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 Quote) and Freddie Mac (FRE Quote). 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. ...