Magazine article The American Prospect

Simplifying Securitization with a Better System, the Economy Can Have Plenty of Credit without the Outlandish Risks and Excess Banker Profits

Magazine article The American Prospect

Simplifying Securitization with a Better System, the Economy Can Have Plenty of Credit without the Outlandish Risks and Excess Banker Profits

Article excerpt

The packaging of loans into securities is one of the financial innovations most deeply implicated in the financial crisis. It is not only closely associated with the explosive growth of sub-prime mortgages and credit derivatives but responsible for transforming the U.S. financial structure from a system based on prudent bank lending to one based on highly speculative securities markets.

The creation of a market for mortgage-backed securities came about as a response to the banking crisis of the inflationary 1970s. Lending institutions were making 30-year fixed-rate mortgage loans but financing them with short-term deposits at newly deregulated market interest rates. As inflation increased, banks lost money on their mortgage portfolios. In response, Congress called on the government sponsored secondary mortgage-market enterprises (known as GSEs)--Ginnie Mac, Fannie Mac, and Freddie Mac--to support savings institutions and small banks by buying their low-interest-rate mortgages. At that time, the GSEs were the only entities converting loans into bonds, which were fairly straightforward and not divided into securities with different degrees of risk, known as "tranches."

By the close of the 1970s, however, a second and larger inflationary spike overwhelmed the safety valve provided by the GSEs. And in the 1980s, private competitors to Fannie, Freddie, and Ginnie began offering far more complex securitized products. In principle, this innovation allowed a lender to go on making fixed-rate mortgages, shedding risks to third-party investors willing to bet on the future movement of interest rates and housing prices. But in practice, securitization without regulation sowed the seeds of the great collapse three decades later.

In the mid-1980s, Congress explicitly authorized private financial institutions to market securitized products, but without the most basic safeguards that apply to other securities markets. Mortgage-backed securities were exempt from registration and disclosure. Congress authorized a "safeguard" in the form of required ratings by government-recognized creditrating agencies as a substitute for due diligence, but these ratings were soon corrupted as securitized packages of highly risky mortgages were nonetheless awarded triple-A ratings. Moreover, mortgage-backed securities were not traded on organized exchanges, so information on the volume and price of transactions was not available to investors. In addition, capital backing along the chain from loan origination to issuance of securities was minimal or nonexistent.

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Attracted by the laissez faire nature of the market, new, unregulated loan originators such as mortgage brokers became major players. Banks and savings institutions increased their lending for housing because they could earn fees for originating and servicing mortgages without having to raise the capital required had they held the loans in their portfolios. In the 1990s, securitization expanded to include car loans and consumer receivables and, together with mortgage-backed securities, issuance and trading of asset-based securities came to dominate capital markets and credit flows. Between 1977 and 2007, the share of total credit-market assets accounted for by GSEs, mortgage pools, and asset-backed securities issuers rose from 5.3 percent to 20.5 percent while banks' share shrank from 56.3 percent to 23.7 percent. The result was a transformation in the traditional U.S. bank-based system and an erosion of the protections so carefully crafted in the 1930s.

THE ROLE OF SECURITIZATION IN THE CRISIS

The sub-prime scandal is a major and well-recognized outcome of this massive experiment in deregulation. The laxity and conflicts of interest inherent in the role of rating agencies is another.

The diversion of so large a share of credit flows into the market for mortgage-backed securities facilitated the buildup of the housing bubble. …

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