Securitization: Dead parrot, or half-dead parrot?

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Arnold Kling, riffing on something I wrote the other day about the end of investment banking as we’ve known it, writes:

I think of securitization as like the dead parrot in the famous Monty Python sketch. Trying to rescue it or revive it strikes me as madness. I keep saying that we need to revert to the mortgage finance system of forty years ago.

I appear to be in the minority. Most people seem to think that the parrot is “just restin’,” and that at some point we are bound to see a comeback from Freddie, Fannie, credit default swaps, and all the rest. I don’t think so. Not in a free market.

I love the analogy, and I hesitate to correct somebody who worked at Freddie Mac for nine years on the subject of mortgage securitization, but I don’t buy that it’s all worthless. It seems to me that standardized, plain-vanilla securitization of mortgage loans still makes a lot of sense.

Mortgage lenders used to run a lot of interest-rate risk. When rates skyrocketed during the Great Inflation of the 1970s, the savings and loans and savings banks that dominated the business at the time found themselves stuck with portfolios of 30-year mortgages yielding 5% or 6% while having to pay double-digits to borrow money themselves. They were under water, and the frantic efforts of many mortgage lenders to grow their way out of that predicament brought us the last big financial-industry bailout, a.k.a. the savings and loan crisis.

How did the mortgage lenders fix their interest-rate problem? By beginning to issue adjustable-rate mortgages, and by selling the fixed-rate loans they made (mostly via Fannie and Freddie, which packaged them into securities) to investors who were in a better position to bear the interest-rate risk. These were real solutions to a real problem–not some kind of scam or regulatory arbitrage–and they worked perfectly well as long as lenders paid attention to credit risk and both the adjustable-rate loans and the fixed-rate securities were kept simple. I don’t see why this kind of securitization wouldn’t work again (and I also don’t see any problem with good old 5/1 or 7/1 ARMs).

Now of course this kind of plain vanilla, standardized securitization is assembly-line work, and there’s really no reason to be paying people millions of dollars a year to arrange it. So we’re still probably talking about the end of investment banking as we’ve known it. Just not the end of securitization.

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