Yes -- Let's Lose the Bath Water, Please Keep the Baby

There's a great deal of uproar, most of it merited, about the contribution of subprime mortgages and securitization to the collapse of global markets.  It's not hard to describe in hindsight -- too much credit splashed around too generously to borrowers (individuals, companies, countries) unlikely to repay.

A lot of commentary, though, has focused on the way in which securitized subprime mortgages made their way into the hands of investors, especially pension funds and endowments (who "should have known better" but that's a different topic).  Securitization allowed originating banks to lend the money, then pass the risk along to unwitting ultimate investors.  Not so good.

The danger in this is that securitization will be seen as the culprit.  That would be bad -- securitization is a very good thing.  It was abused, clearly, by both issuers and investors, and most of all by investment banks (and their suppliers, the rating agencies).  The fundamental concept, though, of cutting out the middleman -- the bank -- is sound.

Why is that?  Because, throughout the history of capitalism, banks have been a necessary evil of the system.  They earn their keep by coordinating information about depositors and borrowers, and connecting them to each other, but, by monopolizing all that data they turn the banking system into a kind of Strait of Hormuz for the whole economy.  (The Strait of Hormuz is that chokepoint through which Persian Gulf oil has to pass, past Iran's batteries of Silkworm missiles.)  This is why a banking collapse can lead so quickly to general business collapse: no banks mean no way to move money from its owners (savers, investors, depositors) to its users.  No banks mean it's time for barter.  No banks -- or, no banks you can trust, which is the same thing -- means the ships don't leave port.

Securitization breaks that bottleneck by routing assets and liabilities through the public markets instead of bank balance sheets.  Public markets, when accompanied by appropriate disclosure rules and not dominated by too-few players, are by far the best way to allocate capital efficiently and appropriately.  Don't ignore those two caveats, though, because they are really what broke down in the last cycle.

Disclosure of securitization needs to be much stronger and more available.  The rating agencies actually sell the data they are given by the originators!  That tells you how non-public the data is.  And the issuer / originators can actually withhold their data from rating agencies they think might be hostile!  That's crazy.  The rule needed is absurdly simple: if you plan to sell your securitization in public markets, you must make all the data behind the assets in the pools available publicly.

And, the securitization market itself needs to be re-organized.  Today it is dominated by the SEC's concept of a "Nationally-Recognized Statistical Rating Organization," or NRSRO (mysteriously, pronounced "nazro" by the cognoscenti).  NRSRO designation is a wacky closed-shop concept that was meant to require money-market funds to buy only top-rated paper rated by respectable firms, but the rule is entirely outdated.  It downgrades the ratings from being independent judgments to mere fishing licenses, driving competition among ratings towards cost alone, not quality.

So, let's fix these two things, and save securitization for all our futures.