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  • The Psychohistory of securitization: An Exchange

    By Christopher Faille, Senior Financial Correspondent and Emma Trincal, Senior Financial Correspondent.     Christopher Faille

    Thursday, January 24, 2008

    Amid the dismal market environment, a HedgeWorld reporter wrote an abstract interoffice memo defining something called physiophobia.Another reporter's lengthy reply began a weekend-long email exchange that hashed out their views on the psychological and tangible evolution of financial securitization and how we might pull ourselves out of the subprime mortgage mire.

    Finance and the Mother Earth

    By Christopher Faille

    I have become convinced by an accumulation of evidence that many of the troubles of industry and finance in the United States at present owe their origin to an underlying unacknowledged psychological disorder, which one might coin physiophobia, the distrust of the tangible world. It would be an overstatement to say that we all want to create simulations of ourselves, and live in a happy digital world untroubled by the gritty realities of molecules and organisms—but not as much of an overstatement as one would like it to be.

    In the world of industry, this flight from physicality gives us the glorification of intellectual property and digitization. In the world of finance, the same flight gives us the exaltation of liquidity and securitization.

    Liquidity is a fine thing. We'd die of thirst without it. But solid ground, illiquidity, has its uses too. Without it, we'd drown. This is how Enron Corp. met its death.

    What, after all, was Enron? In its beginnings, it was a pipeline company. There's nothing abstract or esoteric about a pipeline. It's a hunk of metal manufactured into a usefully hollow and cylindrical shape.

    There's nothing abstract about a power plant, either. In Enron's glory days, roughly the period from 1993 to 1999, the company was dedicated to building power plants around the world. It was an institution driven to develop valuable assets. The development projects could be themselves extremely controversial, and matters of execution were from time to time botched. But Enron was doing the right sort of thing for its investors and for potential customers around the globe. It was allowing the profit motive to lead it, as if by an invisible hand, to serve a variety of interests by increasing the world's ability to create stuff. Better, it was creating stuff that could be used to create stuff that could be used to create stuff that. . . .

    It was also during that period, unfortunately, that the simple idea of building useful things became a contentious issue in internal Enronian politics, for this was when Jeffrey Skilling was rising to prominence, and eventually into a position whence he could muscle aside vice chairman Rebecca Mark and other advocates of what he called "asset heavy" policies. Mr. Skilling's flight from the tangible, his fervent belief in a gravity defying "asset-light" corporation, was explicit and highly intellectualized.

    Mr. Skilling spoke of how the old-line industrial giants were going to split into thousands of pieces as the action moved to "intellectual capital," and of how a 21st century corporation can stay large only by abandoning bricks and mortar … or pipelines and power plants. All that is required to run a trading operation is a handful of computer terminals and desks to rest them on. But then, in the late 1990s such ideas were all too common.

    They were, furthermore, wrong. On the simplest level, a trading operation structured like EnronOnline—Mr. Skilling's showcase—requires a lot of credit, because the traders have to be prepared to take the counterparty side for both buyers and sellers. A more exchange-like model would require a clearinghouse, which again would involve a lot of credit. The market was willing to treat Enron as creditworthy because it had a lot of assets. The asset-light model, then, was bound to prove self-defeating.

    Through 1996 and 1997, the struggle for the future of Enron was fierce, and a remark often attributed to Ms. Mark during this period seems prescient.

    "Sure, the trading operation uses no capital," she said. "It just consumes the entire balance sheet of the company."

    By 1999, when Enron was easing Ms. Mark out the door, the golden age was over, and something akin to the debacle of the autumn of 2001 may already have been assured.

    Once everything is "intellectual capital," then it soon becomes natural to mark its value to a model—after all, the model is of the same intellectual ethereal stuff as the stuff being modeled. Just a bit further along this road, we see a dealmaker desirous of a closing giving exorbitant value away to the counterparty, while still making assumptions (just plugging numbers into a model) that will make the deal look profitable for the books. This ‘feeds the monster,' it helps the bosses show the investors and analysts another record-breaking quarter for earnings.

    The flight from assets, then, leads directly to the mind-set and accounting tricks that took down both Enron and, as a bit of collateral damage, its former accounting firm Arthur Anderson LLP.

    Is the fall of Enron already a matter of only antiquarian concern? To think so is to consign matters to the dustbin of history rather abruptly. Still let us discuss something more recent: What of subprime mortgages and the elaborate structures built thereon? Don't we see the same pattern there?

    A house is a physical structure—made, perhaps, of those bricks and that mortar of which Mr. Skilling spoke so slightingly. Further, a house is a very illiquid sort of asset. If you've ever tried to sell one quickly because you had to move to another city you know what I mean. It can take a long time to turn a home into cash.

    So why would a bank want to hold onto a mortgage—a piece of paper that is itself just a claim on this heavy molecular thing. Far better (we instinctively feel, in our immaterialist mood) to securitize it, and then pool and re-securitize the securities, and so forth, until what we have are numbers that describe other numbers that describe … and so forth, until somewhere down the line, there still has to be a number that stands for a monthly payment by some homeowner struggling to build equity interest in those bricks.

