Securitization shouldn't be the government's business

In his Bloomberg editorial, Amar Bhide makes the case for the government ending its direct involvement in structured finance.

He identifies two sources of government involvement in structured finance.  First, there are Fannie Mae and Freddie Mac.  Second, there is the application of securities law by the SEC.

Regular readers know that under the FDR Framework the government's primary involvement in structured finance should have been to insure that all market participants have access to all the useful, relevant information in an appropriate, timely manner so that they can make fully informed investment decisions about individual structured finance securities and financial entities that hold these securities.

Had the government focused on this responsibility, structured finance securities would provide observable event based reporting under which all activities, like a payment or default, involving the underlying collateral would be reported before the beginning of the next business day.

Unfortunately, the government has neglected this primary role.  The result has been the creation of opaque, toxic securities that cannot be valued and, according to the Financial Crisis Inquiry Commission, frozen interbank lending markets as banks are not able to tell who is solvent and who is insolvent.

The infatuation with securitization goes back 25 years. In 1987, Lowell Bryan, a McKinsey & Co. director, argued that securitized credit would transform banking fundamentals that hadn’t changed since medieval times. 

Since then, many cheerleaders in academia and the financial industry have extolled the virtues of securitization, arguing that by combining advances in financial and computing know-how, it slashes the costs of lending, improves the evaluation and distribution of risks, makes credit decisions more transparent, increases liquidity, and so on.

Here is a case of the Financial-Regulatory-Academic Complex (FRAC) pushing a favored solution without asking if there was any problems with the current model.

Regular readers know that there was one major problem with the current model:  it is opaque.  Investors are not provided with the observable event based reporting they need to know what they own.

Securitization has certainly transformed banking, as Bryan predicted, and fueled an explosive growth in private borrowing. Besides mortgages, securitized assets now include car loans, credit-card balances, computer leases, franchise loans, health- care receivables, intellectual-property cash flows, insurance receivables, motorcycle loans, mutual-fund receivables, student loans, time-share loans, tax liens, taxi-medallion loans and David Bowie’s music royalties. Securitized assets have also helped build a gigantic over-the-counter derivatives market that was practically nonexistent in 1980. 

Yet this transformation has also had serious downsides. Yes, computer models reduced costs and increased volumes. But in lending, as opposed to selling widgets, more isn’t at all better. Bankers have to discriminate between borrowers who can repay and those who can’t. 

Securitization models devised by remote wizards fail for the same reason that Friedrich Hayek argued central planning doesn’t work: They rely on a few abstract variables, ignoring specifics of time and place. As with central planning, erroneous models can also lead to systemic failures....

The fact that the models were wrong is not what caused the systemic failure.

What caused the systemic failure was the lack of transparency in the form of observable event based reporting so that market participants could quickly and easily see that the underlying collateral were not performing as the models predicted.

The Securities and Exchange Commission also played its part: It formulated rules to protect investors, policed the trading of the securities and certified the companies that rated them.

Actually, the disclosure rules to protect investors, otherwise known as Reg AB, simply codified existing practices in structured finance.  The SEC's failure to do its job and ensure that all the useful, relevant information was available in an appropriate, timely manner put the financial market at risk.

Even so, securitization was felled by the crisis it helped cause in 2008. And it shows few signs of recovery: The roughly $128 billion of total asset-backed securities issued last year was about a 10th of the $1.25 trillion issued in 2006, and more securities are now being retired than issued.

The reason so little is being issued is that the buyers are on strike.

They know that without observable event based reporting they cannot value these securities.

Unfortunately, officials in Washington seem bent on pumping securitization back up.

They need securitization to function as it provides the balance sheet to fund the enormous amount of lending that goes on in a modern economy.

The Federal Reserve has bought hundreds of billions of dollars of mortgage securities under its “credit easing” policy, and its staff economists have proposed a permanent insurance program to cover every form of securitized credit. 

Mortgages securitized by Fannie and Freddie account for a higher proportion of home lending than ever before. 

The risk- retention rules in the Dodd-Frank regulatory overhaul aim to reassure buyers of mortgage-backed securities.

The risk-retention rules are a one-off solution to try to compensate for the lack of transparency these securities have.

If these securities provided observable event based reporting, no one would need risk-retention rules because investors could see just how risky each loan in the deal was.

To fundamentally reform the financial system, we need to end state sponsorship of securitization.

Actually, to fundamentally reform the financial system, we need to bring observable event based reporting to securitization as part of bringing transparency to all the opaque corners of the financial system.