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Misplaced Incentives

The “unprecedented” economic disaster resulting from secularization is far from new according to Floyd Norris in the NYT.

As Mark Twain would say “History doesn't repeat itself, but it does rhyme.

The original wave of securitizations took place in the 1920s, when the United States went on the greatest building boom ever. Many investors saw how rapidly real estate prices were rising and wanted in on the action. The builders and brokers were only too happy to oblige.

To be sure, the securitizations were not as complex as the ones invented in recent years, but they were not all simple either. Most were bonds backed by one commercial building whose construction was being financed, but there were also pools of residential mortgages. Some of the bonds included warrants for partial ownership of the building, and some were convertible into stock.

There was even something similar to the exotic C.D.O.’s, or collateralized debt obligations, that failed so spectacularly. Those securities were not directly backed by real estate, but were instead supported by other securities that had such backing. One 1920s bond was called a “collateral trust” security, with a claim on a building’s profits but not on the building itself.

“Easily obtainable financing via public capital markets corresponded with an urban construction boom,” reported William N. Goetzmann and Frank Newman in a paper just released by the National Bureau of Economic Research, titled “Securitization in the 1920s.”

“Regulation and centralization were glaringly absent,” they add. “Ultimately the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning our current financial crisis.”

Yet the lessons of that boom and bust have largely been ignored. Everyone remembers the 1920s and the stock market crash of 1929, but there has been little data collected on what happened to real estate securities or even on how large a market it was. It turns out that real estate securities constituted a major market, and began to falter before stocks did.