"Securitization" — isn't that an ugly word? It's a financial term that means to bundle up a bunch of loans into a structure that can be used to issue bonds. It's one of the "financial weapons of mass destruction" that caused a near-meltdown of Wall Street in September of 2008, just before the election. I was briefly part of that process.
In November of 2005, I had a contract gig as a technical writer working for Harley-Davidson Financial Corporation in downtown Chicago. These are the people who loan you money to buy a motorcycle, and they were "securitizing" these loans with the help of a proprietary computer program they had built. They brought me in to write the user manual for the program.
I'll try to explain the system to you.
The loans that got the industry in trouble in 2008 were mortgages, not motorcycle loans. I have no idea how HD's securitized bonds held up in the storm — for all I know, they're still perfectly good investments. But the securitized mortgage bonds exploded all over the Street, and they worked the same way. So I'll tell the story as I know it, concentrating on how HDFC made securities.
Here's the beginning of the story: one fine morning you, a middle-aged guy with a job, wake up and decide you've just got to have a motorcycle before you die. Your Harley-Davidson dealer not only sells hogs, he also has the fringed leather jacket and the do-rag you'll need. The friendly HD Financial guy can put it all together on one loan — the Compleat Mid-Life Crisis Kit. The average loan is about $15,000 and you'll spend the next five to seven years paying it back. When I was there, H-D was writing about two billion dollars a year of these loans.
The middle part, with more details to come, is this: Harley-Davidson gets payments every month on those loans, and eventually most of them will be paid back. But if H-D can borrow against those loan payments, they'd have money to loan out right now for more motorcycle loans. So they would like to get the money up front. To do that, they go borrow the money from investors such as big pension funds, with the loan guaranteed by all those monthly payments.
The end of the story is in the hands of investors. They buy bonds which pay interest every month for a period of years. At the end of the period, the investors get their money back, pretty much like taking out a CD at the bank. Each bond is something like $100,000 and pays a rate of interest higher than you can get from the bank.
Let's go back to the middle part. HDFC has thousands of loans all over America (only American loans were used for this). The program they wrote was a big database that let them pick loans to package together until they had about half a billion worth, enough for one quarter. This program was fine-grained enough to let them inspect individual loans if they wished.
Once a quarter, HDFC would create a new corporation with an unmemorable name such as "First Quarter 2006 H-D Bond Issuing Company". This is called a Special Purpose Entity (SPE) and it doesn't take up much space in the world: all of the officers and directors of this company are officers of HDFC. The SPE hires HDFC to provide it with clerical service, so it has no employees. If this sounds like the corporate equivalent of playing air guitar, you've got the right idea, except that this near-virtual company can make real-world money.
Harley-Davidson Financial Corporation sells the package of loans to the SPE. This transaction has a particular legal term: it is called a "true sale".
You're to be forgiven if this doesn't sound like any kind of "true sale" to you. It sounds like Uncle Harley moving the money from one pants pocket to another. Nevertheless, this is the crucial technology that made securitization possible. By means of some very clever lawyering, the sale contract is structured in such a way that the courts are willing to consider it a "true sale". The important characteristic of a true sale is that it uncouples the liability. If Harley-Davidson goes bankrupt, it can't take down the assets that are owned by the SPE, which means the bond holders are safe. If the SPE fails for any reason, Harley-Davidson is not responsible for their debts, either.
None of this is evident to you, the motorcycle-buying customer. The SPE also hires Harley-Davidson Financial Corporation to collect and process the loan payments, so from your point of view, you're sending the same check to the same address every month.
The SPE pays for this package of loans by selling bonds. Each month, it collects money and gives some of it out as interest. After a period of years, it has collected all the money, so it pays off the bonds and goes out of business.
The bonds that the SPE issues are rated AAA, the best and safest rating there is. There are a number of industry-wide techniques for making these bonds safe, and every securitization uses some or all of them:
- Pick only the good loans. The database program allowed them to choose only loans to people with good FICO scores. Flakier loans (that is, loans to people with poorer scores) were not made part of the securitization package.
- Pick loans from many states and all areas of the country, so that a regional downturn won't make the package go bad.
- Pack more loans into the package than you need, to allow for some going bad.
When the SPE issues the bonds, they also add safety with other techniques:
- Divide the bond holders into groups called "tranches". The first tranche agrees to take the first wave of bullets — that is, if things start to go bad and the bonds can't be paid off, the first tranche takes the initial losses. In return, they get a higher rate of interest. The second tranche gets a lower rate of interest, but they sleep more soundly because they know the first tranche will get in trouble before them.
- Buy insurance for the bonds. This is where the weird stuff comes in, things like "credit default swaps" and "derivatives". All of these are essentially side bets on something (and it doesn't have to be anything related to bonds or the subject of the loans) that is expected to go up when the value of loans goes down. The idea is that any losses on the loans will be made up when the bet pays off.
You need to understand that none of this is evil. The people at HPFC were not only personally as nice a bunch as you could hope to work for, they were also conscientious about building these securities. They believed, and the bond-rating agencies and sophisticated investors also believed, that the combination of all of these safety techniques made these bonds safe and secure. As I've said, it could be that these motorcycle-loan bonds were and still are safe. I don't know.
But as we all know by now, the mortgage-backed securities were less safe than playing with matches in an ammo dump. What went wrong? I can offer some suggestions.
First, the whole process separates the guys who make the loans from the guys who take the risk, and that's just asking for trouble. Once the loans have been securitized, the company that wrote the loans is back doing business at the same old stand, cheerfully unconcerned about whether the loans will be paid back or not because they don't own the loans any more. The company that does own the loans is a phantom that displaces no air. The investors who take the risk don't see the individual loans and can't do a ding-dong thing about it if they fail.
In other words, nobody's minding the store.
A second problem is that, in hindsight, it's pretty obvious that we don't know how to measure the risk of a package of securitized loans. We thought we did, but we were wrong.
Third, there's the problem of all of those "insurance" dealies that were supposed to pay off if the loans went bad. A lot of those bets were placed with AIG, and when the chips were down, it turns out AIG welshed. They didn't have the money to pay off what they owed, and in fact, they never did have the money. It was all bluff and wishful thinking. This happened, I think, because these kinds of transactions are not only unregulated, they are specifically exempted from government oversight. The Obama administration is trying to address that now, by requiring at least that companies that offer these deals publish audited financial statements to back them up.
Investors are understandably skittish about securitization bonds now, and I think the market for them is pretty much dead, at least for a while. But you can be sure there will come a time when Wall Street gets all liquored up over some new financial invention. I'm pessimistic about that: I think that, once again, by the time all of us (both on and off the Street) figure out what's going on, there will have been another crash.