Krugman is Wrong

Paul Krugman is a Nobel prize winning economist and one of the leading thinkers in the Democratic Party. He is held in high regard by many people -- myself included. In fact, I have cited his work on several occasions and used his statements on television to refute several right wing talking points. However, in one of his latest columns Dr. Krugman advances a viewpoint which I disagree with because it is incorrect.

From the NY Times:

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies -- giants like A.I.G., Citigroup and Bank of America.

And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans -- all went into the financial system's juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization -- that it would make the financial system more robust by spreading risk more widely -- turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed.

.....

But the underlying vision remains that of a financial system more or less the same as it was two years ago, albeit somewhat tamed by new rules.

As you can guess, I don't share that vision. I don't think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don't think the Obama administration can bring securitization back to life, and I don't believe it should try.

Dr. Krugman's criticism of the financial sector boils down to the introduction of "securitization" into the financial world. His argument concludes:

As you can guess, I don't share that vision. I don't think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don't think the Obama administration can bringsecuritization back to life, and I don't believe it should try.

Let's begin with a definition of securitization:

Securitization is a structured finance process that involves pooling and repackaging of cash-flow-producing financial assets into securities, which are then sold to investors. The term "securitization" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities. As a portfolio risk backed by amortizing cash flows - and unlike general corporate debt - the credit quality ofsecuritized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.[1] All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of securitization processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.

Let's put this into English by using a mortgage as an example. Your mortgage is a "cash flow product[ing] financial asset." What that means is when you take out your loan you must provide the lender with a predictable set of payments -- namely, your monthly loan payments. These payments are based on the length of time the loan will be outstanding, the borrowers overall credit risk, the amount of money borrowed etc..... The point is the lender will be receiving a predictable amount of money on a regular basis for a specific amount of time.

Securitization takes your loan and combines it with loans that have similar qualities. For example, your loan is not the only loan where the borrower takes out a 30 year, 5% loan of $100,000; thousands of these loans are written every day. Securtization takes these loans and combines them into one big loan. Then it either sells that big loan as a whole or in pieces or cuts the pool of mortgages into different bonds which it sells to different investors. The former security is called a pass-through while the latter is called a collateralized mortgage obligation, or CMO.

The central complaint against the process of securitization is it removes the oversight function from the lender. For example, it use to be that a bank held a loan for the entire life of the loan. As a result, the bank had a strong incentive to perform a large amount of due diligence to make sure the borrower would repay the loan. Compare that to a "lend to securitize" model where lenders make loans they never intend to hold as a long-term asset, thereby removing the incentive to actually perform an analysis of the borrower. Combine that with a ratings "system" that is at best incompetent, investment bankers providing pressure on loan originators for more and more product, a regulatory oversight system which is non-existent and incredibly cheap money and you get a disaster waiting to happen.

Yet securitization provides two incredible advantages. First, it adds liquidity to the financial sector. Instead of having to hold a mortgage until it was paid off, a bank could sell it for cash and then use that cash to make another loan. This allows banks to increase the number of loans it can underwrite, thereby freeing up credit. Secondly, it allows individual investors to target needs and purchase products for those needs. For example, suppose an insurance company anticipated a financial payout in 3-5 years. Securitization allows investment banks to carve pools into specifically targeted assets which will fill the insurance company's need. This allows them to manage their portfolio far more effectively. In short, securitization increases overall credit and provides more tools for financial managment -- both of which increase overall economic growth when property structured.

In correlation, the process of securitization has been around for almost 30 years, yet this is the first time it has been so prominently in the spotlight. If there were a fundamental problem with securitization in and of itself it would have been exposed when the program originated, not 30 years after its inception. The reality is securitization is not in and of itself a bad financial tool. Instead, the sum total of numerous inter-related issues such as the repeal of Glass Steagall, record low interest rates, a compromised ratings system and lack of oversight rather than are to blame, not merely "securitization".

