Sept. 10 (Bloomberg) -- As we should have learned from the 2008 financial crisis, the mass production of securitized credit enables reckless borrowing, shortchanges productive businesses and destabilizes banks. It has been nourished by regulation, not its inherent economic advantages. Yet officials in Washington continue to favor this top-down misdirection of credit.

To end this bias before it does any more damage, the federal government needs to get out of the securitization business altogether.

The infatuation with securitization goes back 25 years. In 1987, Lowell Bryan, a McKinsey & Co. director, argued that securitized credit would transform banking fundamentals that hadn’t changed since medieval times. Since then, many cheerleaders in academia and the financial industry have extolled the virtues of securitization, arguing that by combining advances in financial and computing know-how, it slashes the costs of lending, improves the evaluation and distribution of risks, makes credit decisions more transparent, increases liquidity, and so on.

Securitized Everything

Securitization has certainly transformed banking, as Bryan predicted, and fueled an explosive growth in private borrowing. Besides mortgages, securitized assets now include car loans, credit-card balances, computer leases, franchise loans, health-care receivables, intellectual-property cash flows, insurance receivables, motorcycle loans, mutual-fund receivables, student loans, time-share loans, tax liens, taxi-medallion loans and David Bowie’s music royalties. Securitized assets have also helped build a gigantic over-the-counter derivatives market that was practically nonexistent in 1980.

Yet this transformation has also had serious downsides. Yes, computer models reduced costs and increased volumes. But in lending, as opposed to selling widgets, more isn’t at all better. Bankers have to discriminate between borrowers who can repay and those who can’t. Securitization models devised by remote wizards fail for the same reason that Friedrich Hayek argued central planning doesn’t work: They rely on a few abstract variables, ignoring specifics of time and place. As with central planning, erroneous models can also lead to systemic failures.

Securitization discourages lending that can’t be easily mechanized: Banks lose interest in making loans to small businesses. Troubled loans end up in needlessly destructive foreclosures or lawsuits because a one-on-one negotiation between a lender and a borrower is impossible.

It’s one thing to securitize credit that can’t be extended by a bank. Without railroad bonds there would have been no railroads. But the issuance of railroad bonds wasn’t mechanistic: Investors expected underwriters to perform due diligence on each borrower.

Mechanistic securitization came to predominate largely because a government hand tilted the scales. A pro-securities bias -- rooted in a long-standing fear of large banks -- dates back at least to Civil War-era legislation that limited nationally chartered banks to a single branch. Since small banks couldn’t satisfy the credit needs of big businesses, bond markets expanded to fill the gap as large enterprise became ubiquitous after World War I.

Fannie and Freddie

But the securitization revolution that really stifled traditional banking was led by Fannie Mae and Freddie Mac. The government-sponsored agencies paid banks a fee for originating mortgages that conformed to certain criteria, sparing banks the expense of in-depth analysis and losses from bad loans. Fannie and Freddie sold securitized bundles of the mortgages by suggesting they were as safe as Treasury bonds. Regulators then encouraged banks to buy the securities. Capital requirements for the residential mortgages that a bank kept on its books were more than twice those for mortgage-backed securities that had AA or AAA ratings. So banks were feeding the securitization machine with loans on one side and scooping up what it produced on the other.

The Securities and Exchange Commission also played its part: It formulated rules to protect investors, policed the trading of the securities and certified the companies that rated them.

Even so, securitization was felled by the crisis it helped cause in 2008. And it shows few signs of recovery: The roughly $128 billion of total asset-backed securities issued last year was about a 10th of the $1.25 trillion issued in 2006, and more securities are now being retired than issued.

Unfortunately, officials in Washington seem bent on pumping securitization back up. The Federal Reserve has bought hundreds of billions of dollars of mortgage securities under its “credit easing” policy, and its staff economists have proposed a permanent insurance program to cover every form of securitized credit. Mortgages securitized by Fannie and Freddie account for a higher proportion of home lending than ever before. The risk-retention rules in the Dodd-Frank regulatory overhaul aim to reassure buyers of mortgage-backed securities.

To fundamentally reform the financial system, we need to end state sponsorship of securitization.

First, the federal government must stop guaranteeing mortgage securities. If lawmakers feel impelled to divert credit to homebuyers, the Small Business Administration’s approach of offering partial guarantees for housing loans would do less harm. Let the private sector securitize the loans if it can.

Second, banks should be required to evaluate the creditworthiness of every individual or business they directly or indirectly lend to, rather than outsourcing credit analysis to ratings companies or relying on reductionist statistical models. Allowing banks to buy securitized assets with only superficial knowledge of the ultimate borrowers is folly.

Finally, the SEC should focus on its original mission of policing stock markets, and not on every security that financial engineers dream up or ratings companies get paid to certify. The expansive application of securities laws has worked only too well, stifling judgment and relationship-based lending in favor of mechanized and anonymous transactions.

We needn’t debate whether a securities-based financial system is better than a bank-based one. A healthy economy needs both loans and securities -- but no one can know the right, oft-changing mix. For that, we need unrigged competition.

(Amar Bhide is a professor at Tufts University’s Fletcher School of Law and Diplomacy and the author of “A Call for Judgment: Sensible Finance for a Dynamic Economy.” The opinions expressed are his own.)

Read more opinion online from Bloomberg View. Subscribe to receive a daily e-mail highlighting new View editorials, columns and op-ed articles.

Today’s highlights: the editors on the politics of long-term health care and on improving and expanding charter schools; Mark Buchanan on hacking the human brain; William D. Cohan on bankers getting fired; Noah Feldman on Amish beard-cutting; Albert R. Hunt on Obama’s slight campaign edge.

To contact the writers of this article: Amar Bhide at

To contact the editor responsible for this article: Timothy Lavin at