As the blue-mist enveloped years of our collective nightmare come to a final end and begin to recede into the distance of memory, we pause for a moment to consider what we’re passing through today. After all the Carnage, the Double-Talk, the Straw-manning, the Witch Hunts; after the awful deluge of bullshit we’ve weathered from the Republican PR machine; after the three frigtening years of male asshole empowerment weathered approximately between 2001 and 2003; after all the self-congratulation and glib analysis; after 8 years, in short, of a bad trip, we finally see the sunrise (with a blue O in it, oddly enough).

Could it have been paradise, though? When Bush stood on the wreckage of the World Trade Center and said the world would hear from us; when some banker, posing for a moment as a public servant, stood outside the stock exchange a week after 9/11 and said “and now, our heroes will open this market”; when millions of Americans first unpacked their flat-screen TVs, plopped down on their Ikea furniture, and first tuned in to American idol, were we still living in some kind of reality? Or was it all just a dream? Perhaps: the TVs were bought with borrowed Chinese money, Wall Street turned out to be a Ponzi scheme, the search for fleeting celebrity and superficial attractiveness turned out to be less than our souls could strive for, and what the world heard from us was that we were mean and didn’t think things through. Maybe, then, it was all just a dream, some strange parable from God that wafted out of the blue smoke of a collective national bong hit taken some time between the breaking of the Lewinsky scandal and Novemeber, 2000, as reasonable people tried to ignore the growing menace of the Christian right–a cosmic practical joke meant to warn us about the dangers of complacency towards the silly. Maybe.

All one can see now is that we have an inauguration today, but this time, it’s not a man who is being inaugurated, but a brand new nation. We stand and watch the pampered scion of a faux aristocracy bow out to a man who, like many of us, had to figure out how to be an American, and one who now wants us to work together for a better future.

So we say bye bye to the intoxicating blue smoke of the Bush years, that haze of pleasant unreality, those mornings of nothing, that blessed lack of purpose, that sense of blah, that surety in hedonism. Say your prayers and line your pocketbook, hug your wife, go to church, all is well. But now I’m lazy, I’m tired, I want my dream back; I just registered Republican in October. I’ve reached my middle-young-adult-hood and now we get inspiration? I’m ready for the picket fence, the mortgage, the TV and the lazy boy.

Our long national nightmare is over, and all I want to do is stand on the sidelines and make snarky comments. Mr. Bush: as a person who entered college when you entered office, let me just say, you really fucked us.

“Securitized lending is here to stay. Regulatory changes provide incentives for traditional lenders to securitize loans. Capital reserves are higher for institutions to hold whole loans vs. rated securities. Institutional lenders such as life insurance companies are now buyers of CMBS and banks are beginning to offer securitized loan programs.”

Ah, securitization, that most ironical of words. The quote above was taken from a now-priceless article in the February 6, 1998 edition of The Atlanta Business Chronicle, an article entitled “Mortgage-backed securities make it easier to find loans.” The article was written by two members of a commercial real-estate firm in an attempt to talk up the burgeoning market for commercial mortgage-backed securities; given that the excesses in the commercial market were far more contained than those in residential mortgages (possibly because it’s harder, though not impossible, to fleece businessmen than the average consumer), we assume that Messers. Petosa and Long are still employed and still promoting the virtues of securitized lending.

We here at Bye Bye Blue Smoke (ok, I here) hope to take a more skeptical view of the boom in securitized lending in the next series of posts. (Ok, I checked, their firm, FINOVA Capital, filed for bankruptcy in 2006, assumedly far after Petosa and Long left the firm so maybe, through some miracle of internet visibility, they can help me out.) Like many frightened Americans, I’ve been wondering how the sudden and massive destruction of wealth that occurred over the past 6 months, with substantial numbers of Americans losing a large fraction of their retirement savings and several major banks collapsing, could have been caused by chicanery by Wall Street bankers–that is, how a bunch of dudes playing with computer bits could have caused the destruction of real wealth–and whether that loss must persist. I’ve been nagged by the following quasi-philosophical question: if silly games with paper, which involve no real productive activity, are assigned an economic value, and then, those same silly games with paper are shown to have no economic value, how could the subsequent reassignment of their value cause actual wealth to be lost? Could it? In life, we have activities we do and the values we assign to them; we assign those values so we know what those activities can be traded for. In the Second Gilded Age, the financial industry grew, with more and more of it engaged in silly games with paper; for a time, these games were assigned great value, and it’s players were paid fees; then, the games were found to be without value; we can’t get the fees back, but surely, aside from that hopefully negligible loss, we should be able to simply go back to a world where the silly games are assigned no value and start anew. This is possible, right? If so, how do we do it?

