 2009 Oct 10, 2009 - 05:56 AM GMT

By: Mike_Whitney

Interest-Rates

Best Financial Markets Analysis ArticleThe relentless financialization of the economy has resulted in a hybrid-system of credit expansion which depends on pools of loans sliced-and-diced into tranches and sold into the secondary market to yield-seeking investors. The process is called securitization and it lies at the heart of the current financial crisis. Securitization markets have grown exponentially over the last decade as foreign capital has flooded Wall Street due to the ballooning current account deficit.


A significant amount of the money ended up in complex debt-instruments like mortgage-backed securities (MBS) and asset-backed securities (ABS) which provided trillions in funding for consumer and business loans. Securitization imploded after two Bear Stearns hedge funds defaulted in July 2007 and the secondary market collapsed. Now the Federal Reserve and the Treasury are working furiously to restore securitization, a system they feel is crucial to any meaningful recovery.

But is that really a wise decision? After all, if the system failed in a normal market downturn, it's likely to fail in the future, too. Is Fed chair Ben Bernanke ready to risk another financial meltdown just to restore the process? The Fed shouldn't commit any more resources to securitization (over $1 trillion already) until the process is thoroughly examined by a team of experts. Otherwise, it's just good money after bad.

Here's Baseline Scenario's James Kwak digging a bit deeper into the securitization flap:

"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...

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." (Baseline Scenario)

Investors are no longer willing to trust the ratings agencies or rush back into opaque world of structured finance. The reason the securitization boycott continues, is not because of "investor panic" as Fed chair Ben Bernanke likes to say, but because people have made a sensible judgment about the quality of the product itself. It stinks. That said, how will the economy recover if the main engine for credit production is not repaired? That's the problem.

Here's an excerpt from the New York Times article "Paralysis in Debt Markets Deepens Credit Drought":

"The continued disarray in debt-securitization markets, which in recent years were the source of roughly 60 percent of all credit in the United States, is making loans scarce and threatening to slow the economic recovery. Many of these markets are operating only because the government is propping them up.

Enormous swaths of this so-called shadow banking system remain paralyzed. Depending on the type of loan, certain securitization markets have fallen 40 to 100 percent.

A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.

The market for securities backed by commercial real estate loans is in worse shape. No new securities of this type have been issued in two years." ("Paralysis in Debt Markets Deepens Credit Drought" Jenny Anderson, New York Times)

Securitization could be fixed with rigorous regulation and oversight. Loans would have to be standardized, loan applicants would have to prove that they are creditworthy, and the banks would have to hold a greater percentage of the loan on their books. But financial industry lobbyists are fighting the changes tooth-and-nail. That's because securitization allows the banks to increase profits on miniscule amounts of capital. That's the real story behind the public relations myth of "lowering the cost of capital, disaggregating risk, and making credit available to more people." It's all about money, big money.

Securitization also creates incentives for fraud, because the banks only interest is originating and selling loans, not making sure that borrowers can repay their debt. The goal is quantity not quality. In fact, this process continues today, as the banks continue to originate garbage mortgages through off-balance sheet operations which are underwritten by the FHA. A whole new regime of toxic loans are being cranked out just to maintain the appearance of activity in the housing market. The subprime phenom is ongoing, albeit under a different name.

So why did the banks switch from the tried-and-true method of lending money to creditworthy applicants to become "loan originators"? Isn't there good money to be made in issuing loans and keeping them on the books?

Yes, there is. Lots of money. But not as much money as packaging junk-paper that has no capital-backing and then dumping it on credulous investors. That's where the real money is. Unfortunately, the massive build-up of credit without sufficient capital support generates monstrous bubbles which have dire consequences for the entire economy.

And do we really need securitization? Nobel economist Paul Krugman doesn't think so:

"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."

There's only two ways to fix the present system; either regulate the shadow banking system and every financial institution that trades in securitized assets, or ban securitization altogether and return to the traditional model of banking. Regrettably, the Fed is pursuing a third option, which is to pour more money down a rathole trying to rebuild a system that just blew up. It's madness.

By Mike Whitney

Email: fergiewhitney@msn.com

Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

Mike Whitney Archive

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