Is securitization like a financial terrorist attack?
A recent editorial in the Wall Street Journal makes it clear that securitization -- the packaging of thousands of loans into securities -- has all the features of a successful terrorist attack. How so? It entered the financial system without attracting any negative notice at all, found its way into the heart of the global financial markets and, once ensconced there, proceeded to destroy the system (and is continuing to do so now).
In fact, securitization is proving to be more costly from a financial standpoint than everything that al Qaeda has cooked up against us. So far, the financial rescue has cost $12.8 trillion and that figure could reach as high as $23.7 trillion. The wars in Iraq and Afghanistan cost only $3 trillion at most. (To be fair, though, securitization has taken a far smaller human toll than al Qaeda.)
Why do I blame securitization for our current financial calamity? Remember toxic waste? That's the $13 trillion worth of residential mortgage-backed securities (MBS) -- bundles of mortgages sliced by level of risk -- and collateralized debt obligations (CDOs) -- mixed bundles of commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and corporate loans sorted by risk level -- residing on the books of financial institutions around the globe.
Securitization is not the sole problem -- it is the fact that some financial institutions (FIs) leveraged up their balance sheets 50:1 to buy the toxic waste. And they bought it because they believed that in a low-interest-rate environment, they thought they were getting a safe, higher-yielding investment.
Almost $2 trillion in write-offs later and despite the $700 billion Troubled Asset Relief Program (TARP) and the $1 trillion Public Private Investment Partnership (PPIP) -- now far smaller -- toxic waste is still a huge problem burning a hole in the global financial system.
And at the core of the toxic waste problem is that it's simply too complex to price. How so? The Journal suggests that in order to price a typical piece of toxic waste, it would require detailed cash flow information on 20 million loans! To get there, the authors assumed a CDO2 -- which is a CDO made up of other CDOs -- that held 100 CDOs each holding 100 RMBSs comprising 2,000 mortgages.
It is humanly impossible to put a price on such complex financial instruments. Although an accounting rule passed in April permits these FIs to set the value of toxic waste however they see fit, eventually, the day of reckoning will arrive.
Securitization received the blessing of Alan Greenspan, who ushered this financial terrorist attack into the global financial system. Greenspan's blessing has turned what any sensible regulator would have blocked into the most costly financial catastrophe in global history.
Greenspan does not deserve all the blame -- but he was the de facto leader who made it possible for thousands of bankers -- who still hold onto their billions in bonuses -- to foist securitization on the world.
The Journal authors naively assume that creating a database to price toxic waste will solve the problem. A few months ago, I proposed spending $70 million to create an army of auditors to do pretty much the same thing.
But I now realize that such a database will not work. Toxic waste is too fiendishly complex -- it is a financial terrorist's dream and everyone else's nightmare.
Peter Cohan is president ofPeter S. Cohan & Associates. He alsoteaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.