The Future of Securitization

For generations, the strength of the U.S. housing market was due, in part, to securitization of mortgages with guarantees from the government-sponsored companies, Fannie Mae (FNM) and Freddie Mac (FRE). Following the savings and loan debacle of the late 1980s, securitization -- which has been defined as "pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors" -- helped bring capital back to battered real estate markets.

Today, securitization of subprime real estate loans is blamed for the global liquidity crisis, but Wharton faculty say securitization itself is not at fault. Poor underwriting and other weaknesses in the market for mortgage-backed securities led to the current problems. Securitization, they say, will remain an important part of the way real estate is funded, although it is likely to undergo significant change.

"Securitization, in the long run, is a good thing," says Wharton finance professor Franklin Allen. "We didn't have much experience with falling real estate prices in recent years. The mechanisms weren't designed for that." He explains that economists were concerned about the incentives and accounting that shaped the private mortgage securitization market in recent years, but as long as real estate prices kept rising, the weaknesses in the system did not become clear. Now, after credit markets seized up and prices have declined sharply, those problems have been exposed.

Allen believes financial markets will get back into the business of securitizing mortgage debt, but only after making some major changes. One new feature of future securitization deals, he says, could be a requirement that loan originators hold at least part of the loans they write on their books. Before the current crisis, loans were bundled into complex tranches that were passed through the financial system and onto buyers with little ability to assess the real value of the individual assets.

"The way the collateralized debt obligations (CDOs) and other vehicles are structured will change. They are too complicated," says Allen. "I'm sure the industry will figure out how to do it. There will be a lot of industry-generated reform and the industry will prosper. This is not, in my view, something that should be regulated."

Privatizing Securitization

According to Wharton finance professor Richard J. Herring, for decades, mortgage securitization was backed by government guarantees through Fannie Mae and Freddie Mac, and it worked well. Of course, these agencies were regulated and bound by less-risky underwriting standards than those that ultimately prevailed in the subprime market which was also, potentially, more profitable. Indeed, default rates were so low in the mortgage-based securities market that banks and other private financial institutions were eager to take a piece of the residential business.

At first, the transition to private securitization worked, because investors were willing to rely on three substitutes for the government guarantees. These included ratings agencies, new business models and monoline insurance designed to guarantee specialized mortgage-backed bonds. "Positive experience with private securitization led to an alphabet soup of innovations that sliced and diced the cash flows from pools of mortgages in increasingly complex ways," says Herring.

Now, the subprime crisis has undermined confidence in all three pillars of private securitization. Ratings proved unreliable as even highly rated tranches experienced sudden, multiple-notch downgrades that were unknown in corporate bonds. Models developed by the most sophisticated firms selling mortgage-backed securities, including Bear Stearns (BSC), Merrill Lynch (MER), Citigroup (C) and UBS (UBS), failed. Monoline insurers, it turned out, were not adequately capitalized.

"There has been a highly rational flight to simplicity," says Herring. Over time, he believes, the real estate securitization market will reemerge as investors regain confidence in the ratings agencies, new models evolve, and monoline insurers are able to increase their capital. "But I think that it will be a long time before the market will be willing to accept the complex, opaque structures that failed," continues Herring. He adds that recovery will be delayed until investors are confident that the fall in house prices has reached the bottom.