Is Prof. Paul Krugman wrong about Securitization?

Prof. Paul Krugman has generated some surprsing criticism from the likes of Barry Ritholtz and Bonddad for an article he posted the other day in the New York Times, entitled The Market Mystique:

Here are the crucial paragraphs:

Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.
I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

Krugman's essential point, and why he doesn't want securitization resurrected (is it actually dead?) is that banks improperly leveraged securitized instruments, thereby creating a debt-deflation when they misfired.

If securitization isn't leveraged, does it pose the deathly systemic risk currently enveloping our system? With one exception, no. Take away leverage (taking out loans to bet on the securities) and the Wall Street meltdown doesn't critically endanger the Main Street economy.

Here's the exception: securitization atomizes risk. But if atomizing risk leads you to take more risk, then atomizing risk creates systemic risk.

A good analogy is anti-lock brakes. They're a great invention. The problem is, too many people take them into account in how they drive, taking more risk of tailgating, thereby defeating their purpose. Similarly, once securitization reaches critical mass, then too many people take too many cumulative small risks, creating the chance of systemic meltdown if the risks misfire in non-random fashion (like in a housing bust).

There are other problems as well. As readers of the late Tanta know, splitting securities into tranches creates a tremendous gordion knot of opacity and inability to modify the terms in cases of stress (how many mortgages can get modified when hundreds of owners of the various tranches need to sign off?). And a large part of the problem with Lehman Bros. and AIG was how interconnected all their various CDS contracts were.

Like Barry Ritholtz, I believe the issue of causality is clouded to say the least by the spectacular overindulgence in laissez faire deregulation in the last decade. Imho, securitization is fine so long as (1) it is properly regulated to ensure that the agents creating it bear real risk if it goes wrong when they sell it; (2) it isn't leveraged; and (3) there is not so much securitization in the system so as to create a credit bubble.

As I read Krugman, he believes (3) is inevitable, but he does not marshall any evidence in support of that crucial point. My verdict is: not proven.



more like the living dead

I don't know where this idea that securitization is dead is coming from, especially from the Obama administration.

From what I can tell it's the ultimate "Zombie" eating away at this point the U.S. economy to the point of the ultimate risk.

The way I read this argument, although Krugman doesn't imply it, is securitization as it's currently implemented caused fictional money, more risk, bloat in the financial sector.

So much is based on flawed models, such as the tranches which were steaming piles of shit layered with AAA rated securities to cover up the stink.

So, the concepts might be ok, but when implemented on flawed models, clearly fictional mathematics which doesn't even pass the smell test and as you point out, the big kauna of 40:1 leveraging...

yeah, that all should die, but right now it seems the zombie oligarchs are brazenly winning.

The CDS and Derivatives

The CDS and Derivatives markets are still active with various Quants and high tech traders. The market in London is still active. See: and The single biggest problem Prof. Krugman is really pointing to is that unregulated securitization amounts to the creation of money
supply qua "credit." It's almost as though overnight money has become defined as credit. Even Barney Frank this week
said there's no turning back from securitization, but the fact is the Chinese and the American people don't have faith in the sausage machine that we call the banking system anymore.

NDD, thanks for another provocative post.

I read Barry's post early today but did not see Hale's post. In any event, I am not a member of the investor class, so I wade into this discussion with much trepidation.

I have been commenting on various blogs the past few days that I think Krugman is actually a reluctant crusader against the status quo. Consequently, I think he has been holding back on his criticism of the administration's moves simply because he has the "conscience of a liberal". He sees Obama as an ally, or compatriot, or at least a last best hope and therefore is hesitant to be seen as a detractor to any "progressive cause". But I think Krugman is now questioning whether Obama, and his programs, are progressive at all. To me, the most interesting part of the reference article is:

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what’s striking is the ... administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation. ... But the underlying vision remains that of a financial system more or less the same..., albeit somewhat tamed by new rules.

As you can guess, I don’t share that vision. I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good.

The emphasis is mine and it highlights what I think is Krugman's questioning of the integrity of, not just our financial system, but our capitalist system in general. He is reluctant to condemn it now, in totality, simply because it is too radical a position to take at this juncture of congenial discourse.

