Filed under: Forecasts, Magazines, Economic data, Housing
The New York Times magazine presents what looks to me like a compelling case that if we don’t change the way securitization works, credit busts like the one we’ve now will be a permanent fixture of the global economy. That’s because securitization — the process of packaging loans into bundles wrapped in insurance and ratings and then selling them to investors — enriches banks by letting them sell asset backed securities (ABSs) that have no clearly determined value. And yet, the owners of the ABSs report their value precisely.
The gap between ABSs’ reported and real value puts our entire global financial system at risk. Here’s an example. The market for collateralized debt obligations (CDOs) — which are packages of mortgage-backed securities (MBS) — totals $6.1 trillion. Hedge funds and investment banks — which borrow $32 for each dollar of capital — have $340 billion in capital between them. So if hedge funds and investment banks owned just CDOs and they dropped in value by 6%, the decline would wipe out the capital of the hedge funds and investment banks. The $250 billion in ABS-related write-offs so far advocate a large gap between said and actual value.
As the Times reports, the ratings agencies that were supposed to attest to the safety of the ABSs were compromised. I’ve posted on this before. The banks gamed the ratings agencies — providing them information about the ABSs that would get them the highest ratings. And the banks played the agencies off against each other to reward the lucrative ratings contract to the one that would offer best rating. And in awarding the ratings, the agencies did not investigate the credit quality of the individual mortgages — resulting in a flimsy basis for the ratings.
Despite support from Alan Greenspan, securitization is a concept whose usefulness has expired. Here are four reasons why:
- No credibility in values. It is impossible to predict the present value of the future cash flows from an ABS. That’s because there are too many uncertainties about the factors that’ll affect the amount that individual borrowers will repay each month. Since the present value can’t be predicted, there’s no credible basis for setting a price for an ABS. And without a credible price, there is no basis for placing a value for that security on an investor’s books.
- Compromised quality control. As noted before, the ratings agencies were being paid by the banks to take an objective look at the ABSs and estimate their riskiness. Notwithstanding that I think they’re impossible to value, this blatant conflict of interest makes an objective ABS rating compromised at best. This conflict of interest problem could be remedied by finding a way to pay the ratings agencies that did not create such obvious moral dilemmas.
- Past is no predictor of the future. Statisticians who develop models to forecast future cash flows assume the past is an excellent predictor of the future. This may be true for short periods of time. But as happened with the collapse of Long Term Capital Management in 1998 and has happened with the current debacle, the future often behaves differently than statistical models predict. And there is nothing that statisticians can do to make their models predict those differences with any assurance.
In 2002, Greenspan saw securitization as a way to make the global economy immune from risk. In fact, securitization is exposing the global economy to one of the biggest risks in recent memory. I don’t know how many innings are left in this disastrous game. But I’d guess that when it’s all over securitization will have cost enough that people will concur that enough is enough.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
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