    This has been the tragedy of the past year, during which our national flight from tangibility has once again led us into a tar pit.

    David Einhorn's October speech at Columbia University helped me draw together my own thoughts on these points. Even at its best, securitization is only a "mediocre" idea, Mr. Einhorn said. "Re-securitization of already securitized assets into a CDO is a bad idea. Re-securitization of CDOs into CDO-squared is a really bad idea."

    Bravo, Mr. Einhorn.

    Spare a "bravo," too, for the ancient Greeks, who have left us the story of Antaeus. Antaeus, a son of Poseidon and Gaia (the sea and the earth) was invincible so long as he remained in touch with the ground—for then he could draw strength from his mother. Hercules defeated him by the simple expedient of lifting him up in the air, holding him there long enough so that prolonged separation from the earth would weaken him, then delivering the fatal blow.

    The too-clever-by-far theories of contemporary finance seem to serve (unwittingly) the role of Hercules in this legend. Productive and physical realities serve the role of Gaia, and investors have to play the part of the hapless Antaeus.

    Everything in Moderation

    By Emma Trincal

    I wouldn't be so severe about securitization. My own philosophical take is that running away from the tangible is part of being human. Isn't that what history is all about? And art? And creativity? And power? And religion?

    Why should it be different with finance?

    The concept of securitization can of course be abused. The kicker for me a few years ago was the securitization of the royalties from David Bowie's music. I love Mr. Bowie but I don't know if I'd want to buy his bonds.

    On the other hand, securitization doesn't lead inexorably to fraud. Just because a bank puts something off-balance sheet to free up capital doesn't mean it is committing fraud. It could just be adopting the natural response to Basel.

    To recover a sense of what's right with securitization, let's think back to the Middle Ages, specifically to the period just after the Black Death. There was so much death and there was so much wealth throughout the fertile land of Europe. It was when Europe was dying that capitalism was born. A major economic depression occurred in the immediate aftermath of the Black Death. But the chapter of the Middle Ages ended then, followed by the Renaissance and the modern times.

    During the Middle Ages, the structure of society was rigid. The feudal lords, or nobles, the serfs and the priests each knew their place. The nobles had a highly illiquid form of wealth—land they couldn't trade. They had no way to measure, sell or expand upon their wealth.

    All they could do was pass it on to their heirs. Nobles stayed noble and peasants stayed peasants, for centuries.

    But then something changed. Within two centuries following the plague, some smart people (the Lombardy bankers or grain merchants, most likely) figured out how to "securitize" the land—how to transform the ultimate illiquid asset into bank loans.

    Though there is much in Richard Bookstaber's recent book, A Demon Of Our Own Design, with which I disagree, he has a fine passage on this point. He wrote:

    "The cost of illiquidity became increasingly apparent on a practical level as new avenues for wealth and investment opened up. The development of overseas commerce and the increasing involvement of leading merchants in the lucrative business of lending money to the government expanded investment opportunities. Finally, there were prospects for building fortunes apart from land ownership."

    In 1938, the U.S. government had to do again what the Black Death and innovative bankers had done once before. President Franklin D. Roosevelt created Fannie Mae as part of his New Deal to provide liquidity to the mortgage market. He succeeded.

    Consider as a lasting mark of his success the home ownership rate in the United States versus other Western countries. In France, for example, as of 2002, 55% of the nation's households owned their own homes. In the United States, in the same year, the figure was 68%. That's a significant gap.

    It's the securitization of the market, which during the past 30 years gave home ownership access to large numbers of Americans by reducing the cost of making loans. If a mortgage is securitized, you can trade it, which you could not do before. The system becomes more flexible and more cost-efficient. Securitization produces wealth and helps to absorb shocks, because it injects in the market the liquidity that makes assets move, just like the gas in your car's tank will propel it forward.

    With all that in mind, securitization has proven to be subject to abuse. The subprime crisis tells us that if you like your cake, good. Eat a slice of it. Maybe two. But don't eat the whole cake, and don't eat too quickly or you'll choke.

    I've covered securitization since 2001 and I've seen the way more exotic and illiquid assets have been bundled together and securitized to create those bizarre bonds sold in various tranches of risks called asset-backed securities: Madonna songs (they tried), life insurance policies, even bridges. It's fair game to look for alpha in illiquidity. But we now know the limits of such a game.

    Just because the art of pooling assets into tranches can go wrong doesn't make it a gigantic fraud. When it goes wrong, it's something worse than fraud. If you buy a bond backed by loans made to people who have no money to pay them back, you're a fool. If bankers sell you these loans, and do so with the acquiescence of an army of rating agencies in bed with the issuing banks, they are crooks. If you buy their pitch, you're a fool again. Is that fraud? If anything, I'd measure that type of fraud on intellectual terms, not moral ones. Let's call it a gross lack of common sense.

    What drives this market is the old temptation of alchemy: How do we turn this stone into gold? There is risk, of course, but not taking any risk at all is risky too. Even one of the most rational beings among us, the Homo Economicus, takes risks, the mere risk to exist without being real. Greed and ignorance get mixed up with the best of human nature—intelligence and invention. We have the power to transform our lives in the best or the worst way.

