Friday, Apr. 23, 2010

Securitization

One of the great themes of the housing bubble and subsequent financial meltdown was that people weren't incentivized to do the right thing. A mortgage broker made his commission the moment a borrower signed for his loan. If the borrower was in default six months later, it didn't matter to the broker who was long gone.

At the highest level of finance, that dynamic played out with mortgage-related securitizations — packages of sliced and diced home loans (or derivatives related to home loans). Once a company created and sold a security, it collected its fee and was out of the game. When the security proved near worthless a couple of years later, there was little recourse, even as pension funds and other investors around the world suffered the fall-out.

Both the House and Senate bill would try to better align incentives by requiring companies that sell products like mortgage-related securitizations to hold on to at least 5% of the credit risk — thus tying their fate to the fate of the people buying their securities. Would such a requirement stymie the securitization market, and as a result, the availability of mortgage credit? That's the argument industry groups make, although returning to the completely free-flowing credit of the bubble years seems to be a dangerous outcome, as well.