Why securitization must end

Posted Apr 26th 2008 9:37AM by Peter Cohan
Filed under: Forecasts, Magazines, Economic Data, Housing

The New York Times magazine presents what looks to me like a compelling case that if we do not change the way securitization works, credit busts like the one we have now will be a permanent fixture of the global economy. That's because securitization -- the process of packaging loans into bundles wrapped in insurance and ratings and then selling them to investors -- enriches banks by letting them sell asset backed securities (ABSs) that have no clearly determined value. And yet, the owners of the ABSs report their value precisely.

The gap between ABSs' reported and real value puts our entire global financial system at risk. Here's an example. The market for collateralized debt obligations (CDOs) -- which are packages of mortgage-backed securities (MBS) -- totals $6.1 trillion. Hedge funds and investment banks -- which borrow $32 for every dollar of capital -- have $340 billion in capital between them. So if hedge funds and investment banks owned just CDOs and they dropped in value by 6%, the decline would wipe out the capital of the hedge funds and investment banks. The $250 billion in ABS-related write-offs so far suggest a huge gap between stated and actual value.

As the Times reports, the ratings agencies that were supposed to attest to the safety of the ABSs were compromised. I've posted on this before. The banks gamed the ratings agencies -- providing them information about the ABSs that would get them the highest ratings. And the banks played the agencies off against each other to reward the lucrative ratings contract to the one that would offer best rating. And in awarding the ratings, the agencies did not investigate the credit quality of the individual mortgages -- resulting in a flimsy basis for the ratings.

Despite support from Alan Greenspan, securitization is a concept whose usefulness has expired. Here are four reasons why:

No credibility in values. It is impossible to predict the present value of the future cash flows from an ABS. That's because there are too many uncertainties about the factors that will affect the amount that individual borrowers will repay each month. Since the present value cannot be predicted, there is no credible basis for setting a price for an ABS. And without a credible price, there is no basis for placing a value for that security on an investor's books.
Compromised quality control. As noted before, the ratings agencies were being paid by the banks to take an objective look at the ABSs and estimate their riskiness. Notwithstanding that I think they're impossible to value, this blatant conflict of interest makes an objective ABS rating compromised at best. This conflict of interest problem could be remedied by finding a way to pay the ratings agencies that did not create such obvious moral dilemmas.
Past is no predictor of the future. Statisticians who develop models to forecast future cash flows assume the past is an excellent predictor of the future. This may be true for short periods of time. But as happened with the collapse of Long Term Capital Management in 1998 and has happened with the current debacle, the future often behaves differently than statistical models predict. And there is nothing that statisticians can do to make their models predict those differences with any assurance.

In 2002, Greenspan saw securitization as a way to make the global economy immune from risk. In fact, securitization is exposing the global economy to one of the biggest risks in recent memory. I don't know how many innings are left in this disastrous game. But I'd guess that when it's all over securitization will have cost enough that people will agree that enough is enough.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

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Reader Comments (Page 1 of 1)

4-26-2008 @ 9:53AM

clem591 said...

When President John Fitzgerald Kennedy - the author of Profiles in Courage -signed this Order, it returned to the federal government, specifically the Treasury Department, the Constitutional power to create and issue currency -money - without going through the privately owned Federal Reserve Bank. President Kennedy's Executive Order 11110 [the full text is displayed further below] gave the Treasury Department the explicit authority: "to issue silver certificates against any silver bullion, silver, or standard silver dollars in the Treasury." This means that for every ounce of silver in the U.S. Treasury's vault, the government could introduce new money into circulation based on the silver bullion physically held there. As a result, more than $4 billion in United States Notes were brought into circulation in $2 and $5 denominations. $10 and $20 United States Notes were never circulated but were being printed by the Treasury Department when Kennedy was assassinated. It appears obvious that President Kennedy knew the Federal Reserve Notes being used as the purported legal currency were contrary to the Constitution of the United States of America.

4-26-2008 @ 11:15AM

s John said...

The assertions of Peter Cohan above are true, but irrelivent. All secrities are valued by some expected future result. US tbills and bonds are valued by the discounted cash flow of future payments and the assumption that the US goverment will be able to make those payments, which though very probable is not certain. Stocks likewise. Loans and mortgages why not? The risk of future events is inhearant in any investment, bias can not be eliminated (but maybe managed better) Diversification by pooling reduces risk with the pool beeing more predictable than any single asset. This is just like life insurance where average life spans are highly predictable but the life span of any individual is not. The real problem with securitization of mortgages is that the underwriter is not held to account for the quality of his work and his errors are simply passed up the food chain. The morgage broker is paid for quantity and not guality the incresaed risk of this system is the fundemental flaw of the securitization process.

4-26-2008 @ 11:40AM

william lindblad said...

Whatever name that is put on a risk obligation is moot. They could be call SIV's or anything else. This is more a matter of semantics. A collie is still a dog - just another breed and the same can be applied to the financial sectors love of fancy names. A debt is still a debt and when it cannot be paid - it is default.
They have names for this too - write-down and write-off, AKA loss. (they don't like the loss word - too descriptive).

4-27-2008 @ 5:56AM

al coholic said...

s John your comments are far more relevent than Peter's.

Peter, I think you have gone out on some kind of tangient. The obvious two problems with these investments were the criminal behavior of those who hid the true risk and the greed of those who should have known better.

Anyone who is close to the housing industry and has half a brain could see this coming for a few years now. Anyone with a pulse could get a mortgage from brokers conspired with agents and appraisers and yes, even applicants to put them in an untennable financial situation.

If banks bought packages of these mortgage backed securities and ignored the reality of why appreciation seemed so great they didn't do their due dilligence and deserve what they got. Most things that look too good to be true usually are.

Unfortunately their stupidity and greed has cost us all.