It Wasn't The Securitization That Was Irresponsible
The Wall Street Journal this weekend ran another article that frustrates me. It complains that bankers are continuing to try to trick investors into buying garbage in repackaged securitizations. This kind of article bothers me for several reasons, all of which relate to the ignorance that many people share regarding securitization and asset-backed securities.
First, let's look at a little of what the article says. Here's the lead paragraph:
Irresponsible securitization helped bring the financial system to its knees. Yet, as banks start to heal, little seems to have changed. Wall Street has quickly fallen back on old habits.
The first sentence many probably hold as obvious fact. It's false. The securitization was completely and utterly responsible. The banks worked with rating agencies to carefully structure deals in accordance with those agencies' standards. There were no errors in banks' models, and their assumptions all had to be signed off on by the rating agencies. Then, they found investors who loved the stuff and bought lots of it. Those investors had a fiduciary responsibility to their clients to understand the securities that they purchased. Clearly they did not.
Banks' only responsibilities were to correctly structure the securities and then find investors to buy them. They performed both of those functions responsibly. The rating agencies and investors acted irresponsibly. The agencies' methodology was critically flawed, as were their assumptions. The investors failed to perform proper due diligence and understand what they were buying. Bear in mind that not just any investors could buy this stuff -- only large institutional investors who should have know what they were doing.
So what are banks doing now that has the WSJ crying foul?
Banks are building investment products to fit ratings firms' triple-A standards, in the process taking advantage of capital rules still tied to ratings.
So let me see if I understand. Banks are closely following the rating agencies' requirements to create securities. In doing so, they are following capital rules. The horror! How dare they? You have got to be kidding me. If the rules are flawed, then direct your anger there, not at the banks for following them in order to acquire much needed capital.
If banks are, indeed, creating more toxic securities -- and I will challenge that notion next -- then again the blame should be placed on two other parties: the rating agencies that are giving them misleadingly safe ratings and the investors dumb enough to buy the stuff.
Let's see what the WSJ is specifically unhappy about:
Several banks have resecuritized chunks of triple-A rated commercial-mortgage-backed securities -- effectively making mini-CDOs out of parts of deals already in the marketplace. The result: A strengthened triple-A tranche and a more speculative triple-A security with less call on cash flows. That means the stronger portion is likely to retain its top-notch rating even in the face of downgrades and won't require extra capital put against it. The weaker tranche can be sold to a more speculative investor.
I completely fail to see how this is bad. The WSJ here admits that new securities will result in a AAA-rated portion of the bonds that will be much, much stronger. I don't doubt it, because the rating agencies have obviously changed their standards to be vastly more conservative after their epic failure in establishing a good methodology the first time. In fact, they're likely overcompensating and making the AAA-rating too difficult to attain, though such a complaint won't muttered by many for several years.
I'm a little unclear on what the Journal means by a "more speculative triple-A security." The methodology shouldn't be vastly different among triple-A portions in the same kind of securities. If there is a much riskier AAA-rated security being issued, then the rating agencies have, again, failed -- not the banks. But I suspect that there's some misunderstanding here and the Journal really means that it's the lower-rated portions that are more speculative -- and that's probably right. But that's fine, because any investor crazy enough to buy the stuff is going to demand an extremely deep discount. And if that investor didn't, and incurs significant losses, then it will get exactly what it deserves.
Finally, I'm consistently stunned at people's belief that, going forward, securitization is just a bad idea. That belief is akin to thinking that all stocks are bad after a stock market crash. The securitization market performed without grave incident for decades. The reason it went bad over the past few years was not because of securitization -- it was because of bad collateral. Had real estate not been overvalued, the market would have continued to function normally.
And in the future it should continue to function. This can be seen through other asset-backed securities not tied to mortgages that haven't seen treacherous losses. Such deals include stuff like auto loan-backed securities from prime issuers like Honda or Nissan. In a recession this bad, some with car loans might go delinquent or default, but the cushion in the deal should account for most of that. The collateral was strong enough that the rating agencies' assumptions worked.
I'm sure it will take a long time for the general public to become comfortable with the idea of securitization, but that's mostly because few people really understand it. Those who do understand it know that it's a perfectly legitimate funding strategy for banks and issuers. The public should hope that it comes back as well, because without it Americans will have a much more difficult time getting credit. And the credit they eventually get will be far more expensive without securitization.