Securitisation and its hidden costs

In an earlier post, we asked whether banks were organized to recognize risk. Now we have an article from the Economist about the role that “securitisation”—the process that transforms mortgages, credit-card receivables and other financial assets into marketable securities—played in the functional separation of loan origination from loan servicing.

Until the early 1980s, finance hewed to an “originate and hold” model. Banks generally held loans on their balance sheets to maturity; some debts were sold on loan-by-loan, but this market was small and lumpy. This began to give way to an “originate and distribute” model after America's government-sponsored mortgage giants issued the first bonds with payments tied to the cash flows from large pools of loans.

This functional separation made it harder for investors to "see" risk.

[Securitisation] creates what economists call a principal-agent problem. The loan originator has little incentive to vet borrowers carefully because it knows the risk will soon be off its books. The ultimate holder of the risk, the investor, has more reason to care but owns a complex product and is too far down the chain for monitoring to work. For all its flaws, the old bank model resolved the incentives in a simple way. Because loans were kept in-house, banks had every reason both to underwrite cautiously and also to keep tabs on the borrower after the money left the vault.

In this characterization of the principal-agent problem, investors are the principals, and the loan originators are their agents.