A Defense of Asset Securitization from Bedford Falls
Over the last couple of weeks, the reputation of MBSs and CDOs have taken a drubbing, with folks insisting that they are little more than instruments of irresponsible speculation at best and fraud at worst. To which I say, “Nonsense!” To understand why, consider this clip from “It’s a Wonderful Life!,” which I used in my Article 9 class last week as a starting point for discussing the financial crisis.
Why was the Bedford Falls S&L failing? We learn that the Bank had called their loan and the crazy uncle, in a moment of panic, shut the doors because there simply wasn’t any cash on hand to pay depositors. Depositors, in turn, took the shut doors as a signal of imminent collapse and began clamoring at the gates for their deposits. George Bailey, in turn, puts up his honeymoon nest egg, and doles out dribs and drabs of cash to the good people of Bedford Falls, just enough to keep the doors of the Savings and Loan open through the day and thus put to rest the panic. I love this scene. Jimmy Stewart does a marvelous performance as heroic Everyman, and the vision that the film offers of community solidarity in a moment of crisis is in many ways inspiring. On the other hand, it is not clear that this is such a hot way of financing home ownership.
There are a number of problems with the “It’s a Wonderful Life” system. The Bedford Falls S&L has serious liquidity problems because it’s assets — the rights to payment of long-term home mortgage loans — while valuable would take a very long time to pay out. To deal with the liquidity problem it leveraged itself by borrowing money from the bank, but this leverage made it vulnerable in times of panic. There were other things that made it vulnerable as well, most notably the fact that its assets were geographically concentrated in Bedford Falls. If there is some economic shock to the community, the S&L is not diversified and is likely to go under, taking everyone’s deposits and home values with it. The solution is to move the mortgages out of the S&L. Turn those long-term payment streams into cash now. This solves the liquidity problem and eliminates the need to take on extra debt, and the associated brittleness in the face of crisis. It also means that the risk of a Bedford Falls specific shock can be borne by investors who can diversify that risk away by bundling Bedford Falls mortgages with Palo Alto mortgages and Milwaukee mortgages. This is all made possible by the securitization of the mortgages that George Bailey originates. In other words, MBSs are not a scam fixed up by greedy financial speculators. They are an investment instrument that provides a real solution to a genuine set of problems.
“Okay,” says the CDOs-are-evil skeptic, “but aren’t we witnessing the equivalent of the run on the bank right now? Aren’t MBSs what has made this all happen?”
Yes and no. To be sure the MBS has some systemic problems, the biggest one being the separation of information about risk from the holders of risk. As I told my class last week, notice that when push comes to shove, George put his own, personal money on the line to save the Bedford Falls S&L. This is what you call “skin in the game.” With what amounts to a personal guarantee of the S&L and an intimate knowledge of the community — “You don’t have to sign anything. I know you’ll pay me back when you can.” — his incentives and his information are perfectly aligned. Not so with bundling of mortgage loans into MBSs. In theory, however, we were supposed to have intermediary institutions — most notably the GSEs and the bond rating agencies — that were experts in the management of such moral hazards. After all, moral hazard problems exist virtually any time one has an agency relationship, and it is impossible to run anything other than a subsistence level economy without agency, so the mere presence of the possibility of moral hazard is not enough to damn any particular arrangement. This basic but not insurmountable problem was coupled in the case of the MBSs with a number of government policies designed to increase home ownership by incentivizing debt, as opposed to — for example — subsidizing equity. Finally, we have a large number of investors who thought that the success of their credit scoring models for subprime loans meant that they had overcome the basic risk of lending money — default — when in fact all they were observing were rising home values. This basic mistake, in turn, led the arrogant, the greedy, and the risk tolerant to leverage themselves to the hilt, creating a brittleness in the face of external shocks that would have made even George Bailey wince. It is worth remembering, however, that even George was living dangerously, floating on a sea of debt and the hope that his mortgage loans would perform.
And this gets to the final point in defense of MBSs. Right now these securities are functionally worthless because no one wants to buy them. The absence of a market means there is no price and without a price no one will guess at what they are worth. On the other hand, they can’t be worth nothing. Even in the subprime market the default rate is hovering below 20 percent. That means that even at the bottom of the market, 80 percent of the loans are performing. Those performing loans must ultimately have some value. So even the junk MBSs aren’t utterly junk. (Although the bottom tranch CDOs at this point are worthless.)
I actually don’t think that any of this has much to say one way or another about how best to restore confidence to the markets and prevent immediate financial Armageddon. But regardless of what the Congress does this week on the bailout, a monster of a debate about the best regulatory approach going forward is going to be launched, and it is worth remembering that vilified CDO is not a scam and we lose something important if we destroy the link between the home owners of Bedford Falls and international capital markets.