Should we be worried about the falling dollar?

What is securitization? Like asset-backed securitization. It appears a lot when news talk about subprime loans, too.
— Isabella, Boston, Mass.

A security — generally speaking — is the name given to a piece of paper that represents financial value and can be bought or sold. Two common forms are “equity” securities, or stocks (which represent a share of ownership in a company), and debt securities, or bonds (which are, in effect, a piece of an interest-paying loan).

But the well-paid wizards of modern finance have cooked up many more. The biggest growth has been in a category known as “derivatives” — so-called because they’re “derived” from other securities like stocks or bonds. You can buy a futures contract, for example, that promises you a stock, bond or commodity at a future date for a price set when it’s issued. An option gives you the buy or sell before a certain date at a certain price.

With ever more powerful computers, Wall Street rocket scientists have expanded their quest for new paper to trade (and commissions to book) by creating more complex securities. You can buy and sell pieces of paper based on the future direction of interest rates, or stock indices, or the consumer price index.

By doing so, you‘re spreading risk. If I hold a lot of bonds, and I’m worried that a big drop in interest rates will hurt their value, I can “hedge” that loss by also holding interest rate futures that will pay me if rates go down. If interest rates go up, the person who sold me those futures makes money (but I make money on my bonds).

Over the past few decades, Wall Street has figured out how to buy and sell of all manner of risk. The current mortgage mess resulted from the belief — now understood to be mistaken — that by spreading around the risk of a mortgage defaulting, more people with shaky credit could be accommodated by the system. By bundling good loans with bad, and paying higher interest rates to investors who bought paper that was last in line if some borrowers didn’t pay, the pool of people who qualified for loans was rapidly expanded.

The problem is that — unlike a stock or bond that trades every day — many of the securities from these mortgage pools went straight to investor portfolios and sat there. The value of these securities was determined by computer models, not real buyers and sellers. And with defaults rising, the market for these pieces of paper has virtually shut down: Real buyers and sellers have no way of knowing what they’re worth. That’s why investors and lenders are now a lot more tight-fisted when it comes to making new loans.

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