Some risk-mitigating advantages of securitization, derivatives, and other financial innovations
An interesting read from the editorial board of the Wall Street Journal which ran in Saturday’s paper. A few excerpts:
…When it comes to the decline of risk premiums and financial stability, securitization and the use of derivatives have both played an unsung role.
…Derivatives can be very complex, but they are fundamentally a tool for hedging financial risk. Say your business has borrowed money with a floating interest rate. Rates go down, and you decide you’d rather lock in today’s rates than risk having them move against you in the future. You could borrow new money at a fixed rate and pay off your debt.
Or you could engage in a form of derivative known as a “swap.” In a swap, you exchange your obligation to pay a floating rate for a commitment to pay a fixed rate of interest. Your actual debt doesn’t change, but the other party in the swap has contracted with you to pay you the difference between the floating-rate interest and the fixed rate you’ve agreed upon — if rates move higher. Likewise, if rates go down further, you would pay your swap counterparty the difference.
Through this basic mechanism, all kinds of risk in an economy can be shifted around, often to everyone’s benefit. The risks haven’t disappeared, but almost by definition they tend to shift toward whoever feels they can best bear them. Perhaps, in the example above, the counterparty has a reason for wanting exposure to interest-rate movements. Perhaps he has a risk of his own he is trying to mitigate. Perhaps he simply disagrees about where rates are going.
Take another, very real, example of a small-town bank in the mortgage business. By the nature of things, it is heavily exposed to the shifting fortunes of the local economy. If a plant nearby closes, it could be hit with defaults that could overwhelm its capacity to lend. To compensate for this risk, it may raise interest rates, or lend less, or both. But suppose it can sell the mortgages on its books to another bank or some other party. It gives up the income from the mortgages, but it gets new capital in return while also lowering its exposure to the local economy.
The purchaser may then hold the mortgages, or package them into securities with thousands of other mortgages and sell them to investors. These “securitized” mortgages are less exposed to any one town than that small bank was, which may make the security less risky overall. The small bank, meantime, has more money to lend, or to invest in assets that are less likely to crash along with the local economy. The buyers of the securities get the income from the mortgage interest and the bank gets money to lend.
The sum of a myriad of these transactions over the economy means that everything moves a little faster. Credit becomes marginally cheaper and more plentiful. Risk is dispersed to those who feel they can better afford it. Thus does the supposedly non-productive financial sector of the economy provide fuel for future growth. Seemingly obscure transactions lower the cost of capital to businesses and consumers and spread risk in a way that decreases the danger of catastrophic financial accidents.
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