The Corner

by Bart Ward

With the advent of the 2008 financial crisis, we heard more about the word “securitization” than anytime before. What is it, what does it mean and how did it affect the economy leading into 2008?

Securitization is the pooling of different types of contractual debt. Most often debt related to commercial and residential mortgages, credit card obligations, auto loans and other types of loans. These pools in turn are sold to investors as “structured investments” in the form of collateralized mortgage obligations (CMO), collateralized debt obligations (CDO) and various types of consolidated debt bonds. These pools contain tranches, which are a number of related securities that have different risks and rewards. The word “tranche” is the French word for slice. In short, these pools were and are slices and dices of underlying securities that are layered with some high and low quality obligations.

Securitized investments are supposed to pay back investors on the principal and interest on the debt of the underlying security. Mortgage-backed securities (MBS) are backed by mortgage receivables and asset-backed securities are backed by other types of receivables. According to Nicole Gelinas in her book “After the Fall,” “this great invention in ‘securitization’—the packaging of long-term loans and other streams of future cash flows into securities—began with home mortgages.” This went back to the 1970s and in the 1980s and ‘90s MBS exploded.

As the structured investment market grew MBS were cut up into many different pieces and sold to investors all over the world. This slicing and dicing of MBS created an environment where should something go wrong, it would be nearly impossible to get to all these investors to renegotiate terms.

These structured investments were to have principal protection, contain tax benefits, provide better returns and be less volatile. In reality what happened, as we led up to 2008, was the revelation that these investments were complex and not well understood, there was a good deal of unsecured credit risk and there was lack of pricing and liquidity because of the inability to trade these investments in a deep and liquid market.

In “The Sellout,” Charles Gasparino writes, “By late 2006 market players estimated that nearly 80 percent of even the safest pieces of each CDO, the triple-A super-senior tranches, were packed with debt directly tied to the increasingly credit-challenged subprime mortgages, meanwhile, default rates, stable for the past five years, began to rise, at first gradually in the mid-2006 but then with great ferocity in the new year and beyond… The question in early 2007 wasn’t really if and when it would unwind but how much.”

As this giant market began to come unglued, many inside the official regulatory apparatus and those on Wall Street were unaware of the consequences that were yet to come. Part of the reason is because of much of what happened was not transparent in the financial system—this was especially true in the mortgage market as 2008 approached. Michael Lewis summed it up in his book “The Big Short.” Lewis states, “How long would it take before the people walking back and forth in front of St. Patrick’s Cathedral figured out what had just happened to them?”

Quote of the Week: “A good knowledge of what happened in 1929 remains our best safeguard against the recurrence of the more unhappy events of those days. Since 1929 we have enacted numerous laws designed to make securities speculation more honest and, it is hoped, more readily restrained. None of these is a perfect safeguard. The signal feature of the mass escape from reality that occurred in 1929 and before–and which has characterized every previous speculative outburst from the South Sea Bubble to the Florida land boom–what that it carried Authority with it. Governments were either bemused as were the speculators or they deemed it unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution.” – John Kenneth Galbraith

Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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