Tim Reason says
that Jonathan Weil is right
and I’m wrong
when it comes to securitization:
Securitization may have its economic benefits, but it is also a ridiculous
concept, a strained legal and accounting fiction invented by too-clever-by-half
investment bankers. It proves John Kenneth Galbraith’s contention that all
financial innovations are just various forms of leverage with a new name.
Reason is no rube, and he knows
the arguments why securitization is a good thing – I daresay he knows
them better than I do. But his arguments against securitization seem
weak. He’s particularly worried about what
happened at Aspen Technology, where a bunch of off-balance-sheet debt became
on-balance-sheet debt when some accounting rules got violated.
But if you take a step back, it’s really no big deal. If you’re a company,
you can raise money in two ways: you can sell debt, or you can sell equity.
At any time, with the help of your friendly neighborhood financier, you can
convert equity into debt, increasing your leverage, or you can convert debt
into equity, decreasing it. Securitization is just one way of converting equity
into debt – you lose cashflows which used to go straight to the top line,
and you gain a large up-front cash payment.
When Aspen moved a bunch of cashflows which it thought were off its balance
sheet back on to its balance sheet, the opposite thing happened. Its debt went
up, yes. But its income went up too.
Let’s say I own a money machine, which pours money down onto my head. The problem
is that I don’t have a suitable hat, which can catch the money so that I can
then deposit it in a bank account. I go to my bank and ask for a loan to buy
the hat, and they demand a very high rate of interest, because I’m a bad credit.
(After all, I don’t have any money – yet.) So raising debt to buy a hat
is expensive. But raising equity to buy a hat is even more expensive: my friend
Fred will pay for the hat, but only in return for a percentage of all the money
that flows into it in perpetuity. I don’t want to pay off Fred for ever, I just
want to get that hat.
The answer to my problems is securitization. I go to my friend Tom, and he
buys the hat. He doesn’t give me the hat immediately – he keeps possession
of it. And whenever money pours in, he takes that money until he’s paid off
the price of the hat, plus interest. But his interest rate is much lower than
the bank’s interest rate, because he has a guaranteed income from the hat –
which is a much better credit than my sorry self. And when he’s been paid back
for the hat, I get the hat: it’s all mine, and neither Tom nor Fred owns any
That’s why securitization is a good thing: it’s a way of lowering borrowing
costs for companies with bad credit. Which has got to be a good thing.