Tax Analysts Blog

Nobel Prize Highlights Value of Traditional Banking

Posted on Oct 13, 2009

Economists have faith in the marketplace but once in a while some heretic will express doubts on its infallibility. Oliver Williamson, co-winner of this year's Nobel prize in economics, is no radical. But the life work of the 73-year old UC Berkeley professor shows how transaction costs and lack of information could cause markets to malfunction. To overcome these market frictions, firms internalize markets through "vertical integration." One implication of Williamson's work is that big firms are not necessarily bad. Yes, anti-trust laws should fight monopolistic behavior. But, Williamson showed, sometimes big firms improve economic performance and correct market failures.

A 2005 paper by Michael Jacobides of the London Business School applies Williamson's ideas to the mortgage banking industry. The author describes how the mortgage business "disintegrated." Traditional banking that provided all mortgage services under one roof gave way to a highly specialized and decentralized approach. In this brave new world, marketplace securitizations seemingly obviated the need for integration.

We now know, however, that disintegration-through-securitization is a mine field of economic problems. Adam Ashcraft and Til Schuermann point out seven (!) "frictions" in subprime mortgage securitization markets that should send shivers down the spine of even the most ardent free-market advocate.

Tax laws are not blameless. Tax lawyers engineered structures that made it possible to keep securitization deals from being mangled by tax rules. And to prevent being ensnared in the nets of the IRS, they went out of their way to make sure securitization structures were extremely "disintegrated." To retain their tax-free status, special purpose vehicles that issued asset-backed securities were required to remain wimpy passive entities rather than active businesses. They could not originate loans (thus breaking the chain between lending and investing and providing an incentive to allow credit worthiness of underlying assets to slip). And they could not renegotiate troubled loans (thus limiting flexibility needed to minimize losses).

Securitization will not and should not fade into oblivion. But in light of the multi-trillion dollar financial meltdown, Congress needs to rethink securitization tax rules and remove tax barriers so securitizers do not sanitize their structures so much that they squeeze out sound banking practices.

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