The Obama administration this month unveiled some new ideas for reforming the nation's battered financial markets. One item high on the agenda is the future of the securitization industry.
These days, almost anytime someone borrows to fund a business, buy a car or get a mortgage, the debt gets repackaged into a security that can be bought or sold like a stock. But critics say abuses in the securitization market helped bring about the housing meltdown.
Securitization is one of those little-understood financial concepts that touch the lives of nearly everyone every day. The credit cards you use are securitized. So are your student loans. Even the music you listen to can be securitized.
A case in point: Pullman Bonds. What is that?
"Pullman Bonds is securitization of music royalties, entertainment royalties and other intellectual properties," says David Pullman, an investment banker and the creator of Pullman Bonds. "So we take the future royalties that will come from music and other intellectual properties and we give the creators money up front for that."
Among the artists whose work Pullman's securitized are Ashford and Simpson, David Bowie and the late James Brown.
Securitization as we know it got under way about 40 years ago. Until then, if you wanted a mortgage, you went to your local bank, and if it felt good about your credit record, it dipped into its own funds and gave you a loan. Then mortgage lenders discovered they could sell their mortgages. Big investment banks were buying them up and turning them into securities.
"And this was a breakthrough that allowed a lot more money to come into the mortgage market than had ever been there before," says Alyssa Katz, author of Our Lot: How Real Estate Came To Own Us.
Feasting On Mortgage Securities
Katz says once mortgages could be converted into securities and traded like a stock or bond, big institutional investors like pension funds couldn't get enough of them. They bought everything they could see. Suddenly, lenders were inundated with cash. A lot of new mortgage lenders sprung up. And soon Wall Street was securitizing other kinds of debt. George Miller, president of the American Securitization Forum, says this was a good thing for consumers.
"The ultimate beneficiary has been the consumer or the business who's had another source of finance available to them at more competitive rates. And overall, those are good for economies, good for societies," Miller says.
But the boom eventually would lead to new problems. Lenders found the demand for mortgage-backed securities was so intense they could unload just about anything — even risky, subprime debt. And because of that, lenders never had to hold the loans on their books very long — which means they didn't have to worry too much about whether the people they lent to could really pay back their loans, says attorney and securitization expert Jason Kravitt.
"I think as an industry, we were sloppy in subprime mortgages. We didn't have adequate credit standards for originating mortgages," Kravitt says. "We didn't have strong enough due diligence. There wasn't enough transparency in the marketplace."
Neighborhoods Overwhelmed By Foreclosures
In poor neighborhoods, the result has been a sad and by-now-familiar story. Katz says borrowers took out mortgages they couldn't afford.
"What it meant to have this flood of mortgage money coming in to neighborhoods like east New York was that suddenly, that money was there for the taking. And by that I mean, if you had borrowers buying a home for the first time who didn't necessarily know what it involved, who were trying to reach for the American dream, you would have an opportunity for mortgage lenders, brokers [and] real estate agents to take advantage," Katz says.
On a street in Brooklyn with one of the highest foreclosure rates in New York, for-sale signs and abandoned houses are everywhere. And residents like Marie Emmanuel have seen the impact of that up close.
"Every block, maybe, you see a house foreclosed or banks taking over. It's just a depressing scene, period," she says.
Many critics now believe the mortgage meltdown and the recession itself simply wouldn't have happened if the securitization market had been better regulated. One idea floated by the Obama administration has been to require securitizers to hold on to a small piece of whatever product they're selling. That way they'd be a little more careful about what they're selling, says investment banker Pullman.
"If you have an equity piece in something, if you have your own investment in it and you have that risk, you'll maybe trade a little differently in it, you'll be more conservative," he says.
The Role Of Rating Agencies
Pullman says there's also a problem with the rating agencies whose job is to analyze securities for investors. He says they often gave passing grades to some of the worst products. Right now, he says, the ratings industry is dominated by two or three major players. He says more competition would be a good thing. Officials of the securitization industry agree that reforms are needed.
"I think those criticisms are legitimate. There are steps that both the industry and the government are taking to address them," says Miller of the American Securitization Forum.
And the industry has no choice but to take the problem seriously. With the recession, the securitization market fell off a cliff. Today parts of the industry are improving, but the once-vibrant market for mortgage-backed securities remains on life support. If the housing business is really to improve, the industry will have to convince investors the securities market is safe again.