“It was not securitized debt that caused the Great Recession of 2009, but erroneous valuation of these securities.” I have said this several times in my blogs but the bad valuation crowd persists in dire warnings about “toxic assets.”

Securitized or collateralized debt produced the greatest new source of credit ever seen. I say this since it accounts for the largest share of mortgages, by far, and mortgages constitute the largest component of our overall debt. Unfortunately this class of debt has never been fully understood or measured, since it is not bought and sold on an regular market, where transparency and rules control the action. This also makes it difficult to value these investments.

To get a better understanding, we can compare securitized debt to bonds, and, in fact, the securitized debt is usually sold as bonds. The difference is that a traditional bond is issued by one borrower. Securitized debt is a bundle of loans and one buys a share in that bundle. Instead of one borrower, you can have hundreds or thousands of borrowers represented by one bond. The main idea here is to spread the risk. Instead of having one borrower go bad and ruin thousands of bond holders, under the securitized debt bond, if one borrower goes bad, it does not ruin the whole bond and the loss is dispersed among thousands of bond holders.

While reduction of risk is good, the large collections of loans that go into the securitized debt bond make it impossible to rate the bond issuer. Bonds issued by a corporation or a government entity are rated as an investment based on several criteria, assets of the issuer (although this is a moot point with a government bond), the issuer’s repayment history, and most importantly the issuer’s ability to repay, i.e. its earnings prospects, current and future. But a securitized debt instrument represents hundreds, if not thousands of borrowers.

Now we are all familiar with the requirements to get a mortgage. We have to prove our ability to pay with proof of funds on hand, income statements, statements of expenditures and so on. But this evidence of ability to pay becomes impossible to track when one speaks of a securtized debt instrument covering hundreds or thousands of mortgages. Thus there is no way to rate the issuer of a securitized debt instrument. One has to rely on general results for these loans and repayment of mortgages has a good record, generally.

Rating the issuer is important since that sets the price of the bond, i.e. the interest rate, which in turn yields the value of the bond. Since there is no way to rate the many issuers or borrowers involved in a securitized debt instrument, there is no way to value the bond this way. And here is where the problems began.

Since analists were not able to rate, and thus value, securitized debt in the normal way, they were left to finding indirect ways to value the bonds. They chose to do this by looking at the undelying collaterall of the bonds, in the case of mortgages, the properties involved. But since they could not see all the properties represented by a given securitized debt bond, they looked at the overall property market.

The important thing to remember here is that these analists began to sharply devalue the securitied debt instruments as soon as prices in the property market began to fall. They did not wait to see how this affected payment of the mortgages. They began to devalue these bonds long before loan defaults and foreclosures began to rise. And they devalued these bonds as much as 90%. When they devalued these investments they caused losses for nearly all financial institutions, since they were all heavily invested in securitized debt. This in turn severly depressed balance sheets everywhere and the financial institutions were no longer able to lend. Enter the credit freeze that led to the recession.

Properly valued, the securitized debt should have been valued according to the borrowers’ ability and propensity to repay. But that was not done. No, they devalued the securitized debt because the property market went south. That makes about much sense as devaluing a bond issused by the water works because the level of the dam has fallen.

Since the propensity and ability to repay was not the immediate problem, the securitized debt should have been valued for its long term or maturity value. This is easily done by multiplying balance due by the interest rate by the number of payments left and subtracting the loss to foreclosures or total defaults.

Fortunately the Feds recognized the mistake being made in valuations of securitized debt. The immediate reponse to the near total collapse of our financial system last October was the TARP program. At first the idea was to buy securitized debt from banks and thus take them off their balance sheets. But that was dropped when the Feds realized that this was a lengthy way to do the job and turned to injecting the TARP funds directly into banks to correct their balance sheets.

The plan worked. We averted the collapse of our financial system. More importantly, my position that the problem was caused, not by securitized debt per se, but by the erroneous devaluation of these investments, was proven true by the banks being able to repay the TARP funds in a matter of a few months. Moreover, the famous “stress tests” administered to the major banks showed that they were not “stressed.” In other words, the securitized debt they held that had been savagely devalued, regained its true value.