The Paradox of Securitization
By Ann Rutledge | October 19, 2009
Structured finance mania gripped the global debt capital markets earlier this decade. When the bubble burst and left a hole estimated at 3.5 trillion dollars, some observers saw a reprise of the U.S. savings and loan crisis; others, a Japan-style property market bubble; and still others a replay of the 1929 Crash, with greedy investors seduced by leveraged schemes wrapped in academic mumbo-jumbo.
In hindsight, the global financial crisis may come to be viewed as a referendum on market capitalism and the modern fiduciary conscience. Great quantities of capital were marshaled for ends that were ultimately enormously wasteful. If markets are our best mechanism for allocating resources, as modern financial theory leads us to believe, then how could they have failed so spectacularly? And can we ever trust them again?
The short explanation is that financial markets have become increasingly self-referential (or reflexive as George Soros calls it) and disconnected from fundamentals. Markets are organized not to price assets at their intrinsic value, but to streamline the management of financial capital for banks.
With the dissemination and use of consensus models on Wall Street, as well as in financial engineering and MBA programs, a single language of value has evolved that facilitates communication between trading desks at lightning speeds. In this language, price and its proxies (like ratings) are used to predict price. Unfortunately, the information that prices are presumed to contain is often lost in translation to digital shorthand. Put another way, capital market efficiency appears to come at the expense of the ability to respond to the complex needs of economies.
It is easy to blame markets for gazing at themselves approvingly in the mirror, but it is hard to build consensus on economic models that link up the entire supply chain of credit. Just ask the last economist to propose such a model, Karl Marx. Nevertheless, if we choose to live in a market economy from a belief that markets are good at allocating resources, it is reasonable to expect markets to allocate capital efficiently; and if they do not, to repair them or change our beliefs.
Paradoxically, the financing technique that nearly tanked the economy actually succeeds where the consensus models fail.
Proper implementations use fundamental data on the value of the borrower's goods and services, not security prices, as the main model input. When time-tested engineering methods are used to value receivable-backed securities, the results are much more precise than price-driven models. New enterprises and niche businesses disadvantaged by traditional corporate finance may be able to raise affordable capital via securitization if they have demonstrably good asset quality.
This is not just a theoretical point. Securitization was an important engine of growth in the U.S. capital markets from 1983 (the birth-year of the rated market) through 2003 (the last year before the floodgates on mortgage credit were opened). Security losses in those years were de minimus, except in a handful of fraud cases. The full paradox of securitization is thus revealed. Every positive claim made for it in this essay is validated by the early market experience and contradicted by the crisis. This is not because the theory is false, but because the theory ignores fraud risk.
Securitization is an arcane financial language. One cannot learn it simply by going to business school. It can only be acquired on the job, where the learning is hit and miss. (The best place for on-the-job training was in the rating agencies in the 1990s before they became overly commercial.) Given securitization's obscurity, it was not difficult for powerful financial institutions to bend or break the rules in broad daylight and escape detection. And they did so, sometimes with rating agency collaboration.
For large banks, securitization presents an opportunity but a franchise risk as well. Securitization puts liquid power in the hands of banks with deep structuring expertise. Meanwhile, its transparency and efficiency are a threat to the large banks and the financial status quo. Securitization, in the history of financial ideas, is a radical departure from the market-capitalist paradigm in which lenders extract economic rent from borrowers by hoarding capital and information—because it exposes the dirty little secret of lending. Namely, credit is self-fulfilling.
Treat a company like a AAA borrower; give it a AAA cost of funds; and you will make it a AAA borrower. Classify a borrower as high-risk; charge a high rate of interest; and though the company will use every means to pay you back, it may well default. Indeed, the rate of interest you charge may cause the default. Banks as we know them cannot hoard capital and pay large bonuses to themselves any other way.
Securitization is a different kind of capitalism—informational capitalism, where the cost of borrowing can be reduced by, effectively, substituting reliable information for additional risk premium. That is how securitization recycles capital into the economy more efficiently. Every company with a well-defined user group and good cash flow controls can repay a loan charging AAA (or double-A or even single-A) interest—with AAA certainty.
That's why the financial crisis is a referendum on market capitalism and the modern fiduciary conscience. It has demonstrated that if we are going to act responsibly and make sound economic decisions from inside the capitalist framework, we need new models—ones that can feed back more than what we already think. We need models that produce information to help us make complex economic decisions when we are not sure what to think.
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