As we should have learned from the 2008 financial crisis, the mass production of securitised credit enables reckless borrowing, short-changes productive businesses and destabilises banks. It has been nourished by regulation, not its inherent economic advantages
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Yet, officials in Washington continue to favour this top-down misdirection of credit. To end this bias before it does any more damage, the federal government needs to get out of the securitisation business altogether.
The infatuation with securitisation goes back 25 years.
In 1987, Lowell Bryan, a McKinsey director, argued that securitised credit would transform banking fundamentals that had not changed since medieval times.
Since then, many cheerleaders in academia and the financial industry have extolled the virtues of securitisation.
Securitisation has transformed banking, as Bryan predicted, and fuelled an explosive growth in private borrowing.
Yet, this transformation has also had serious downsides. Computer models reduced costs and increased volumes.
But in lending, as opposed to selling widgets, more is not at all better. Bankers have to discriminate between borrowers who can repay and those who cannot.
Securitisation models devised by remote wizards fail for the same reason that Friedrich Hayek argued central planning doesn’t work: they rely on a few abstract variables, ignoring specifics of time and place. As with central planning, erroneous models can also lead to systemic failures.
Securitisation discourages lending that can’t be easily mechanised; banks lose interest in making loans to small businesses. Troubled loans end up in needlessly destructive foreclosures or lawsuits because a one-on-one negotiation between a bank and a borrower is impossible.
Mechanistic securitisation came to predominate largely because a government hand-tilted the scales.
The securitisation revolution that really stifled traditional banking was led by Fannie Mae and Freddie Mac.
The government-sponsored agencies paid banks a fee for originating mortgages that conformed to certain criteria, sparing banks the expense of in-depth analysis and losses from bad loans. Fannie Mae and Freddie Mac sold securitised bundles of the mortgages by suggesting they were as safe as treasury bonds. Regulators then encouraged banks to buy the securities.
The Securities and Exchange Commission also played its part in formulating rules to protect investors, policing the trading of the securities and certifying the companies that rated them.
To fundamentally reform the financial system, we need to end state sponsorship of securitisation.
First, the federal government must stop guaranteeing mortgage securities..
Second, banks should evaluate the creditworthiness of every individual or business they directly or indirectly lend to.
Finally, the Securities and Exchange Commission should focus on its original mission of policing stock markets, and not on every security that ratings firms get paid to certify.
A healthy economy needs both loans and securities, but no one can know the right, oft-changing mix. For that, we need unrigged competition. – Bloomberg
Amar Bhide is a professor at Tufts University’s Fletcher School of Law and Diplomacy and the author of A Call for Judgment: Sensible Finance for a Dynamic Economy. The opinions expressed are his own.