Is securitization good or bad?
Photo: Kerstin Riemer. Source: Pixabay
Securitization is a five-dollar word that 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 centralized call-center.
Securitization is actually pretty simple: it takes ordinary bank loans and bundles them up into securities that can be sold to investors. It’s been around for over 150 years. During the California Gold Rush, the railroads boomed. Everyone was moving west. This took money – for building railroads, for buying locomotives, for expanding the railroad companies. By 1855 there were over $400 million in outstanding railroad bonds, many of which were secured by the land under the tracks. When land values fell, the bonds defaulted, which helped cause the Financial Panic of 1857.
This caused people to wonder if any bonds were safe, and for a while, bank lending contracted. A similar thing happened with our Financial Crisis. In reality, most bonds are quite safe: Treasuries, Municipals, Corporates. People generally pay their bills on time. The US now has a bond market worth some $25 trillion. Just about any cash stream can be securitized. Music fans may remember Bowie bonds: royalties from David Bowie’s albums were so stable that Prudential Insurance bought bonds based them in 1997.
Only a small portion of our bond market got into trouble ten years ago. 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 sharp recession, which we still don’t quite understand. This has made many investors and regulators question 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. The essence of securitization is getting money from where it is to where it’s needed. Until financial engineering is as boring as civil engineering, our economy won’t grow as well as it might.
Douglas R. Tengdin, CFA