It Was a Wonderful Life – And Then Came Securitization

Via Money Morning:

There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

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The Problem with Securitization

James Kwak from Baseline Scenario:

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.

Are investors going to go back to that mindset? Do we want them to? It seems to me the rational investor response is this: “I have no idea what is in those securitization trusts. I don’t trust the banks, since they are taking fees out of each deal. I don’t trust the credit rating agencies, since they are being paid by the banks, and don’t have enough staff and expertise to do the job properly. I don’t trust the models, because they’re wrong. There’s no way I can do the analysis myself. So I’m not buying.”

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