Finally, let me end by pulling the lens back to a much broader macro-level view. Over the last two years there has been an understandable criticism regarding the people who created this situation -- namely, the upper echelons of the financial sector. Many of the people involved in this sector made many mistakes which we are now paying for. The mistakes were large and spread into many areas of the economy. They are one of the primary causes of the current recession. Additionally, the system as a whole -- its overall organization -- needs to be significantly restructured to prevent this situation from happening again. As I have pointed out, the current mess is the combination of numerous factors, not merely one boogie man called "securitization."

But that does not mean that finance in and of itself is evil or that all people involved in this area of the economy are corrupt. I have often read the criticism that "The US doesn't make thinks anymore" as if creating financial structures is somehow less valid than making a physical good. In fact, both activities are equally valid and should be treated as such. Individuals who prudently manage other's money and take well-thought out risks provide a valuable service to the economy; they should not be publicly vilified because other members of their profession have made huge mistakes. In essence, there are good practitioners and bad practitioners in any profession; but the presence of bad practitioners does not nullify the contributions of the professions as a whole.

In addition, many finance people provided invaluable advice to their clients throughout this recession -- advice which preserved their client's money during an incredibly difficult time. Market watchers such as Barry Ritholtz, Mish Shedlock and Tim Iacona all provided invaluable advice to their clients and the public at large. Yet the criticism of finance groups all people in this industry together -- or provides asterisks and caveats regarding industry professionals who are agreed with while still spilling a fair amount of bile at the industry as a whole. Throughout this recession I am often reminded of the public's attitudes about criminal defense lawyers -- a profession which is ridiculed and roundly criticized on a regular basis until you need one. Then you can bet your bottom dollar that you want Johhny Cochran at your side saying, "If the glove does not fit, you must acquit." The point is broad brush strokes about any profession are inappropriate at best.

In short, Dr. Krugman's analysis is wrong. Securitization has provided many benefits to the economy as a whole. It is not the sole problem with the current situation; we arrived at out present crisis because of a combination of numerous ill-thought out events and decisions. Finally, finance is not in and of itself bad and not all "wizards were frauds." Securitization has been around a long enough time to indicate that properly done it does not pose a threat to the economy as a whole. The current mess is not solely caused by securitization, but instead a combination of many inter-related events.

In short, I respectfully disagree with Dr. Krugman's analysis.

Comments

[Project4NuBostonTeaParty]

Bonddad, in this post you promote securitization as a valid financial tool. OK, fair enough. But why criticize Krugman for his educated opinion, when the problem is much deeper and more complicated than you are letting on here. The initial step in the securitization (or selling) of home mortgages wasn't the problem -- it was everything that happened afterwards. Once these securities were assigned, packaged and sold, they were divided up anew, repackaged, and resold. This happened over and over and over again. This is why there are many people right now in foreclosure who can't get the mortgage holder to produce the original documents.

On top of that, there were investors placing bets on whether the mortgages would be paid off or not (just what the hell is that about?! and why is this legal?), and on top of THAT, many were mortgages called "liar loans" in which the lenders knew from the beginning that the borrower would default. All this certainly should come under the headings of "Crime" and "Fraud"... It's too bad Obama's listening to Geithner and Summers; he really should be listening to honest and sincere people like Krugman. (Must be all that cash he received from FIRE during the past two years that keeps him in the throes of Wall Street.)

In fact, I'd feel a whole lot better right now if Krugman were the Sec. of the Treasury.

In short, I respectfully disagree with your analysis.

[zaydee]

It is not securitization that encouraged abuse, it was the subsequent mingling (contaminating) of the homogenous mortgage pools. As a former fixed-income broker, I invested in GNMAs with enthusiasm.
Greed cannot be regulated. It can be punished.

[Guitarsandmore]

“Out of sight, out of mind” seems to be the philosophy of bankers today. Let’s just pass the problem on to somebody else and we’re done with it? And this is secure, how? The bank that caused the problem may feel secure because they got rid of the bad loans but the American people end up getting stuck with the bill when the loans fail. Not safe, not secure, and not a good idea. Krugman is right.

