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This is borrower’s-eye view of the securitization whipsaw that The Elliott Wave Financial Forecast has been discussing since the middle of last year. EWFF anticipated a reversal in which the influence of financial engineering would shift from contributing mightily to the upward charge to weighing down the markets and economy last summer. Here’s an update from this month’s EWFF Special Report:
Last summer when the industry’s bust was still under the radar, many claimed that the situation was not serious because the industry’s high levels of securitization, i.e. the ability to package loans and sell them, meant that the risks were widely spread and thus less dangerous. But our contention was that the “innovation” was more likely to broaden the impact of decline, not contain it. In July of last year, when the public was being drawn into the market for these complex structured debt products, EWFF noted that the “separation between issuers, who are intimately familiar with default possibilities, and holders has gotten wider and wider. The passing off of structured products to the public shows that they are now completely divorced.” We also offered the following quote from the “dean of derivatives,” Louis Ranieri: “By cutting [a derivative] up in so many ways or complicating it by so many levels, do you still have clarity...on the nature of the underlying risk? It’s not clear that we haven’t gone, in some ways, too far.”

Nine months later Ranieri answered his own question when he told the audience at the Milken Institute Global Conference that, for the first time in history, the median home price in the United States is likely to decline in 2007. He added that rather than mitigate the fall, securitization will likely compound losses because there will be greater difficulty in working out defaults. He said that the vast majority of problem loans are securitized, as opposed to individual portfolios in past credit crises. Instead of a single lender, there are now many, many interests in most mortgages. This means that more parties must comply with the terms of each default. The May issue of EWT notes that as the decline gathers steam, this will slow down decision making enough to turn even a mild recession into “systemic disaster.” In this way, the financial engineering that pushed debt levels, valuations and investor optimism through the roof on the way up reverses and will foster an atmosphere of rising caution, falling prices and ill will.