Coincidentally, I read a blog earlier today discussing the consequences of reaching "peak capitalism". The following chart was presented which signifies the paradox of our capitalism in recent years.".
Real Wages (CPI adjusted) vs Real Productivity (GDP Deflator Adjusted) 1830-2007
-Source: Professor Richard Wolff - U Mass - Amherst

While there are many explanations for the increase in worker productivity, the stagnation and decline of real wages over the same timeframe is more remarkable. The gap between real wages and productivity gains is PROFIT and this is what corporations and banks have exploited to their advantage. In other words, this is a graphical depiction of the transfer of wealth from the workers (i.e. the producers of real assets) to the rentier class. I believe this is unsustainable and I'm pretty sure Krugman thinks so too.

At this juncture in history however, this is a blatantly Marxian view and therefore is not "ready for prime time". I am free to call for dramatic changes to the system, including diminishing the effect of "the market". I can call for monumental changes and risk little blowback but a public figure like Krugman is more exposed to criticism. We need a paradigm change, and I believe Krugman thinks so too. I am free to say it out loud, Krugman can't(at least for now).

Prof. Krugman makes some good points about

securitization and I don't think it is a matter of absolute right or wrong. Securitization serves a useful purpose but like every factor contributing to this crisis too much of a good thing is bad.

The system failed on so many levels. The financial sector went hog wild with securitization and regulators and policy makers did nothing to stop it. Basic principals of diversification and risk assessment were abandoned in favor of higher returns. Accountability and responsibility were disregarded because financial conglomerates and Fannie/Freddie were making a ton of money. The quicker a mortgage could be produced the better who cared about underwriting standards because real estate prices always go up.

The last paragraph of Prof. Krugman's article is spot on in the sense that it is misguided to make securitization the focus of any bailout strategy.

Securitization: pure bunkem

Prof. Krugman, despite his ties to the Peterson Institute and the Group of Thirty, is beginning to make more and more sense (remember, he was a big supporter of jobs offshoring!).

Securitization (transforming debt into securities) is responsible for the super- or ultra-leveraging, with the subsequent de-leveraging we'll be sadly experiencing for many years to come. Fraud by any other name, is still fraud.

One could accept the mini-fraud of fractional reserve banking, but as with all frauds, it was taken to the ultimate extreme, thus as that many others have stated, we end up with the "shadow banking system" leading to the predictable demise of capitalism.

It's been a great wealth-transfer to the super-rich with the all-too-obvious leveraged buyout of America, but perhaps the citizenry will awaken before all is lost......

Krugman often promoted "NeoCon" "theory"

as I recall and is still clinging to the "free trade" bandwagon.

Where the theory really falls people. These people seriously believe that trading people is great and we should have corporate controlled global migration and that will all be "good"...., uh no, That represses wages incredibly so, causes dramatic changes in domestic population, which puts massive burdens on some nations social infrastructure and others with a sudden labor shortage....I mean by the equations, by the theory itself, at least in terms of middle classes the theory shows this will lead to a "slave" class.

I don't find anything too Progressive on that score.

I actually heard a Harvard economist try to claim offshore outsourcing was "good" because it gave our jobs to other nations. It was pathetic. It's almost like one can put a quarter into these people and have them play the corporate talking points tape and damn any statistics, anything at all that shows the contrary is going on.

I do agree with you that Krugman has been sounding more and more circumspect these days, looking at real evidence in the real world...

But I fear people are putting him on the level of "God" and one needs to examine someone's track record instead of personality.

James Woolley read this

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Keep in mind that

Keep in mind that securitization was intended as a way of sharing risk, beyond smaller single note holders. It has become utterly abused, to be sure. Securitization is an innovation that is unlikely to go away, but one doubts that policy-makers and regulators fully grasp the totality of what it truly means on a global scale. Public Pension Plans in the Baltics connected to new subdivisions in Lancaster
or San Bernardino, California (and elsewhere). And, securities owners all interlinked in ways unbeknownst to even them. It's a beast, really. It's one thing to bundle 500 mortgages (aka a tranche) into a single security. But then all the other derivative instruments are designed to hedge, protect, manipulate, etc. against various market contingencies. No thought given to where the real action occurs, which is at the individual home price level. Home prices have been so inflated and methinks our leaders still just don't totally grasp true simplicity yet. (I think the Chinese leadership team does get it...very much so.)