All of this is because capitalism puts profits ahead of people. Capitalism fails people every time.

A bank’s goal should be to help homeowners be successful and stay in their homes not to make a buck.

[RhetoriCons]

It would seem to me that the tranched structure of CDO's which produced the "toxic asset" equity tranches and opacity-vi­a-complexi­ty problem are at the root of this issue. Is securitization with out these complexities going to be viable?

[robizio]

Seems to me Krugman isn’t saying there are no potential benefits, merely that the benefits are far outweighed by the risks--especially when compounded by a demolition of oversight and regulation that will not be back in place functionally any time in the near future.

You say: "If there were a fundamental problem with securitization in and of itself it would have been exposed when the program originated, not 30 years after its inception."
Are harmful ideas normally exposed immediately upon their inception? Ponzi-schemes. Internet scams. Lead paint. Cigarettes. There’s a character limit, so I’ll move on.

You take offense to the broad demonization of the industry and everyone who works in it. I understand your concern. But you know as well as anyone that people aren’t referring to the guy who works at the neighborhood bank who helps people set up a college fund for their kids. They’re referring to the decision-makers; the power-brokers whose actions in rolling the dice with other people’s money and deciding their own winnings regardless of reality were either systemically fraudulent or criminally negligent. Also, the real story is that people are starting to question the wisdom of the financial system. Should someone who just wants to retire at a reasonable age and send their kid to school really need someone to “manage” their money? Do we really want to pay people to gamble with our future? Should profit be economy’s only goal when our citizens have many others?

[Martin Nagel]

Let's be clear about one thing here: 'creating financial structures' IS less valid than creating a physical good. The real economy doesn't need complicated fincancial products to function; however, the opposite is not true.

[CaptD]

Krugman's cute sayings "made for prime time headlines" will not solve our financial problems; Geithner just needs some help in Congress (and Wall Street) to get it moving again! I'm tired of "foot draggers" whining about "everything" while out debt gets larger daily, thanks to them... it is like the Rich/Greedy want things to get worse so that they will become even more Wealthy and report on it!
+
That's why he is on the show...

The real question is "how" to jump start the system! You have to start someplace and do something, make that first step; until then all the doom and gloom talk just delays that first step and makes things worse... Obama's team has started taking steps and of course all of them will not be perfect but I predict most will propel our recovery forward; a useful analogy would be to imagine crossing a stream walking on slippery rocks, sure you will surely slip and slide a bit but you will cross the stream!

[outnow]

Krugman continues to hit against the bailout of toxic assets created by the securitiza­tion-run-a­muk mess in his NYT articles. He is supported by many economists. Bonddad deserves his own name, just as I deserve mine. Yes, that reminds me, I would get out now - both military occupations and out of the markets. No offenss intended, just a reality check.

[quietbetween]

“Bonddad”s basically saying, Guns Don’t Kill, People who use them do.

That the economy would have collapsed long ago if Securitization were bad doesn’t explain the obscene misuse and impropriety of financial professionals. Was it a lack of regulations or institutionalized fraud?

We must stop sanctifying and subsidizing capitalism. Cease our promotion and acceptance of a Corporate State. Stewart doesn’t illuminate how Securitization works in the real world. How, when the majority of "consumers", those fueling the economy, don't generate enough money to feed the kitty, now that "bad credit" is out.

Securitization is a cunning way to keep money flowing, but a half-baked recipe, missing crucial ingredients, human activity. The soufflé will never rise. The smartest guys in the room may not care beyond their own cleverness or waterfront villa. We're distracted by the hole in the boat, but this "catastrophe" didn't suddenly happen. We’ve been sliding here long before the monoliths collapsed.

The primary element to recovery must address and advance Social and Environmental Justice. Securitization will not rebound the economy. Our economy is dependent upon a healthy, educated citizenry, upon a strong, vibrant infrastructure and environment, not sly accounting.

