Any examination of the causes of the financial crisis is exceedingly complex, with a variety of causes that include bad lending, monetary policy mistakes, a bubble in real estate prices, bank capitalization, etc. In this light, the recent congressional hearings on Goldman Sachs should not be dismissed as mere theatrics, as they highlighted the industry's willingness and ability to unload defective transactions into the market. A candid assessment of the causes of the crisis and the future of securitized lending forces us to address why the "market forces" that had protected investors in prior years failed to prevent the market from being flooded with flawed securities. It is imperative that we understand and identify market functions, determine why they broke down and devise both market- and regulation-based remedies.

The business of securitizing financial assets is different from other forms of bond issuance, since the performance of the resulting securities is dependent on both the quality of the collateral and the distribution of cash flows within the transaction. While the process has worked well for decades, the market forces that traditionally protected investors gradually failed between 2004 and 2007.

There are two primary factors responsible for this failure. The most obvious was the rating agencies' inability to adequately evaluate transactions. Their willingness to put triple-A ratings on bonds in intensely complex transactions backed by increasingly shaky loan collateral was a key component in the proliferation of unsound deals, as it facilitated the marketing of increasingly complex and exotic transactions to investors.

Equally important, however, were the changes that took place in the investor community. Without restraint, issuers will securitize any asset; investment managers historically check this impulse by evaluating a proposed transaction and withholding their investment dollars if they are not satisfied with its structure and collateral.

A key development was when investment managers shrugged off their traditional role of gatekeeper and instead focused on managing CDOs and structured investment vehicles (SIVs). In this alternative role, they were not judging whether an individual bond merited an investment, but whether it could be included in a secondary transaction to be sold to other investors. Rather than acting as "investment managers," they became simply another layer of deal management; their primary focus was on buying bonds to complete transactions, rather than profitably putting their own money to work. Of course, these activities intersected with the rating agencies; CDO managers closely followed rating agency guidelines to structure the deals.

Ultimately, non-agency securitized finance represented a set of great ideas carried to illogical conclusions. The ability to place unconventional loans into securities using innovative credit support mechanisms originally was a positive development that allowed access to credit for many creditworthy but unconventional borrowers. Over time, this activity evolved into a system that facilitated the origination of highly speculative loans that were essentially options on real estate.

Enormous amounts of securities backed by these loans were eventually created and distributed to the investment community. In addition to being backed by loans tied to an overvalued housing market, the bonds became increasingly difficult to evaluate. Ironically, it wasn't only unsophisticated investors that were unable to effectively evaluate the later-vintage deals; portions of the Timberwolf transaction memorialized in the Goldman hearings were sold to a Bear Stearns hedge fund shortly before it collapsed in mid-2007.

With the GSEs dominating the mortgage market despite their precarious finances and uncertain future, it should be a priority for Congress, regulators and market participants to rebuild the private-label MBS market. In addition to stronger regulation, a sustainable future requires that the checks and balances that traditionally protected investors be fully restored and enhanced.


Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is

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