Securitization - more comments from class discussion

I would like to use this opportunity to comment about the opposing viewpoints regarding securitization discussed at class.

First, one needs to understand that the most direct link of subprime loans to the economy as a whole involves the securitization of subprime loans. Local banks and thrifts are no longer the main source of funding for American homeowners who wish to assume mortgages. Once mortgages were securitized the entire spectrum of capital market institutions - pension funds, mutual funds, insurance companies, investment banks, and ultimately foreign investors – provided funding to the U.S. subprime market (Zimmerman, 2007). Thus, a wide range of individual investors and financial institutions worldwide were linked to the U.S. mortgage market. A large amount of subprime defaults translates into major losses on balance sheets that might even lead to bankruptcies.

Second, we all need to realize how investors make their decisions when purchasing securities. Thomas Zimmerman, Managing Director of UBS Investment Bank in New York wrote:

"...This problem is only compounded when subprime

securities are used in CDOs. As we’ve noted, it is difficult

to estimate which bonds (tranches) will be written

down on a single subprime deal. Mezz CDOs contain or

reference (if synthetic) hundreds of individual subprime

bonds and often contain CDOs of other CDOs. Calculating

expected bond losses on Mezz CDOs is a complex,

highly data-intensive task that requires access to a large

database and a large amount of computing power, as well

as knowledgeable analysts. Hence, it is difficult for the

average investor to forecast how a specific level of subprime

losses will impact a Mezz CDO."

Investors just trusted that the amount of risk they are undertaking corresponds to the risk the underwriters and the banks that created the CDOs believed it to be. Asking investors to exercise due diligence is unpractical in this case. Hedge funds, pension funds, insurance companies, and even private investors do not have the resources to examine hundreds of individual subprime loans in a given CDO. In other words, the new financial products have caused a lack of transparency which we can all agree is vital to a healthy, well-functioning market.

A corollary to that is the uncertainty that surfaced in the financial markets. While securitizing subprime loans funneled a large amount of capital into the subprime market and led to the dispersion of risk, it also created a growing uncertainty over the location of risk or, more precisely, losses. Scott Anderson, senior economist in Wells Fargo Bank and member of the ABA Economic Advisory Committee confessed: “while default risks have been widely spread and are unlikely to bring down any one industry, now nobody knows where the risks lie, since traditional financial products like mortgages have been sliced and diced and traded.”[i] In other words, a lack of transparency over the scope and potential losses of many deals created a vast amount of uncertainty in the market. Even if the scope of subprime-related deals were transparent, the average investor lacks the tools and knowhow to calculate the expected subprime-related bond losses.

Since investor do not know which banks, cooperation, hedge funds, and other publicly-traded companies will be affected from subprime-related losses, investors were (and still are) reluctant to invest in a dysfunctioning, uncertain market. The vast amount of uncertainty this situation created not only discourages investors from investing in the financial markets but it also leads to a liquidity crisis – a situation in which investors cannot resell their securities in the open market.

Third, one needs to also understand that securitization created a situation where the originator of a loan did not remain with the burden of the debt ( and the risk associated with). One of the themes coming out of the congressional hearings on subprime loans was the role played by securitization. The premise is that the relationship between loan originator and loan risk was broken due to securitization, and as a result lenders were less responsible in underwriting loans (Zimmerman, 2007). Thus, each party in the mortgage lending business had its own roles and interests. But all had a common goal: to pass the burden of the debt to the next level as quickly as possible. This segmentation had destructive repercussions that resulted in difficulties in determining where responsibility lies.

Summing it all up, securitization not only incurred losses to careless investors who did not exercise due diligence, but it also had rippling effects that undermined the very foundation of the U.S. and even global economy. The Fed (or any other pertinent policy maker for that matter) must take this fact into consideration when thinking about the future of securitization. Something has to be done to reestablish investors' confidence regarding securitization. Needless to say, if nothing is done about securitization, investors will simply stop investing in such securities in American markets; they will go elsewhere where they can enjoy more transparent, stable, conditions.

That being said, I think the benefits of securitization are too high to simply abandon it. After all, securitization enabled millions of people that would otherwise remain homeless to purchase homes. We just need to rethink how to tackle the current problems that it causes.

[i] Scott Anderson "How a liquidity crisis becomes a credit crunch." American Bankers Association. ABA Banking Journal 99, no. 10 (October 1, 2007): 88. http://www.proquest.com/ (accessed December 19, 2007).