Like sports stars on steroids, all guts and glory, we know it's an unsustainable, false practice, doomed to self-destruct. We must see beyond Wall Street as savior. Securitization may be beneficial when theoretically applied; irresponsible to concede it’s failure to low interest and a few bad eggs, because the safety was off.

[AlexHidell]

Derivatives are 'securitized' by THIN AIR, Bonddad.

Steve Pizzo's Follow The Numbers shows us that speculative derivatives numbers are overwhelming the world's banking system

""Here's the breakdown, according to the International Bank of Settlements, which acts as banker for the world's central banks:

1) Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion"

http://www.opednews.com/articles/Follow-The-Numbers-by-Stephen-Pizzo-090302-530.html

World derivative debt is $1.14 Quadrillion USD. For the US banks share of that see Table 1, page 22 of 33 at

http://www.occ.treas.gov/ftp/release/2008-152a.pdf

The jig is up folks. The US banks are essentially bankrupt, with $10.5 trillion in assets vs. $176 trillion in derivative debts.

At the April 2nd G20 meeting world leaders should WRITE OFF this toxic speculative derivative 'debt'.

Put in further perspective, the entire world's GDP, according to the CIA's world book, is $71 trillion USD annually. Compare that with that $1.14 quadillion and you now understand that a huge transfer of wealth is taking place, crowding out legitimate recovery efforts.

[dolphy]

I think Geithner knows what he's doing but he's not doing it for the betterment of the population. This is a rehash of W and Hanky.

[dolphy]

I'm sorry, Hale, but securitization promotes a vicious cycle of greed. If you give people who are basically greedy a chance to screw up by getting easy money in a short time they will do it even with the knowledge that in the long run, the scheme would collapse.

[zmjz01]

To: outnow and other smarties who wrote. I am retired now for 10 yrs and have just been advised to get out of stock mkt entirely and into all safe investments. Stock mkt predicted to be down for a long time, and we face something worse than the Depression. I'm also advised to control my own money and not to let anyone at Smith Barney or the like to make covered call investments for me as it is a gamble. It's very frightening as I don't understand a lot of finance terminology such as derivatives, and hardly trust myself to buy or invest in the right things, so I'm trusting Smith Barney. Not a comforting fact at all that you cannot trust anyone.

[unionave]

Did anyone advise you to "Buy American" ? If more of us had US Treasury Accounts instead of Wall Street accounts our country would have less of a need to borrow from other countries just for us to exist . Also us old guys would not be mixed up in this mess created by Wall Street gambling and the money value we put in our secure US Treasury Accounts would never decrease . It would always increase because of the good interest paid by our government . So , Please help America !

[GorBud]

I understand most financial instruments and investment methods. Knowing and understanding them I chose a few years ago not to "invest" in the gambling hall called Wall Street, Just the compensation packages being given by boards of directors to CEOs made it clear that it was impossible that they could have been bringing the value they were being paid to the companies they were running. NO ONE person was worth what they were being paid. I decided that there were too many cheats out and about. Did not loose a dime during this crash. There are no free lunches is trite but very true. The more you read about the market the more it becomes clear #1 it is not for the average guy #2 if you can't work as hard investing your money as you worked to get it someone will take it. Good luck.

[tilted windmill]

It is a scary time, but you can learn to manage your own investments. Your local community college may offer adult education classes in investing for beginners. When in doubt, and for your age, stick with FDIC insured banks or NCUA insured credit unions. The returns may be small, but your money will be much more secure than with other investments. Capital preservation is the watchword for you now.

[Zoe2]

I was curious about this post but I am getting tired of every financial viewpoint that fails to look deeper. I come from the right brain psychological point of view. Money is the gateway to deeper issues. For example: Psychologically speaking, Madoff did everything because he wanted to belong. If he would have dealt with this emotional issue then he wouldn't have created a Ponzi scheme to keep him socializing with the wealthy and famous along with their praise of him. The technical reasons why we are in a recession are important but it is more important to look at the deeper emotional issues. If we don't, then it doesn't matter what regulations we impose, we can even get rid of the Fed or even if we came up with a new financial system this will happen again. People will figure out how to get us in a new mess under the new circumstances if the emotional issues are ignored. It's like the person who wins the lottery that spends unwisely. We know they will be broke in 2 years because they never deal with their money issues. We have all these financial wizards to try and lead us out of this but where are our emotional wizards to ask us questions and to give us a solid foundation?

