Securitization has become a panacea on financial markets.
Indeed,
it is predicated on the simple idea that balance sheets are more often
than not the best parking for risks. In other (shareholders) words,
they are the most costly parking you can find. Hence, commercial banks
with the structuring help of Wall Street firms have "shipped" assets
and liabilities that were so far stored in their balance sheets to
investors.
It sounds like a marvelous and lucrative never
ending innovation spiral à la Merton where banks can do more business,
investors have access to a wider spectrum of securities and risks are
more efficiently shared.
Too good to be true: The subprime mess is a wake up call, one that calls for deep thinking.
There
are some things that do not change. In October 1987, the equity market
crashed and portfolio insurance was designated as the culprit.
Portfolio insurance used to be considered as the solution to downside
risk protection. Investors hate downside risk even more than they love
upside. University of Berkeley mavericks, Hayne Leland and Mark
Rubinstein (co-founders if LOR), came up with a technique that promised
to replicate what a long put option does, namely pay off, when the
market goes south. The "trick" was simply to use Black-Scholes-Merton
option hedging argument to replicate the put option payoff. In other
words, they were selling stock index futures (mechanically/dynamically)
and going long T-bills (cash) when the equity market was tanking. When
the market was rallying up, they did the opposite. That's why when the
market crashed in October 87, LOR was accused of provoking/amplifying
the downward trend. The argument is a bit odd: Mark Rubinstein rightly
pointed out that nobody praised LOR when the market was going up for
making the growth even stronger.
The truth is that while
portfolio insurance is in effect more of car insurance than earthquake
insurance type there is an important market item that it paradoxically
"destroys": Information. Indeed, when lots of investors are willing to
buy put options bidding the price up they signal their bearishness to
the market. What portfolio insurance does is to break down a single
(put) transaction into two separate transactions: stock index futures
and T-bills. Information about market expectations may get distorted in
the process as it is hard for the rest of the market to decipher the
initial intent. Worse, as shown by Sanford Grossman and others when
portfolio insurers sell mechanically to dynamically replicate the
target put, people may mistakenly think that this signals bad news.
Asymmetric information problems have increased and we know both from
the seminal works of George Akerlof, Michael Spence and Joseph Stiglitz
and casual business experience that this is a sure recipe for trouble.
Sadly
enough, the same holds true with securitization as witnessed by the
subprime mess. Bad loans have been securitized. As a result the
shareholders of the originating banks do not bear the consequences,
good or bad, of their loan activity anymore. They have no incentive
anymore to monitor these loans that get "diluted" in securitization
vehicles. Hence while risks seem to have been more efficiently cut into
pieces and shared the overall situation has worsened drastically
because asymmetric information problems are now more toxic (1).
Asymmetric information is a market killer and we end up collectively
harvesting what others have planted.
Not convinced. Well,
think of what microfinance does. It does exactly the opposite: It
reduces information asymmetries by putting monitoring and safety
devices in the micro-lending process: Lend only to women, in a village
where everybody knows each other, make the borrowers collectively
liable when one of them defaults etc... This is why it is successful.
So,
next time innovation in the form of sophisticated securitization knocks
at your door, ask yourself whether information and incentives have been
reduced or not before joining the bandwagon. If portfolio insurance and
the subprime can teach us one thing or two, it is precisely this.
(1)
Not to mention the fact that it becomes very hard, almost impossible,
to restructure the (securitized) loans when disaster strikes.
