A Rocket Scientist Explains Securitization

From a Marketplace report on the American Securitization Forum comes the following conversation between Kai Ryssdal and Bob Moon:

RYSSDAL: …How do you restore investor faith in what is admittedly a very important part of the economy?

MOON: Well, they’re promising straight talk, for one thing. There’s agreement here that things did get so confusing, you almost needed to be a rocket scientist to figure out what you were investing in….

RYSSDAL: Do they know, the people you talk to in this [securitization] industry, that part of the problem we’re in is because of the way they did their business?

MOON: Yes, they’re very much aware of that and there was a lot of talk today about ending the rocket science, if you will.

Look, securitization isn’t really that hard. Let me step you through it. Securities are a standard financial instrument that have some commonly-agreed-upon cost. Government bonds are securities. So are stocks. If money is an abstraction, securities are doubly so.

The nice thing about securities is that we have well-established markets in place for trading them around. Think of bonds and the bond market, where governments or companies issue bonds and pay interest, while the bond itself may change hands bunches of times.

Now, say you’re a company who has, I don’t know, a lot of mortgages on the books. They’re producing cash, but you’d really like to move them off of your books, recognize a profit right now, and let someone else deal with them. But who wants a mortgage here and a mortgage there? They come in such inconvenient irregular sizes. So you bundle them all up and sell off regularized shares of the bundle. You’re averaging out the risk that way, and no one has to buy a whole mortgage if they don’t want to.

But what are these things worth? Hang on, I’m going to have to pull out some math, namely, the idealized rocket equation.

The ideal rocket equation

This equation tells how much the value, v, of the securitized asset can change by. The change in value, Δv, depends on the estimated value ve, times the natural log of the ratio of the market’s total value right now m0, to its value when the security was first put together m1.

“But, Stephen,” you ask, “estimated by whom?” Why, by rocket scientists, silly! Because when you want to know what something’s worth, ask people who supposedly only buy parts from the lowest bidder yet managed to make the International Space Station cost somewhere around 10 times what we originally said it would — not, mind you, that we can pin down the cost any more precisely than “somewhere between $35 billion and $100 billion”.

I trust the confusion over the actual cost of things like securitized mortgages is making more sense now.

Ideally the value of these mortgage-backed securities would have kept going up and up and up. Unfortunately, they didn’t. Instead, they crashed dramatically. That’s because they didn’t achieve their escape value, defined as the price at which people say, “Well, shit, that thing’s worth so much that it’ll never cost less than it does now!” Mathematically, that value is

The equation for escape velocity of a rocket.

where ve is the escape value of the security (not to be confused with the estimated value ve above), M is the mass of the market as measured in Denmarkian GDPs, r is the radius of the building in which the securities are traded, and G is the Greenspan constant.

All of which is most easily summed up by

Any questions?

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