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But before we do everything we can to get back on track, it might be worth asking exactly how much securitization we want. After all, securitization enabled us to gorge on borrowed money, which is what got us into this mess. In 2007 nearly half of all mortgages, corporate bonds and leveraged loans in the U.S. worked their way into securitizations. That report, published by the American Securitization Forum (ASF) and its counterparts in Europe and Australia, points out that the very firms that created some of the most complex products have suffered hundreds of billions of dollars in losses, "suggesting that even they did not fully understand or were unable to monitor and manage the risks." The task now is to find the proper role for securitization so that it doesn't detonate again.
At its core, securitization is an extremely useful tool. Though it was developed in the 1970s to boost lending in the mortgage market, canny investment bankers and lawyers have discovered plenty of new uses over the years. Anything that brings in a steady stream of revenue can be securitized — computer leases, utility bills, mutual-fund-management fees, royalties paid on David Bowie's songs — letting businesses move assets off their books and delegate payment collection to someone else. Lenders also, then, can borrow more cheaply, since "investors don't have to worry about everything that goes on with the company, just the quality of the assets themselves," says Duke University law professor Steven Schwarcz.
In the American scheme of finance, though, a good idea once is a good idea a million times. Over the past dozen or so years, securitization soared, providing many a meal ticket — for banks, which didn't have to keep as much capital on hand as long as they sold their loans; for finance companies like mortgagemaker Countrywide, which were able to grow into lending giants without deep deposits; for traders, who used leverage to buy the bonds and move them around the secondary market at great profit.
Then, the conflagration. As interest rates remained low and investors greedily scoured for yield, Wall Street's securitization engineers were more than happy to oblige by creating a vast supply of bonds without asking too many questions about borrowers' ability to repay. As volume increased, so did complexity, and with it risk. Worldwide issuance of collateralized debt obligations (CDOs) — Frankenstein-like securitizations built from parts of others, which were perhaps best at ginning up fees for investment bankers and lawyers — more than tripled in just two years, to half a trillion dollars in 2006.
When lax underwriting standards and borrowed money on top of borrowed money finally caught up with the world, the pyramid-style system crashed. Even slight changes in economic conditions sparked fatal domino effects in complex securitizations. The market for new products evaporated; CDO issuance fell 90% last year.