Friday, March 27, 2009

Throwing away the baby with the bath water

http://krugman.blogs.nytimes.com/2009/03/27/was-i-unfair/

Yes, of course you're unfair. You're throwing away the baby with the bathwater.

1st. I agree that finance needs to be a much smaller percentage of gdp and that it has been sidetracking our best minds into nonsense.

Securitization is not rocket science and it's benefit was quite specific. For large concentrations of assets looking for a liquid place to park, the residential real estate market in the united states was/is a rich resource. It's one of the largest concentrations of capital in the world.

When we first came up with the idea, big pools of pension fund money were looking for a way to invest in mortgages, but our model of prepayments made them a very difficult cash flow to manage in a portfolio. Who needs an asset that gives you your money back just when it's going up?

On the other hand, giant corporations were very much in need of overnight and short term funds. Liquidity was important to them too.

Rearranging the cash flows of this huge pool of assets so that one party got them earlier and another got them later was logical and productive. Mortgage rates fell to lows of 6 and 7% from highs of 17 and 18%. It broadened the investor base to include the vast pools of funds in pensions and insurance companies. There was some volatility in prepayments, money was lost in 93 when everyone repaid at once, but by and large they have been good assets for investors.

The game for securitization went nuts when leverage went nuts just like everything else. When hedge funds, ballooning with cheap money and leverage came swooshing in for assets, the games began in the securitization market just like it did in the stock market, the housing market, the commercial market, the retail market (just about any market.)

That old world you describe when banks just took in deposits and made loans was made in a world where the fed contrived to keep rates constant. In a world of wildly fluctuating rates and shapes to the yield curve ushered in by Volker, that model has a whole world of hurt built into it. Ask the S&L's. They borrowed short and lent long when short rates soared.

CDS Swaps are at the heart of the mess we're in, complicating it in ways that are incomprehensible, and in a magnitude that we can't even fathom. They are not securitizations, but fraud and at some point someone needs to walk some of these guys down a plank, somewhere.