Is securitization a boon or a bane?
Securitization is one of those five-dollar words that gets leaves people scratching their heads. It’s been alternately described as the greatest financial innovation since double-entry accounting or as the worst banking product since the Bombay-based call-center.
Securitization is just what it sounds like: it takes ordinary loans and bundles them up into securities. It’s been around a long time, as long as banks have been selling loans to one another. In the 1850s, during the California Gold Rush, westward expansion led to a boom in railroad construction. This required money, and by the middle of the decade there was over $400 million in outstanding railroad bonds, many of which were mortgage bonds—secured by the railroads’ land. When land values declined, the bonds defaulted, leading in part to the Financial Panic of 1857.
But most bonds are quite safe: Treasuries, Municipals, Corporates. The US has a bond market worth some $15 trillion. Just about any cash stream can be securitized. Music fans may remember Bowie bonds: royalties from his albums were so stable that Prudential bought bonds based them in 1997
Only a small portion of our bond market—sub-prime mortgage loans—got into trouble in 2007-8. But the risk of that sector was concentrated in a few critical financial institutions, which fell like dominos: Bear Stearns, Fannie Mae, AIG, Lehman. The ensuing financial crisis led to a huge recession, the effects of which are still with us. This has made many investors and regulators shy of the whole securitization process.
But when you fall off a horse, often the best thing to do is to get right back on again. The problems of the financial crisis weren’t the techniques, but the assets to which they were applied. At its heart, securitization moves money from where it is to where it’s needed. Until financial engineering is as trusted as civil engineering, our economy won’t grow as well as it could.
Douglas R. Tengdin, CFA
Chief Investment Officer
Follow me on Twitter @tengdin