Sunday, November 02, 2008

A Post on the Growth Commission Blog

It is here. I wrote:

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 current financial world's 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 it self 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-was 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 if house prices did rise nationally, if they 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), 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 modestly 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 is a good way to match up households with capital markets, and remains true today.

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 infrastrucure (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.


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