In Defense of Securitization

Tim Reason says that Jonathan Weil is right and I'm wrong when it comes to securitization:

Securitization may have its economic benefits, but it is also a ridiculous concept, a strained legal and accounting fiction invented by too-clever-by-half investment bankers. It proves John Kenneth Galbraith's contention that all financial innovations are just various forms of leverage with a new name.

Reason is no rube, and he knows the arguments why securitization is a good thing – I daresay he knows them better than I do. But his arguments against securitization seem weak. He's particularly worried about what happened at Aspen Technology, where a bunch of off-balance-sheet debt became on-balance-sheet debt when some accounting rules got violated.

But if you take a step back, it's really no big deal. If you're a company, you can raise money in two ways: you can sell debt, or you can sell equity. At any time, with the help of your friendly neighborhood financier, you can convert equity into debt, increasing your leverage, or you can convert debt into equity, decreasing it. Securitization is just one way of converting equity into debt – you lose cashflows which used to go straight to the top line, and you gain a large up-front cash payment.

When Aspen moved a bunch of cashflows which it thought were off its balance sheet back on to its balance sheet, the opposite thing happened. Its debt went up, yes. But its income went up too.

Let's say I own a money machine, which pours money down onto my head. The problem is that I don't have a suitable hat, which can catch the money so that I can then deposit it in a bank account. I go to my bank and ask for a loan to buy the hat, and they demand a very high rate of interest, because I'm a bad credit. (After all, I don't have any money – yet.) So raising debt to buy a hat is expensive. But raising equity to buy a hat is even more expensive: my friend Fred will pay for the hat, but only in return for a percentage of all the money that flows into it in perpetuity. I don't want to pay off Fred for ever, I just want to get that hat.

The answer to my problems is securitization. I go to my friend Tom, and he buys the hat. He doesn't give me the hat immediately – he keeps possession of it. And whenever money pours in, he takes that money until he's paid off the price of the hat, plus interest. But his interest rate is much lower than the bank's interest rate, because he has a guaranteed income from the hat – which is a much better credit than my sorry self. And when he's been paid back for the hat, I get the hat: it's all mine, and neither Tom nor Fred owns any of it.

That's why securitization is a good thing: it's a way of lowering borrowing costs for companies with bad credit. Which has got to be a good thing.

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