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Inefficient Markets: Structural Flaws

Securitization means that lenders aren’t stuck with bad loans. Investors are.

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By Edward Chancellor

WHEN BANKS DISCOVERED how to securitize loans, they inadvertently created a sexy alternative investment. Looking for an asset that isn't correlated to the stock market? Then invest in mezzanine tranches of collateralized debt obligations. Or better still, give your money to a credit hedge fund that promises to produce double-digit returns. Rampant demand for structured securities has been a boon to bankers, homeowners and private equity firms. It has also led to the mispricing of credit risk. But participants in this brave new world of finance have little cause to worry about that.

Last year some $304 billion of collateralized debt obligations were issued in the U.S., according to Credit Suisse. That represents a 58 percent increase over the previous year. The true size of this market is probably much larger when private deals arranged by investment banks are included. The securitization of loans has enabled banks to remove credit risk from their balance sheets. It also provides institutional investors with a means of diversifying and creating exposures to new risks that were previously inaccessible.

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