Blogvesting

In the wake of the credit crisis, many of the recently invented financial products will be found wanting and discarded. Since massive losses in mortgage-backed securities were the immediate cause of the current crisis, many people have suggested that securitization itself is intrinsically flawed, and the entire CDO/ABS/MBS industry will cease to exist in the future, with the obvious dire results for FMD. However, I believe that securitization will continue to play a role in the future because it has fundamental economic value.

Firstly, securitization facilitates diversification and reduces risk. In the past, small local banks will take deposits from the local populace, and lend money to local businesses and house-buyers. When a local economic downturn strikes, the banks go bust. Only large banks with operations in many geographical regions were sufficiently diversified to withstand the periodic local economic crises that will strike from time to time. By pooling together uncorrelated risks, securitization diversifies away geographical risk, allowing smaller banks to survive periodic downturns, and giving investors access to a security with superior risk characteristics and more predictable cash flow.

Secondly, securitization makes more efficient use of capital. Without securization, only local depositors can fund local housing and business loans. If China has a surplus of capital, this surplus cannot flow to fund high return uses in the US, it must simply find another use at lower return. Securitization allows local businesses to access global financial markets, and allows capital to flow to where it finds the highest return, enhancing the overall efficiency of the global economy.

Even before the crisis, the agency problems inherent in securitization were recognized, and mechanisms were put in place to minimize them. Securities were divided into tranches, and the lowest tranche (the first to be hit by any defaults or prepayments) had to be held by the originating banks. This was supposed to ensure that underwriting standards were upheld, since the banks were the first in line for any losses. In addition, investors required that the securities be insured. Because insurers will have to make the investors whole in the event of any losses, they were supposed to perform due diligence and refuse to insure any substandard securities. In the end, it turned out that banks (and FMD) were able to charge such enormous fees when selling the securities that the residuals (the lowest tranches) became just gravy, and the insurers were seduced by the profits and failed to properly estimate the risks involved.

Can the agency problems of securitization be overcome? Just as the nothing-down mortgages will be abolished in favor of the conventional 20% down mortgages, the securitization process is likely to be significantly altered to give greater protection to investors. Several mechanisms can be utilized, including over-collateralization and/or greater retention of the securities by the originator. No matter how the process is altered, it will take some time for investors to again become comfortable with CDOs and ABS, and FMD is unlikely to find the business as profitable as it has been in the past few years. However, in the final analysis, I think that securitization will indeed begin again in the future, and FMD will find a niche in that new market.