[Woggles]

This is one of the best and most unusual ways to analyze what is really happening.

[priscianusjr]

No, I don't think it is. Basically what he's saying is that if everybody were nice and emotionally well-balanced, everything would be fine. Which is true, but doesn't help very much, because not everybody is nice and emotionally well-balanced. And too many people are naive or just don't think, they just do what everybody else does. Therefore you have to understand that there are all kinds of scams out there, including many that are officially sanctioned and encouraged by other people who really are not so nice. Then after that, you have to learn what these scams are so you can recognize them and not fall for them.

[ellaichell]

The act of "creating financial structures" IS less valid than making a physical good. As Lincoln said:

"Labor is prior to, and independent of, capital. Capital is only the fruit of labor, and could never have existed if Labor had not first existed. Labor is superior to capital, and deserves much the higher consideration."

Bonddad tries to argue that securitization helped people by making more credit available. Ultimately, credit is unhelpful to an individual because it is debt. If inflation weren't so high and the U.S. still had good-paying jobs producing physical goods, people wouldn't need credit.

But average annual inflation has never decreased since 1956. Inflation is of course a hidden tax on the worker, and it is caused by the presence of too much money in the system. Which of course is caused by things like securitization, which is a product of the fractional reserve banking system.

Don't be fooled--se­curitizati­on may help the little guy a little bit in the very short run--i.e., he gets a house or a degree--but the grossly inflated prices of things ensure that the little guy is tangled up in debt for literally most if not all his life.

The real beneficiaries of securitization are/have been the big financial institutions, who can create money literally out of nothing and treat liabilities as assets in a way that the little guy is not allowed to do.

[Lemeritus]

Kevin Phillips in American Theocracy, 2006, quotes a 1996 article in Foreign Polcy ("Securities: The New Wealth Machine") which envisioned "a new age in which a nation could increase its wealth by enlarging (through inovative structuring) the market valuation of its production assets. *Producing more goods and services wasn't actually necessary.*" (Emphasis added).

At the end of financialization, the most important economic dynamic is the creation and trading of abstract financial instruments rather than the production of genuine goods and services. Further, finance "distributes its concentrated profits to a smaller slice of the population" (Phillips).

Securitization doesn't help the little man and never has -- it is simply one express elevator to debt, the dissolution of the middle class and the emergence of policies/politics designed to protect the financial system above all.

[outnow]

It is not the case that securitization of subprime mortgages is a long-term phenomenon. It is something which has been a practice, prevalent practice, for about eight years at the maximum. Before that, the markets would not have contemplated the massive securitization of loans which are subprime...And in the case of subprime loans in the middle of the decade, there was systemic fraud in the appraisals, systemic overstatement of what the houses were worth, because the bigger the loan, the bigger the fee you could book...The Treasury plan is in the way of creating a new derivative, a new bond, if you like, which the Treasury has half the capital and provides 85% of the value of the purchase in the form of a low-interest, non-recourse loan that's designed to make the purchase of these so-called assets from the banks a highly profitable proposition for the hedge funds and private equity investors and others who are in a position to risk their capital without having to face fiduciary consequenc­es....crea­ting a conduit, which would take these losses off the books of the banks, put them on the books of the FDIC. And I would say that would solve the problem for the banks, but wouldn't solve the problem for anyone else.

Professor James Galbraith speaking to Amy Goodman and Juan Gonzales on March 27, 2009 about Geithner's plan to overhaul nation's financial regulatory scheme at Democracy Now.

[dolphy]

I heard that discussion and I agree with the professor.