One of the villains of the current financial crisis is "securitization." The alphabet soup of securities structures--CMOs, CDOs and SIVs--is roundly blamed for the financial world's current mess.
The irony is that it was not so long ago that emerging countries looked to securitization as a savior for the problems that they faced in developing capital markets. Specifically, many countries (particularly in Latin America) looked to Fannie Mae/Freddie Mac Mortgage Backed Securities as models for instruments for providing housing finance, and others (such as India) looked at special purpose vechicles as a potential method for getting around the poor financial conditions of local government attempting to finance infrastructure.
So which is it: villain or savior? Well, of course the answer is neither. Securitization is just an instrument, and when applied appropriately under appropriate circumstances, is a useful instrument. So let's begin by dispensing with the notion that securitization is itself a villain, and then talk about why it is not a savior either.
I believe investors made two fundemental mistakes about subprime mortgages. First, some investors thought US house prices would never fall nationally, in part because they never had (in nominal terms) in the post-War era. So long as house prices rose, these investors reasoned, mortgage borrowers would retain a powerful incentive not to default; consequently, default risk for all mortgages was deemed to be low. True story--around 2005 I was in the elevator of a large investment bank, and one person said to another, "you can't make a bad real estate loan." That happens to be the moment that I began to worry about the subprime market.
The problems with this line of reasoning were two: just because house prices had never fallen nationally didn't mean that they couldn't, and even when house prices rise nationally, they can still fall regionally (as they did in the US Midwest in the 1970s, in Texas in the 1980s and in New England and California in the 1990s), and then one will still see defaults. This was an underwriting issue, not a securitization issue.
The second problem is that Wall Street Ph.D.s thought they could outsmart bad underwriting. This reflected insufficient modesty about how confident we can be about parameters. The idea behind Collatoralized Debt Obligations was that one could combine subordinated securities (those that were in the first loss position) and use diversification to get a very precise estimate of the losses that one could expect from those securities. Suppose that the expected loss of a security was ten percent with a standard deviation of ten percent. By combining 30 securities, one reduces the standard deviation by 1/(sqrt(30)), or by more than 1/5, so investors can have confidence that the actual realized loss would fall within a narrow band. Investors could then use the knowledge to further slice and dice.
For this to work, however, one needs to know that the parameter estimates for expected losses and standard deviaion of losses are correct. For a whole host of reasons, we didn't have remotely enough information about parameter stability to make these sorts of judgments. Something we need to remember is that as our models get cleverer, we start losing degrees of freedom. But we also need to remember that the vanilla MBS security structure, and even simple senior-subordinated tranching, worked very well for a very long time. Securitization was a good way to match up households with capital markets, and that continues to remain true.
But the recent crisis suggests that securitization is no magic bullet for emerging countries. For securitization to work, investors need to understand the loans that are being securitized, and that means the loans must be underwritten robustly and consistently. For this to happen, emerging economies will need stronger financial infrastructure (such as well developed banking systems) and property rights infrastructure (so investors can have confidence in collatoral). I remember when I did a Bank mission in one very low-income country, I was asked about whether it should develop a Fannie Mae. This was a country whose courts couldn't enforce foreclosure rules, and that had no long term sources of finance. If any good news arises from the current crisis, it is that emerging countries might focus on getting fundementals right, instead of hoping for a magic securitization scheme to solve all their problems.
Some may wonder how the
Some may wonder how the observations of the Growth Report, dealing with sustainable high growth patterns over long periods, can be reconciled with policy choices currently facing government decision-makers. Clearly the food and fuel price spikes earlier in 2008, followed by the financial meltdown affecting all markets, were dramatic challenges, especially for poorer developing economies, but also for emerging market economies generally. This will inevitably be followed by a global recession in 2009, a slow-down that has already started, even in China, the world’s dominant growth engine in recent years.
The icon thing is not meant
The icon thing is not meant to have the same effect as contacting your congressmen. It's predominantly a way for people to publicly advertise their own beliefs. It's a way to say "hey everyone, I have $OPINION about $ISSUE homeschool programs ," analogous to wearing a ribbon or t-shirt or slapping a sticker on your car. As with the shirts and badges, the person behind the icons may or may not actually be doing anything to effect actual change.
Securities doesn't seem like the proper name
The idea that no one saw the housing bubble bursting the way it did isn't too far out there, if it is true that home values haven't declined, or at least dramatically, since World War 2. If that is taken as what was generally true at the time, then the securities backing would seem like not a bad idea. However, as history points out time and again, what is known to be true at one time (such as the idea that the sun revolves around the earth, trial by ordeal really proving anything) is not necessarily true at a not too distant point.
Also, the idea has to be stated that the securities that were used were other people's debt, which if defaulted in meant an immediate loss of income. Going by the assumption that default was such a low risk, then it makes sense, but the idea is that the only other people that I've heard of doing that is the Mafia. Loan shark tactics - is that what they teach at Harvard?