Economics of Securitization

I found this paper from Van Order on securitization pretty good.

It discusses how securitization in a pretty lucid manner. Unlike other papers that get into fancy modelling, this one sticks to basics and explains the same using traditional finance theories like Modgiliani-Miller model.

Much of the focus in studying MM has been on debt vs. equity funding. However, the securitization issue is less about debt-equity structure than it is about the structure of debt funding, particularly as it is related to institutions that typically use different types of debt funding. For instance, the most common type of debt funding for financial institutions is deposit funding by banks, but the important alternative, especially in the U.S. in mortgage markets, has been securitization, typically performed by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac or the government-owned Ginnie Mae, the three “Agencies.” So the point of departure is why should there be any ifference between deposit funding and securitization?

I never really thought it this way.  

He begins discussing the evolution of the market and how the 3 agencies came up. He then discusses the 2 securitization models and explains the process.

He has 5 lessons for policymakers:

1. It is the function, connecting mortgage and capital markets, especially the long term market, rather than institutional (e.g., charter) details, that is important.

2. While working on the “back end,” e.g., doing some deals and getting some mortgages off banks’ balance sheets may be a good idea, it is the getting the “front end” right that is the sine qua non of developing good mortgage markets. It is even more important to have proper registration, foreclosure and eviction procedures in setting up secondary markets because of the potentially severe selection problems.

3. Controlling safety and soundness requires serious consideration of risk-based capital, not like the old accounting capital ratios, but really risk-based standards that make companies hold more capital if they do things that increase risk to the company (and taxpayer stakeholders). The old Basle model cannot do this.

4. Interest rate risk is a concern, no matter how much you securitize.5. Diversification is important

Nice insights.


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