(This article appears courtesy of International Financial Law Review, sign up for a free trial on their site)
But with all the attention on Northern Rock's UK products, and property securitisation in the US, you would have thought they'd have taken the time to understand the structure, to learn how it works and to appreciate the implications of the term bankruptcy-remote.
It would seem not. A recent example was the op-ed piece in the New York Times on December 3. It claimed that: "The innovations of recent years – the alphabet soup of CDOs, Sivs, RMBS and ABCP – were sold on false pretences. They were promoted as ways to spread risk, making investment safer. What they did instead... was to spread confusion, luring investors into taking on more risk than they realised."
There are so many things wrong with this it's hard to know where to begin. The suggestion that all products simply lied in their offering documents jumps out first. Then the running together of acronyms that mean so many different things. But the real problem is ignorance of what securitisation is.
Securitisation is attractive to issuers because it's cheap. It's cheap because it's safer. Rather than lending money to Northern Rock the bank, you are lending money to houses – to people paying off their mortgages. This is safer because you are unaffected by Northern Rock's other misadventures or mismanagement. As long as a decent number of people don't default on their payments, you're fine. Of course, this has become an issue in the US sub-prime market, but the problem there was irresponsible loans, not their securitisation.
"So few people take the time to really understand what is going on," bemoans a lawyer at a bank that arranged Northern Rock's securitisations, the Granite master trusts. "Not one of the Granite deals has gone bust, no one has lost their money. Northern Rock's problem was one of liquidity. It had nothing to do with securitisation."
The tragedy is that the New York Times piece began by describing liquidity very well. The metaphor of motor oil in car engines explained why inter-bank lending is such an issue. But it quickly forgot this point and declared that the words financial innovation "should, from now on, strike fear into investors' hearts". Apparently the financial industry has "innovated itself, and the rest of us, into a big, nasty mess".
No. If investors had bought bonds from Northern Rock instead of Granite they would be in far more trouble than they are now. They would almost certainly have lost their money. Innovation saved them. Calling innovation bad is like saying all bankers are swindlers or all lawyers are evil.
Unfortunately, this is no laughing matter. Ignorance breeds panic, and panic regulation. Ill-informed commentary risks creating political pressure for blanket legislation. There is certainly an issue over disclosure of structured products that are repackaged and resold, and ratings agencies have serious problems. But any other misjudged calls to arms are inflammatory and irresponsible.