An antidote for toxic assets

The government is betting that by lending large amounts to private investors to purchase securities, markets will revive and security values will rise. It is a costly and risky venture, I hope it works, but fear it won't. This article proposes another approach to the same objectives that would cost the government nothing. I call it "desecuritization." All it requires is the appropriate enabling legislation.

Desecuritization means reversing the securitization process. Securitization converts large numbers of individual loans into security issues. Desecuritization converts the securities back into individual loans. The objective of both is the same: to enhance value. The first works during normal periods, while the second can work during a crisis period such as the one we are in now.

Securitization enhanced value during normal periods because a single type of loan could be converted into a variety of securities with different characteristics fashioned to meet the diverse needs of investors. For example, a pool of 30-year fixed-rate mortgages could be transformed into a security issue subdivided into sub-issues that vary in their duration (how long before the investor gets his/her money back), their exposure to risk of default as indicated by credit-quality ratings, and their sensitivity to changes in market interest rates.

Where investor demand for 30-year fixed-rate mortgages was limited, the diverse securities fashioned from a pool of such mortgages could appeal to a wide range of investors. With securitization, the whole was worth more than the sum of its parts.

The breakdown of financial markets during the financial crisis, associated with high default rates on loans in pools supporting securities, has reversed the equation. The total value of any mortgage security issue on which the AAA-rated pieces have been downgraded is now much smaller than the sum of the values of the individual loans, assuming those loans could somehow be disentangled from the security.

For example, assume 20 percent of a portfolio of 1,000 mortgage loans defaults and each default costs 50 percent of the balance. Because the 200 loans that default do not affect the value of the 800 that don't, the decline in the total value of the portfolio is only 10 percent. But if the loans are in a security issue, every piece of that security may be contaminated by the defaults. The overall decline in value could be 30 percent or even 60 percent -- we have no way of knowing because markets have largely shut down.

In an interesting paper called "The Law of Unintended Consequences," John Mauldin attributes this excessive value decline to the decision by the credit rating agencies to rate asset-backed securities in the same way they have always rated bonds. I agree with him that the rating system needs fixing, but I doubt that any rating system can wholly avoid value contamination within a security when default rates are very high. ...CONTINUED

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