A Primer on Securitization

"The book I’ve chosen on securitisation really is accessible. It’s a collection of lectures from people in the industry who are or were involved in securitisation. The first line says that securitisation is one of the most important and abiding innovations to emerge in the financial markets since the 1930s. This is a lecture from 1996, so people already recognised that it was important back then. There is a chapter about the role of rating agencies, securitisation’s role in the housing – something we’ve been reading about a lot with respect to Freddy Mac and Fannie Mae. But we had a series of crises before the Civil War too and attempts at preventing them were kind of short-circuited by the system’s evolution and the national banking era, during which repeated crises allowed the government to finance the war. What did prevent crises was not intelligent design by intellectuals, but a populist mandate in 1934 – deposit insurance. The economists were jumping up and down saying: ‘Don’t do it!’ It worked until we had another change. This crisis is viewed as a unique event and people point to credit derivatives and compensation, but in the background of all this is this bank liability that looks just like demand deposit and people didn’t know about it. If we don’t understand that there is a common structural problem then we can’t act. We should recognise the problem. The size of the repo market. I’ll walk you through it with a hypothetical example. So, Fidelity Investments (for example) is a huge mutual fund manager and, let’s say, has $100 million in cash that people have sent in and they’re going to use it to buy securities, but not right now. They’d like to put it in a checking account but the ceiling on checking accounts is only $250,000. So, they’ll use a repo. This is a sale and repurchase agreement. They are going to go to, say, Bear Stearns and deposit the money and Bear Stearns will pay them interest and the transaction will happen overnight. But how will they make it safe? Bear Stearns owns securitised bonds that it has purchased. So, Fidelity will receive $100 million dollars of bonds at market value such that Fidelity doesn’t have to worry about Bear Stearns going insolvent overnight because it has bonds. This market in securitised bonds grew very large and the government never collected data on it. Then the market suffered an economic shock – housing prices went down. That alone is not a global financial crisis, but nobody knew where the risks were. It’s like E.coli in ground beef. People then stop buying all sorts of things. So, Fidelity says: ‘I’m worried you might have this sub-prime housing risk and I need to sell some bonds so I want to haircut the collateral.’ They deposited $100 million and got an equivalent amount of bonds. Now they say they only want to deposit $90 million so they make a withdrawal of $10 million. Now Bear Stearns has to come up with that money. I have estimated that the repo market before the crisis was around $10 – $12 trillion. So, if the haircuts were zero and are now 30 per cent that’s a sudden withdrawal of $3 trillion. Because the repo market is an obscure market. We did see the housing market collapse coming, but then, with the repo market, what people saw were only the effects of it and they eventually started to associate the effects with the causes."