Should be a simple question with a simple answer, but, unfortunately, it’s not, or all the smart people in the US government wouldn’t have been so hysterical about it for the past 6 months. Why is it hard? Well, for one, we know that one of the silly games with paper was run-away securitized mortgage lending or, more to the point, leveraged investing in subprime mortgage-backed securities by large Wall Street banks. So there’s lots of bad subprime mortgage-backed paper out there–the silly paper in the silly game. Why not just burn it all (i.e. write it off) and start over? The assets were created pursuant to imaginary, not productive, activity–the playing of silly paper games. If the value of the assets is imaginary, pretending the assets don’t exist should be a good strategy. Simple, no? Well, no. This is essentially what the TARP, or Troubled Asset Relief Program, that bastard of a cure-all legislative action that amounted to $700 billion no one knew the purpose or use of, was supposed to do: Print money (imaginary money) and use it to replace imaginary assets. Problem solved, right? Well, what if you borrowed money that was ultimately produced by doing real things (selling produce, building machines, transporting cargo) and invested it in imaginary things like subprime mortgage paper (i.e. the mortgages of people who can’t afford their mortgages)? Then you’d need to take the imaginary money the government gave you and use it to pay back the real money you wasted on the imaginary assets. Insofar as this helps you redeem the real money (and pay it back to the real person you owe it to), all is well for the economy (well, at least for the private sector: government debt will increase, but the government can borrow at lower rates than households, and they can print money).

To slip uneasily from metaphor to history, this exchange of real money for fake (or, fake money for fake assets to redeem real money) was what Henry Paulson, the (current-at-the-time-of-me-writing-this-but-hopefully-by-now) former Treasury Secretary, was originally charged with and was planning to do–that is, he was planning to use TARP money to buy bad assets so banks could take them off their books–but, for reasons that remain unclear, he chose to use the money to inject capital into banks instead. How this turnaround came about will be the subject of a subsequent post in our series , but for now, one wonders if the exchange of printed money for imaginary mortgage-backed securities to pay back the real money of creditors would have done the trick? If so, it fits easily into a simple, if modified, model of government counter-cyclical activity: a sudden increase in the demand for money (to cover losses on mortgage paper) meets with an increase in the money supply by the government (through buying the mortgage paper). If not, however, we’re left with the horrible prospect that these silly paper games can cause real and lasting destruction of wealth. This is a frightening prospect and, indeed, it may be the reality: Paulson’s choice of using capital injections into banks instead of buying bad assets should have theoretically allowed the banks to work collectively to do what the government would have effectively done through purchases–write off the bad assets and move on. For some reason, they couldn’t do it. Why? Are the imaginary losses far greater than the $250 billion they’ve been given? Are they unwilling or unable to write off the values of securities that may have some, though very little, value? Or, can they not get these assets off their books because these assets are their books–i.e. so much real money has been pumped into these imaginary assets that, without redeeming at least some of the real value, these banks would become insolvent?

Given that, whatever would have worked, we continue to find ourselves in a seemingly intractable financial crisis, we assume going forward that, even if the TARP had been executed with Obama-ish smoothness and professionalism and some mechanism was established to effectively buy the bad assets, the crisis would probably still not have been averted. So we ask ourselves, what is this silly paper game called securitization, and how does it affect our lives? The rest of this post will introduce the concept and attempt to provide historical context. In subsequent posts, I hope to analyze it’s role in the growth of American consumer practices and culture over the past 40 years, whether securitization itself will survive as a common practice, and what role, if any, it will play in the new economy. A large part of this task for the blog and everyone else, though, will be telling a coherent story of the history of securitization itself and tracking its effect on the availability of credit, a story that remains largely untold. (To that end, I hope to find more articles like the one above.) And it’s a story with consequence, because, if my hunch is correct, and the very model of securitized lending as a means to direct investment capital to consumer credit is fundamentally flawed, it could mean that we’ve been living in an imaginary castle for the past 35+ years that’s about to come crumbling down.

