Securitization and the Global Economy

In 1858 William Gladstone wrote, “Finance is, as it were, the stomach of the country, from which all other organs take their tone.”¹ This sentiment still rings true (Mason 2015; Turner 2015). Mukunda (2014) describes the financial system as the “economy’s circulatory system” and the large banks as “the heart”. Furthermore, (Mukunda 2014) attributes the “enlarged heart” of the US economy to the impact of financialization. Financialization is a term used to describe the expansion of financial trading associated with the abundance of new financial instruments (Phillips 2008; Orhangazi 2008; Krippner 2009). The increasing influence of financial markets and institutions impacts other societal institutions (including the government) placing a reliance on short-term liquid assets. Eventually, investment in real assets is crowded out by financial asset investment, an activity Orhangazi (2008) describes as “distributive” rather than “creative”. Due to the transference of income from the real sector to the financial sector, financialization is also credited with contributing to increased income inequality, wage stagnation, increased private and public debt, ownership concentration, and destabilizing economies due to an increasingly complex and opaque financial system (Palley 2007; Engelen 2008; Kindleberger 2011; Giron and Chapoy 2013; Rajan 2010; Legoarde-Segot 2015). Since 1973, in many developed countries, debt has soared and wages have stagnated. If wages stagnate and more profits are generated from mortgage and credit card loans, there will reach a point where this is clearly not sustainable.

February 19, 1970, is a defining moment in the history of financial innovation. On this date the Government National Mortgage Association, Ginnie Mae (GNMA), in association with the Federal National Mortgage Association, Fannie Mae (FNMA), issued the first mortgage-backed security. Later that year, the Federal Home Loan Mortgage Association, Freddie Mac (FHLMC) followed suit with its issuance of mortgage- backed securities (MBS). Hyman (2011) states that the origins of securitization lie at the intersection of “turbulent global currency markets and equally turbulent urban unrest in the late 1960s”. In the late 1960s securitization was utilized to restore stability to the American housing market. Four decades later, after being regarded as a catalyst for the financial crisis, securitization is once again being viewed as a solution to economic unrest (Haldane 2009). In this chapter, I examine securitization in a global historical context and argue that securitization is not the relatively new phenomenon many believe it to be.

The Government National Mortgage Association (GNMA, or Ginnie Mae) started the modern securitization era in 1970 with the creation of US government guaranteed pass-through mortgages. Freddie Mac issued its first pass-through security in 1971, followed by Fannie Mae in 1981. In 1983 Freddie Mac issued its first collateralized mortgage obligation (CMO). A competing private label securitization market emerged in 1977 when Bank of America issued residential mortgage-backed securities (RMBS). Fidelity Mutual Life followed with one of the first commercial mortgage-backed securities (CMBS) in 1983 (IMF 2013).

The role that financial institutions and corporations should play in the global economic and political framework has been widely debated since the financial crisis. In 2009, at a meeting of UK bankers and clergy, Mark Costa, Chairman of Lazard International, stated, “Capitalism has slipped its moral moorings.”¹ Five years later, Mark Carney, the Governor of the Bank of England, stated, “…just as any revolution eats its children, unchecked market fundamentalism can devour the social capital essential for the long-term dynamism of capitalism itself” (Longley 2014). An examination of ethical lapses is inevitable in the aftermath of any financial crisis. Aspects of the 2007 financial crisis may be characterized by greed, recklessness, and dishonesty, but it may also be described as the result of good intentions gone amiss (Tett 2009; FCIC Report 2011). Scalet and Kelly (2012), Donaldson (2012), and Graafland and van de Ven (2011) have examined moral and ethical issues that emerged from the recent credit crisis. Securitization has been attributed to be one channel that facilitated the amplification of systemic risk by increasing excessive leverage and risk concentration across the financial sector.

The growth of the US securitization market has been primarily due to mortgage-backed securities, whereas Europeans have historically tended to trade in covered bonds. Covered bonds are very much part of the European bond framework. As of mid-2007, the covered bond market ranked as the sixth-largest market in the world and the largest asset class in Europe. One of the strongest cases for a covered bond market is in reaction to the 2007 global financial crisis. Relative to the US securitization market, the covered bond market is regarded as having had a “good crisis” (OECD 2011) because the market continued to be very resilient against the backdrop of the 2007 global financial crisis. When bank funding markets seized up European lenders were still able to issue covered bonds.

A rising trend in lawsuits filed against lenders, originators, and home builders erupted as the US housing market started to decline during late 2006 and into 2007. There were a number of other surprising responses to the US mortgage crisis, including the suggestion that local governments use “eminent domain”. Eminent domain usually applies to the government seizure of real property (not loans), such as homes for an urban renewal project or highway construction project. In this case, eminent domain was intended to take underwater, but performing mortgages, in the private label securitization market. The seizure of troubled mortgages would enable the homeowners’ debt to be written down. San Bernardino County in California was one of the first and more visible cases during the crisis where eminent domain was proposed. Numerous criticisms by Wall Street groups and the mortgage industry argued that such a plan would spark lawsuits, higher interest rates, and a tightened market for borrowers.¹ The measure was eventually voted down in 2013.

The 2007 global financial crisis continues to have a lasting impact on consumer behavior, financial markets, financial institutions, interaction of economies, and the nature of government policies. Atkinson et al. (2013) estimate that the financial crisis cost to the USA to be an estimated 40 percent to 90 percent of one year’s output. In dollar terms this is an estimated $6–$14 trillion or the equivalent of $50,000–$120,000 for every US household. If we consider the loss of total US wealth from the crisis (which includes human capital and the present value of future wage income) this is estimated to be as high as $15–$30 trillion, or 100 –190 percent of 2007 US output. Adelson (2013) estimates the global costs of the financial crisis to be between $5 trillion and $15 trillion.