One of the more annoying memes spreading virulently during this subprime-mortgage
crisis is the idea that securitization itself is a ridiculous idea. Subprime
borrowers have higher default rates, that’s obvious, and so anybody who honestly
thought he owned a AAA-rated bond backed by such loans had to have been deluding
The problem with this line of thinking is that it has a tiny kernel of truth:
at the height of the subprime boom it’s far from clear that investors were
actually modelling higher default rates on subprime than they were on prime
mortgages. Nevertheless, if Wall Street got the default rate right, it would
have been trivial for bankers to structure a genuinely AAA subprime product.
There is a big problem with securitization, however; it’s just got nothing
to do with things like default rates. Rather, it’s our old friend information
asymmetry. And who better to explain it than the guy who more or less invented
the economics of asymmetric information, Joe
I totally predicted this. Securitisation was pushed because of its advantages
in risk diversification. But I emphasised in some of my work on securitisation
that you have to offset that advantage with the awareness that you are creating
an agency problem. And you are creating a potential for asymmetries of information.
In the old days, it was the banks that originated loans and kept the loans.
But once you went to securitisation you created the possibility of the originator
having different information from the buyer. Not only is there information
asymmetry but in this context there are perverse incentives. The originator
has an incentive to provide distorted information. The buyers should have
been aware of this, but it’s quite apparent that they weren’t
as aware of this as they should have been.
This was partly because they bought into the notion of risk diversification
– they thought they didn’t need to worry about it because of the
law of large numbers. But the law of large numbers says only that you don’t
need to worry about a single one; you do need to worry about systemic risks.
And securitisation helped create systemic risks.
The lesson here is one of the oldest lessons in the history of investing. If
you’re lending money, know your borrower, even – especially – if
that borrower is a special-purpose vehicle. And don’t trust bankers or ratings
agencies to do that work for you, because your incentives are not aligned.