In defense of Securitization

Credit crisis is about to claim its latest victim: securitization. This mechanism is now blamed by some as one of the important causes of this crisis. Lately, America’s most influential economist, Paul Krugman, was very harsh on securitization and the government’s efforts to revive it. He noted that “Bear Stearns failed; Lehman failed; but most of all, securitization failed”. I believe Krugman is making a big mistake here.

There is no doubt that securitization has been an enabler for banks to take ever larger risks. Yet, securitization is just a tool, like many others. It brings benefits, but it has its costs and risks as well. Using securitization to add more leverage, the bank managements were missing the larger picture. Systemic risks posed by this mechanism were not understood, even when the individual portfolios of securitization products were risk managed in excruciating detail. There was very little questioning of the systemic risks! What would occur in a dynamic, interactive system when everyone follows the same strategy. What was the extent of liquidity? How could you take it granted that markets would trust the accounting of banking books ignoring market realities?

Such risks of systemic nature are not unique to securitization. Every financial product, every financial mechanism is subject to abuse and misuse. Even good regulatory systems are no guarantee of stability. Paths of financial crashes follow the same contours: ever increasing risk exposures in the face of diminishing margins, overcrowding and eventual collapse. Consider Iceland’s financial crash in late 2008, for example. That has been achieved thanks to no help from securitization markets. From Asian crisis, to 2000 tech crash, we observed the same: the rush of capital to an increasingly crowded, competitive market, followed by the inevitable flush. Just as it would have been wrong to stop globalization, to stop influx of money to internet ventures at those times, it is wrong at this time to stop the securitization engine.

Let’s remember that securitization was only one part of the credit bubble. Our credit risk taking was not limited subprime mortgages. It involved prime mortgages, commercial mortgages, company debts, levered buyouts and acquisitions that inflated the equity markets and a lot more. Even without securitization, we had reached to an over-levered financial system primed to burst in short order.

Let’s consider also what would happen if there were no securitization. A large part of the world lives under such constraints. Obtaining credit in such countries is difficult or impossible. Financing is largely done by individual savings. Getting a house, financing a new business venture is prohibitive. Existence of securitization in richer countries has benefited their borrowers.

Just to put a number on it, I have made some calculations. I have found some figures on the debt accumulation of households and non-financial corporations in United States. The data I found indicates $16 trillion cumulative borrowing by them since 1995 (approximately the point when securitization has accelerated). I assume 50% of this borrowing has benefited from securitization. Here is my critical assumption: I suppose these borrowers may have paid 2%-3% less on their loans they would have otherwise, thanks to securitization. Assuming 2.5% less interest rate on the loans for every year, I guesstimate the total reduction in interest paid by these borrowers might have added up to nearly $2 trillion. Credit crisis has been costly, but perhaps it has not yet erased all the savings achieved so far.

As usual, the story is a lot more complex than this simple calculation shows. Dismantling the securitization machine would not help us to prevent future bubbles and crashes. Instead, it is likely to make us poorer. We should focus instead on how to limit our systemic risks.