Is it time to separate the truth from the fiction about securitization?

The recent news cycle has produced another spate of news articles once again laying the blame for the global financial crisis at the feet of securitization.

We are especially fond of the academic pundits who have conducted a thorough study of the structured finance markets and reached the conclusion that securitization was always doomed to fail and would, inevitably, bring the markets down with it.  With no disrespect to the many hours of analysis that these folks have conducted to reach their conclusions, we really do think it’s time to back the conversation all the way up to the opening credits to understand if this “urban legend” is accurate.  We think we know where folks got off the tracks in their analysis. 

It seems that back in 2007, when the markets were tanking and regulators, lawmakers, academics and the financial media were getting a crash course in the capital markets, it became very easy to try to follow the easy path and simply boil down all the buzz words, like credit markets, off-balance sheet financing, CDO’s, credit default swaps, etc. into a few interchangeable terms and securitization seemed to fit the bill.

Further, it became valuable to many actors in this play to place blame for the whole mess on the bankers and other Wall Street types for the crisis.  When they looked around for words to describe exactly what the bad guys did and why they were to blame, the term that seemed to stick the best and the term that was seemingly tied only to this group of “villans” was securitization.  You certainly couldn’t refer to such things as “lending laws'”, “regulatory oversight” or “main street bankers” and hope to deliver the same sizzle in your story.  You also couldn’t tie the other buzz terms ONLY to the Wall Street Bankers, so your story or theory just wouldn’t be as clean as following the securitization theme and hanging the blame on the Buttonwood Tree.

The problem with this “blame securitization” angle is that it completely ignores the successful 25 + year run that this financing tool had in the global markets.  So, if we are right, that securitization is not to blame, then where would we suggest folks look?

The answer is less complex than you might think.  It is currently in vogue within academic circles to conclude that the US residential mortgage market had become an “originate to sell” market and that because lenders could easily sell new loans into securitization structures (either to GSE’s or in the private market) the market entered into an inevitable downward spiral.  In other words, because these loans could be dumped so easily, bankers could not help themselves. 

We sort of see this logic as blaming the car for a speeding ticket.  Securitization is simply a set of tested structuring tools and methodologies which provide originators of financial assets with a mechanism for attracting non-financial investors into the market.  It is not these structuring tools which led to crisis; it was the quality (or lack thereof) of the assets which were placed into these structures.  If the underlying assets had performed as expected (or even close), these programs would not have collapsed. 

We would take note of the hundreds of securitizations completed during the period of time leading up to August 2007 , even many CDO’s, that continued to perform throughout the crisis, despite a series of downgrades and pressure on the underlying assets.  The same can be said for thousands of transactions that were completed 5 and 10 years ago that continued to pay their investors throughout the past 3 years.

Our conclusion is fairly simple.  It wasn’t the structures (i.e. securitization) that tanked the markets, it was the collateral.  If this view is correct, then it seems to us that the way to correcting the problem will not be found in restricting securitization through revised Safe Harbor standards, FAS 166/7, Skin-in-the-Game and onerous reporting standards.  The real answer lies in doing  a much better job ensuring that lenders do not create financial assets of such poor quality.  In other words, we much prefer a strategy which puts us in front of the ball.

Of course, to suggest such a theory begins to open the door to a less than clear-cut explanation and begins to bring in a number of different actors that may not sound as appealing to an audience as blaming the Wall Street crooks.  These other actors would have to include local and regional banks and mortgage companies that were creating exotic loans, federal and state regulators who had all the power and plenty of regulations already at their disposal to oversee the activities of these lenders.  It would also include Congress who had the responsiblity for overseeing the  activities of the largest participants in these markets; namely the GSE’s.

We do not believe that it would be productive at this point in time to simply make this an exercise of attempting to shift blame for the crisis.  However, what we do believe would be helpful to the dialogue going forward is to point out that fixing securitization, at least in the manner that has been proposed, is far from the answer.  In fact, unless the powers that be begin to understand that we need to separate the discussion between reforms to “asset origination” and those for “asset securitization”, we do not see how the securitization markets can recover.  The current “fixes” make securitization too costly for issuers, too uncertain for investors and too much trouble for both sides to get involved with this security type.

No wonder, so many traditional issuers of structured debt are now looking to other funding alternatives including high yield debt and asset-based financing.  This all sounds like a return to the 1980’s to us.

So let’s split the discussion, focus on the real culprit, “asset origination” and let’s restore most of the very good components of a highly functioning securitization market, including “real” Safe Harbor, true sale and off-balance sheet standards that both issuers and investors can rely upon.

About markferraris
Managing Principal Orchard Street Partners LLC

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