Say you go to a bank to get a loan for a house, a car, your kid's tuition, whatever. The bank lends you money. Then it packages your loan with a bunch of others into a bond. Investors buy the bond because they like the steady stream of cash that comes from people slowly paying off their debt. In exchange, the bank gets a slug of money up front, which it turns around and uses to make more loans. This goes on for a long while.
Then one day you need another loan. You go back to the bank. But this time there is no money to lend because the global financial system has turned upside down, and the market for securitization the process of packaging loans into bonds and freeing up cash for more lending has fallen off a cliff.
At the heart of the problems wracking financial institutions the problems that have drawn trillions of dollars in rescue funds from governments around the world is securitization. When securitization was developed 30 years ago, it was a true breakthrough: lenders no longer had to wait to be paid back before making additional loans and were able to more quickly plow capital into the economy, thereby driving growth. But over time, securitization fanned by techniques that teased apart different levels of risk spread beyond plain-vanilla bonds and easily understood products, especially in the mortgage market. Eventually, those innovations collapsed under their own weight and a slew of faulty assumptions for instance, about the ability of borrowers to repay. "People pushed it too hard," says Juan Ocampo, a onetime McKinsey consultant who helped popularize securitization in the 1980s. "You can build a very efficient nuclear power plant, but if you run it too hard, it'll blow up."
We're now suffering a financial Chernobyl, and securitization is radioactive. For the first nine months of 2008, the dollar value of new securities backed by auto loans was 40% lower than for the same period a year before. Student-loan issues were down 42%, and issues tied to credit cards 21%. That means less money available to help you buy a car, pay college bills or charge purchases to plastic. The damage in the housing market, as anyone trying to buy, fix up or refinance a place can tell you, is much worse. Home-equity-loan issuance is off 98%, and new issues of private-mortgage securitizations, worth three-quarters of a trillion dollars in 2006, have come within a hairsbreadth of zero.
There are plenty of people trying to get things going again. In the housing market, government-related agencies like Ginnie Mae and Fannie Mae are still securitizing mortgages. The Federal Reserve has started buying up to $500 billion of those issues in an effort to quicken the pace and has set aside $200 billion to prime the pump of securitizations backed by consumer or small-business lending. In December an international consortium of financial trade groups issued a 76-page blueprint titled "Restoring Confidence in the Securitization Markets." And ratings agencies like Moody's, which have been blasted for not raising red flags precollapse, are overhauling their evaluation process in an attempt to regain investor trust.