I consider plain old mortgage bonds (MBS) the last clearly socially useful innovative financial product. Here I will argue contra MBS basically in an attempt to understand Krugman’s not so recent root and branch denunciation of securitization.
First the case for the original MBS (which I actually believe). Securitized claims on the cash flow from mortgages make it possible to diversify regional risk. Banks mortgage portfolio’s are concentrated geographically, so, without securitization, a local down turn can bankrupt a local bank. There is no need for anyone to bear this risk — it can be diversified away.
So what could be wrong with this argument ? I try to counter argue after the jump.
1. Banks will go bankrupt. If the risk of bankruptcy is zero, bank managers and shareholders can do better by taking a bearing a little more risk. This is like the principle that, if you have never missed an airplane, you are going to the airport too soon (a view expressed by one Lawrence Summers).
For the rest of us, it is vital that they not all go bankrupt at once. This means that we should force banks to bear idiosyncratic risk. If they can hedge all idiosyncratic risk, then they will bear systemic risk until we have a total collapse every few decades.
2. There will be real estate bubbles that burst. If the system is protected from local bubbles (“froth” according to Greenspan) then there will be a national bubble. Financial innovation made it safe to loan so long as national average home prices didn’t collapse. Bankers believed (or pretended to believe until they received their bonus checks) that such a collapse was impossible, because it had never happened before (not counting the great depression which happened so long ago that it never happened). This made a national bubble and national collapse necessary.
Both 1 and 2 argue that there is conservation of risk. Any risk diversification strategy will lead to more leverage and equal risk. The good old fashion diversifiable risk is costly, but less socially costly that common risk. Improved risk management (really genuine improved risk management which, other things equal would really reduce risk) is therefore socially undesirable.
Now I’m not convinced, but the argument isn’t crazy.