    Instead of rejecting securitization and moving backward, I think we can move forward, being smart about the progress we've made and learning to limit its misuse.

    Here's an example. Why is it such a big deal to ask the ratings agencies to bill the investor, rather than charging Merrill Lynch or Citigroup, the very alchemists that depend on the agencies to sell their magic bonds? The Securities and Exchange Commission has been sitting on this idea for years. It hasn't acted, partly because it's gotten distracted by other battles, such as its fight with the hedge fund community over registration. Now it's about time to move on.

    And what about some obvious level of regulation, like regulating the sale of mortgage loans by making mortgage brokers as accountable as stockbrokers? Stockbrokers, unlike what people imagine, are never off the hook. As a broker, you can always sell annuities to an 86-year-old, but if you do, you're on your own. Compliance is a dissuasive weapon against bad behavior in the securities industry and a lot of bad guys have been put out of business for not following the rules. Why should it be different for mortgage salesmen?

    Instituting reform in such areas requires some common sense.

    Like you, Christopher, I'll make an allusion to the Greeks. Aristotle pointed out that every virtue is a golden mean between two extremes, one of excess and the other of deficiency.

    Financial engineering doesn't have to be chaos. Make it easier for investors to understand the rules. Make the actors more accountable. Let the banks keep a percentage of the risk on their books so that they remain cautious when extending credit. Don't rely entirely on third parties tainted by conflicts of interests. In other words, use the securitization in moderation. Take a healthy dose of Greek temperance, and make sure to absorb both the intellectual and the moral directions.

    Accountants and Physiophobia

    By Christopher Faille

    I thought of the famous Cartesian claim, cogito, ergo sum, when I saw your assertion that "running away from the tangible is part of being human."

    Personally, though, with all due respect to Descartes, I have no doubts that my body exists, and I'm certain that it is through this body, with its senses and its neurons, that thought becomes possible. Further, most thought is for the sake of telling some body what to do. Thought starts with a cue from the senses and ends with an order to the muscles. When it doesn't—when abstraction cuts itself off from practicality—then we have physiophobia, and in the financial world we have the excessive towers of securitization that you and I both abhor.

    Allow me to tie in yet another thread. This is proxy season, and as corporations plan their annual meetings, they face the usual round of challenges from activists—some of them hedge fund managers—who maintain that they aren't earning enough profit and they aren't doing their best to keep the stock price up.

    A number of times you and I have heard management say this in response: "The hedge funds are so short-sighted. They only see the latest quarter's results. We, on the other hand, need continuity on our board, because we're looking to build our business for the long haul."

    Personally, I think it's generically nonsensical. After all, why is an acre of fertile soil more valuable than an acre of desert? Clearly, it is because the market, in valuing the fertile soil, is valuing next season's harvest, and the harvest after that and the one after that. The market value of the acre represents its prospects for as far in the future as the collective wisdom of all potential buyers can foresee.

    Likewise, given a liquid (yes, I said it, a liquid) stock market, the present market capitalization of a corporation reflects the long horizon of possibilities, insofar as the collective wisdom of the marketplace can see and appraise them. Liquidity, like abstraction, is a good thing when it keeps us in touch with concrete productive realities. When an activist investor complains that the management of an issuer has let the stock price fall immoderately, he or she isn't complaining about something immediate, but about something long-term, as reflected in those prices.

    Unfortunately, a lot of investors buy into the excuses of non-performing managers. Why? As you say of those who rely uncritically on the ratings agencies as collateralizations get squared and cubed … maybe they're fools. But they're fools in a specific way. Their foolishness comes from taking numbers as the realities, from taking the map as if it were the forest.

    I can't help but believe that this is a collective psychological problem, and that it will prove to have its solution not in the specific reformist band-aids of the sort you mention, but in a broader turning away from the sky, back toward the earth.

    Antaeus needs to kick himself out of the arms of Hercules.

    The Laws of Nature

    By Emma Trincal

    If you are so much in favor the course of nature, then let this crisis reach its conclusion in a natural way. We are going through a credit predicament because credit was too easily available and housing prices ballooned. Now prices need to go down. It's the law of gravity.

    The more you stop the re-pricing of risk, the longer the pain.

    Securitization does not have much to do with the pain. Securitization is merely a tool. Let's use it, and let's use it well. Would you say that cars are pollution? They don't have to be. Let's make better cars.

    I'm noticing that in today's subprime panic, most people want to avoid the post-bubble pain like the inescapable hangover one must feel after a crazy party. People need to avoid pain. But just like the compulsion to suppress negative emotions through psychological defense mechanisms may lead to mental illnesses, this tendency we have now to avoid the natural cycles of our financial markets can lead to a major and much bigger disorder.

    It is by interfering with the natural course of the market and by putting human creativity on hold that you engineer real crises, those that take not just a year or two to fix but several decades, if not generations.

    If we want this credit crunch to end, let it begin. If we want to limit it, let's see it unfold. Don't put an end to life. Prices will go up and prices will go down. It's the law of gravity.

    You see? I, too, respect Mother Nature.

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