Abstract finance: Securitization

One basic idea to help understand contemporary finance is securitization. To explain what securitization and how it works, first think about the following: what happens when you and your best friend decide to open a business together. How are you going to divvy up responsibilities, management decisions, profits, and losses?

One way is to just decide, you do this part, I’ll do that part, and we’ll split the proceeds. This is very local ownership. It is tied directly to you and your friend’s relationship, the specifics of the business venture, the particulars of the agreement you forge. For the current purposes, I want to call this concrete finance.

An alternative way to divvy up your company is to create shares of one sort or another.

How to divvy up the profits from you & your friend's cookie business.

How to divvy up the profits from you & your friend's cookie business.

When you create shares, you can assign ownership rights to them, so that each share might represent an equal percentage of end-of-year profits. If I put in half of the money, but my friend is doing most of the work, maybe he would get more shares than me. Maybe not. But to one degree or another, these shares represent ownership. Shares can be a legal agreement as well as an informal one.

What you’ve done formally is to create an instrument to stand in as financial value. It’s a kind of abstraction. The ownership no longer depends so specifically on the relationship between you and your friend. The rights to ownership, and maybe future profits and losses, are now formally invested in the shares, not just in your relationship. When you agree to partition the company into shares, you are turning the rights to future management and earnings into these more abstracted instruments.

What makes them ‘abstract’? Well, they become abstract in two distinct but related ways. First, the shares themselves are worth something. So ownership of the shares are ‘worth’ whatever profits come out of your business at the end of the year, plus they are worth whatever someone will pay to get those profits. If your business is great, with bright prospects, someone might well be willing to pay a premium for your shares. Or expect a discount if your business’ prospects are lousy. This means that there are actually two values to shares, a representational value and a market value: the representational value is how much value the shares stand in for (i.e., your share of the profits), and the market value is how much someone would buy or sell those shares for.

The second way they become abstract is that the value the shares can be thought about in ways that are not specific to the business that you started. For you, the shares are a shorthand for the blood, sweat, tears, and rewards you get for taking chances on and working in your business. For someone else, the shares can be represented as cash returns over time. And these cash returns over time are compare-able to other cash returns over time from other kinds of things. For instance, owning a totally different kind of business, buying and selling rare coins, or lending money to arms dealers all have ‘cash returns over time’ that can be compared favorably or unfavorably to your shares. In this way, what was once only understandable as a local, concrete financial arrangement between you and your best friend gets brought into the wider universe of other financial stuff. This is what I want to call abstract finance.

What's a pension fund manager doing with shares of a cookie business? Making profit.

What's a pension fund manager doing with shares of a cookie business? Making profit.

If you’ve got this imagery (a concrete set of relations that is transformed into abstracted commodity), you’ve got the basis for all kinds of financial instruments. Just about any ‘stream’ of financial value can be split into shares. A company’s future earnings, a corporate loan, leases on heavy equipment, credit card debt, US tax revenue, mortgages, annual cell phone plan subscriptions, all of these things are concrete streams of financial value. They can be split up and sold as shares. These shares are secured by their underlying pools of value. When they are securitized, they become measured not in their own terms but in more formally abstract terms: rate of return, risk of default, time risks of pre-payments, costs relative to other kinds of investment.

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