INVESTING: How financial innovation facilitated subprime mess

Since the mid-1980s, a lucrative activity on Wall Street has been to pool financial assets and then issue securities representing an interest in these pools-a process called securitization. All sorts of assets are securitized, including auto loans, mortgages, leases, credit card

receivables and corporate debt. Investors purchase the “asset-backed” securities and receive the cash flows generated by the underlying loans in the pool.

Securitization was a tremendous financial innovation. Before securitization took off, financial institutions often would keep loans on their books and hold them to maturity as an investment. However, retaining these loans tied up capital and restricted the amount of future lending an institution could handle. Securitization allowed financial entities to underwrite loans, package them up and resell them to investors. And by clearing these loans off their balance sheets, this freed up capital to make more loans.

Institutional investors and hedge funds liked to invest in these “collateralized securities” for their diversification benefits, their relative safety and their incremental yield over Treasury securities. Some hedge funds formed solely for the purpose of investing in asset-backed securities and would usually borrow large sums of money to leverage their purchases.

At present, problems have developed in the securitized pools that contain subprime mortgages. Mortgage lenders made increasingly unwise loans to less-than-creditworthy home borrowers under terms that were arguably surreptitious, and now many of those loans are starting to default. With a rising number of subprime mortgages going into default, the value of these mortgage pools is dropping.

The problem worsened because these securities are not liquid and they are difficult to value. As many investors began selling all at once in an illiquid market with sketchy values, the credit markets ceased to function smoothly. Throw in the leverage that hedge funds used in purchasing these securities, and a significant decline in price can bring down an entire fund. A few hedge funds already have gone bankrupt in this current round of credit market disruption.

Other problems are being discovered in the commercial paper market-usually a liquid market where banks and corporations issue short-term debt. Investors are finding out that the large banks have set up “structured investment vehicles”-offbalance-sheet entities formed to issue commercial paper.

The words “off balance sheet” unfortunately conjure up memories of Enron. And while nobody is comparing the SIVs to Enron’s financial hijinks, SIVs are not disclosed on the bank’s financial statements. And there is concern as to whether SIVs hold subprime securities and the potential obligation the banks might have if they were to suffer losses.

A final concern is whether the subprime indigestion will spill over to other assetbacked securities, like leveraged loans. It is these uncertainties that have both the stock and bond markets spooked. As such, the near term could be quite a rocky ride.