Paul Krugman slanders stage magicians

The money quote from his latest editorial:

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

As Krugman points out on his blog, this slanders stage magicians. Stage magicians make an honest living. FInancial wizards don't -- they sell products with no real backing using fraudulent means to investors who have no way of knowing better.

The basic problem with securitization is that it moves the risk from the banks to the investors, thereby reducing the incentive for banks to make loans only to people who could repay the loans. See, if the bank owned the loan, they would have to eat any losses themselves. But if they sold them to investors, the investors would have to eat the losses! So there was an incentive to make risky loans, because the risk fell on investors, not on them.

Institutional investors, however, had an "out" -- they could write into their contracts that if the loans went bad within less than a year, they could give the loans back to the bank and get paid back what they paid for the loans. This is what did in Countrywide Home Loans, their loan brokers made loans so risky that all too many of them went sour before the first payment. At that point, Countrywide was a) out the money they'd paid the broker for originating the loan, b) out the money it would take to foreclose upon and re-sell the home whose loan had gone sour (generally around 10% of the price of the loan). The losses killed them.

So anyhow -- securitization encouraged brokers to scam the system. They'd get their brokerage fees, yet have none of the risks. Which is why Krugman is concerned that the White House's proposals amount to nothing more than a shiny paint job on a broken-down old jalopie. Yeah, they're painting that old Ford Pinto a nice pretty color of red. But it's still a Ford Pinto, and it still will burst into flames upon the merest little tap of a downturning economy... only by putting both risk and reward back into the same institution, like it was back when banks and S&L's were in charge of lending money for new homes, will there be any real reform. No amount of regulation will make the perverse incentives of securitization go away. You might as well ask a horse to not eat grass, or a dog to not eat meat... it's just the nature of the beast.

-- Badtux the Economics Penguin