So, to begin, what is securitization? Securitization is, basically, the selling of debt payments in the form of a security (a security is just any financial obligation (a stock is a security)). So, a mortgage securitization would work like this: There’s, say, three families with mortgages at three different locations somewhere in the Northeast. I’m a mortgage banker who owns these mortgages, so the families’ payments are going to me. I currently carry the risk that one or more of these families will stop paying me. I don’t like this, particularly because I know these families personally and one in particular is kinda dodgy. My big banker friend, however, keeps calling me and saying he’d love to buy these mortgages off me. Annoyed by the possibility that at least one of these families won’t pay, I say to my banker friend, sure, pay me $1000 extra and I’ll sell you these mortgages. He says great, pays me $1000 plus some percentage of the mortgages and now he owns them and can worry about that dodgy family (to ease his mind, I choose not to tell him about the dodgy family). All I got to do now is collect the payments from the three families and immediately pass them on to my friend. My big banker friend, being a whiz with numbers, quickly finds three other mortgages he’s bought from another guy like me that are all located in the Southwest. Based on a mathematical analysis of the basic parameters of the mortgages, and considering the geographic dispersal of them, my friend then creates a security whose value is backed by the debt payments from me and from the dude like me with the Southwest mortages. Later that afternoon, my friend, a real mover and shaker, is already on the phone marketing his new security. It has two levels (or tranches): senior, and subordinate. If you like risk, invest in the subordinate: the interest rate it pays will be higher than that for the senior, with the tradeoff that the subordinate absorbs losses first, losses which would occur if one or more of the families stopped paying their mortgages. If you don’t like risk as much, therefore, you can invest in the senior side of the security, and you’ll then be insulated from losses since the subordinate tranche will absorb losses first. Lastly, my friend says, don’t worry, the mortgages that back up this security are dispersed all across the country, so the prospect that they’d all default at once, due to, say, a bad regional economy, is low. The potential investors take the bait and agree to buy the security. My friend is likely paid a fee for setting this whole thing up, and the security will work like a bond, paying a regular interest rate to the two tranches of investors and then paying some value at maturity above the original purchase value. The security can then be traded like any other bond.

So that’s a securitization. Despite the mind-boggling complexity of financial instruments that industry insiders and media commentators like to advertise, it doesn’t take an financial economist or any other form of rocket scientist to see the possibility for perverse incentives in this model. One need only observe that only I personally know the families whose payments I’m selling to see that something is wrong. The crucial historical point is that this way of doing business is fairly new; what’s essentially happening with securitization is a shift from a financial system based on banks–i.e. me lending to families without the benefit of my friend to sell their mortgages to–to a financial system based on securities markets. This shift has been a long process by which the George Bailys and Mr. Potters of the world are replaced by me and my pink-shirt-and-vodka-martini Wall Street friend (he’s that type of guy). To finish off this post, then, we return to the article cited above to set the stage for a historical review (which will occur as soon as I can find some historical material on securitization).

Financing

Mortgage-backed securities make it easier to find loans

Atlanta Business Chronicle – by John Long and Tony Petosa

In our ongoing scrutiny of Tim Geithner, the Treasury-Secretary designate, we witness light touch Tim forgetting to pay nearly $40,000 in income taxes and hiring an undocumented person as his housekeeper. And in disclosures today covered in a New York Times editorial, we see even further evidence of tax malfeasance, and a potentially disturbing pattern emerging. In my previous post on Mr. Geithner, I liberally cast aspersions on his character, painting him as a darling of Wall Street, a serial self-ingratiator who spent more time sucking up to industry than regulating, and whose primary accomplishments may well be imaginary; in an act of supreme disloyalty to my former employer, I even suggested that he represents the very worst of the self-aggrandizing and self-congratulatory culture of Wall Street, a culture that looks with disdain at the very economy it is serving and from which it skims its out-sized profits, a culture that would not hesitate to engage in tax evasion simply as a matter of principle, a culture–above all–steeped in the self-serving, disingenuous rhetoric of market fundamentalism that was both the scepter and the shield of the corporate robber barons of Bush’s now-dead Managerial Revolution.

I was glib at the very least, haughty at the very worst, but given that, as I assume, no one is reading this, I assumed it was alright. After all, though Mr. Geithner seems to represent the consummate self-assured Wall Street personality, he didn’t actually have any finance industry experience and had dutifully spent most of his life in the service of the public. (And anyway, who else is Obama going to pick? At least Geithner’s smart, experienced, and semi-new.)

Now, however, I feel vindicated. You’re going down, Timmy G! You and the rest of the mandarin mauraders of the Bush years are about to be thrown on that old dust heep of history. Paulson was the end of the line. Your revolution is over! Government is back, and it’s for the people this time. Pay your taxes!