Friday, April 10, 2009

Securitization and Conspiracies

What the financial system does is match savers with borrowers, that's all in the grand scheme of things. That simple task is actually quite hard, just as matching two people in search of love is very hard.

The point is that there is no conspiracy or Illuminati behind the scenes pulling strings. All the credit derivatives and other tools are there to help money from savers flow to borrowers. Of course each saver has his own risk tolerance and most people don't have the time to check out every potential borrower for credit worthiness. That's why we pool savings together into banks, who vet the borrowers, or purchase bonds through mutual funds who also do research.

Securitization splits risk into different sections so that money from low risk savers can still find its way to high risk borrowers. It is a tool and is incredibly useful. Before, a high risk borrower like GM needed to find a high risk saver willing to lend at appropriate yields. Now, GM's debt is bundled, maybe with other companies, and then chopped up so that grandma's savings can be used to purchase senior tranches which are much less risky than whole GM bonds.

The problem wasn't securitization or chopping up debt. It was that the tranches were mis-priced and mis-allocated. Turns out that not as much of the bundle can be treated as relatively safe. Instead of 92% of a bundle being AAA, more like 88% is or something like that. Once more data is collected, the system will work better, but one thing is for sure, we'll never go back to life without these tools. That would be stupid. Just because a madman like OJ Simpson used a knife to kill two people doesn't mean the rest of society will stop using knives. Securitization is here to stay and it's not a conspiracy or some trick. It's just a tool to allow savers to lend to borrowers