Academic

Of course the New Year has many of us wondering whether and to what extent there will be a fix to our economic crisis.  In this vein, many people have been pondering the future of securitization.  I just finished Professor Steven Schwarcz?s very interesting article on the subject.  Of course securitization of subprime loans has shouldered at lot of the blame for the current financial crisis and as a result the securitization market has basically dried up.  As one Wall Street Journal article noted, that market had been a dominant means of financing, ?moving from $1 trillion to $12 trillion in annual new issuances.?  Hence it is little wonder that people have been pondering whether or not that market will return, and if so, what form it would take.  Professor Schwarcz and others believe that securitization likely does have a future?but the strength of that future will depend upon whether or not securitization can be adapted to eliminate or at least minimize some of its major drawbacks.

Professor Schwarcz points out at least four drawbacks that need to be addressed.  First, and perhaps most obvious, is reliance on a flawed asset type?that is, reliance on the subprime mortgage market and its dependence on increased home appreciation.  To the extent reliance on a flawed asset type is the key problem, the fix seems relatively straightforward?avoid such assets, and if avoidance isn?t the best or most efficient solution, at the very least better manage such assets.  Importantly, Professor Schwarcz suggests that even with less exotic or seemingly less risky assets, the current crisis reveals the need to be more diligent with respect to potential vulnerabilities associated with any asset underlying securitizations.

Second, is securitization?s reliance on the originate-and-distribute model pursuant to which loan originators sold loans to be repackaged without retaining any significant risk of loss.  As Professor Schwarcz notes, many people viewed this model as the most problematic feature of securitization because it appeared to create a moral hazard problem since it meant that lenders ?did not have to live with the credit consequences of their loans.?  While Professor Schwarcz believes the moral hazard argument has its weaknesses, he does seem to concur with the assessment of others that the model needs to be changed so that originators retain at least some risk of loss.

Third are servicing conflicts which Professor Schwarcz explains makes servicers reluctant to restructure underlying loans.  As Professor Schwarcz points out, to the extent securitization impedes the ability to resolve problems with underlying loans, there needs to be a fix.

Fourth, overreliance on complex math models.  To be sure, there has been a lot of talk about complexity and its role in our current crisis.  Professor Schwarcz suggests that the future of securitization may depend on our ability to better understand and grapple with the complexities of our financial markets.  Another commentator notes that the best fix for securitization may be a ?highly rational flight to simplicity.?  Thus, while securitization, if properly modified, may still have a future, that future likely depends upon our ability to keep things simple.  And at first glance, that sounds simple . . .