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Securitisation Must Take the Centre Stage Again

Written by Barbara Ridpath and Arvind Sivaramakrishnan

3 September 2010

The collapse of the US subprime mortgage market in 2007 resulted in a firesale of a broad range of assets, engendering a liquidity crunch for banks which tipped off a worldwide recession. As the painful process of de-leveraging in the financial markets continues and hampers credit growth in the broader economy, it has become clear that some form of securitisation will be critical to matching the supply and demand of credit in the broader economy. The key question is how to restore the benefits of securitisation to the market whilst eliminating the opacity, complexity and risk concentrations it gave rise to. 

Why did securitisation fail? There are a multitude of reasons. First, the techniques of securitisation strayed from their original purpose, that is, to repackage large quantities of relatively low value consumer assets (mortgages, auto loan and credit card receivables), so as to improve the credit risk, geographic concentrations and maturity profiles of lenders while increasing the diversity and yield of investors’ portfolios. This model was stretched to do the same, first, to less diversified and more closely correlated wholesale assets such as corporate receivables and corporate loans and later to packages of already securitised assets in ABS squared’s and cubed’s. Second, many institutions saw an opportunity with securitisation to gather the fees from lending without ever having to ‘rent’ their balance sheet by using an “originate-to-distribute” model, or with a temporary use of their balance sheet, in a ‘warehousing’ model, and began to create or buy loan products they never intended to hold, thus lowering the incentives to verify and validate the quality of that product before it was included in a securitisation. Third, the low absolute investment returns due to low interest rates, led investors to seek ever more risk to increase their portfolio returns. As demand for traditional asset securitisations lowered their yield, ever more exotic products were developed in search of yield.

All of this sprung from a desire to maximise banks’ return on capital by maximising fee income and minimising the cost of on-balance sheet assets based on the simultaneous push and pull of bank regulatory capital requirements and shareholders demanding increased returns. This process allowed banks to increase their leverage and the growth in securitisation worldwide was so rapid, that “it went from $767 billion at the end of 2001 to $1.4 trillion in 2004 to $2.7 trillion at the peak of the “bubble,” in December 2006.” [1]  However, what led to the fall from grace of securitisation, in addition to the fact that the loans underwritten were of bad quality, was a false sense of security created by the assignment of top-tier ratings on many of these instruments, together with scarce incentives for investor due diligence and understanding of the underlying transactions. Key contributing factors included:

i. Increased complexity arising out of the proliferation in synthetic structures made up of credit default swaps as well as re-securitisations of asset backed securities,
ii. Inadequate disclosure of underlying asset quality, performance histories and structures,
iii. A proliferation of ‘bespoke’ structures that made transactions difficult to compare and illiquid,
iv. Model dependence on inadequate data and ‘guestimates’ of correlation among asset classes,
v. Overdependence on quantitative modelling,
vi. An unforeseen concentration of owners of these securitised assets that were far more closely correlated in a downturn than originally presumed, leading to a much higher concentration of risks within the banking system than anticipated.

As the world became aware of the US subprime mortgage problems,  financial stability was threatened as uncertainty on the quantity and quality of asset-backed securities held by counterparties made banks reluctant to lend to each other.
Non-bank lending reached its peak before the crisis bolstered by the demand for securitised assets. It can be argued that such artificial demand boosted asset prices, particularly in the consumer and commercial real estate market. Banking problems were exacerbated by Fair Value Accounting (FVA), which classified securities by their perceived market value. When market liquidity eroded, the prices of these assets had to be written down dramatically leading to significant losses which were only partly related to the underlying value of credit but mostly to market contagion and counterparty confidence [2]. This virtually paralysed the structured credit markets and lead to a massive backlog of debt needing to be refinanced. A successful refinancing of credit in the economy is difficult to achieve without the participation of the private securitisation market.

Policy makers acknowledge the need to restart this market. A recent paper [3] by the United Kingdom’s Department of Business Innovation and Skills (BIS) notes that, “the financial crisis indicated significant underlying failings in these markets as previously constituted, and underlines the importance of reform to ensure that in the future the securitisation market is a more sustainable and robust market. Conditions in some countries’ securitisation markets have improved ...” And in the UK, bankers have set up a taskforce under the auspices of the BBA to tackle the issue of stagnant lending levels in the economy, while the Joint Forum is exploring the future of securitisation markets in a separate working group. The ICFR will also consider the topic of restarting securitisation markets in a roundtable scheduled for early September.

The process of re-starting securitisation markets can only be successful by resolving issues that caused it to freeze in the first place. Whether resolution of these issues will be adequate remains to be seen. Lessons from the crisis suggest the following six measures are critical:

i. Product simplification: a clear understanding of both the seller’s and the buyer’s interest in the assets needs to be evident,
ii. Improved transparency: through increased disclosure at issuance and on an ongoing performance basis,
iii. Other ways to reduce informational asymmetries between originators, issuers and investors are critical. It is easy to criticize the failings of mandatory capital requirements or tranche retention. Perhaps a better route is to ask investors what they want to see before they re-enter the market,
iv. Improved liquidity: investors found themselves unable to sell securitised assets at any price once the subprime crisis began. The development of the synthetic market was, in part, due to the difficulty in trading the underlying assets. For this market to restart, investors must know there is a secondary market that works,
v. Changes to bank liquidity/funding ratios could increase the demand for securitised assets due to increased requirements for long-term debt as noted in a recent European Central Bank (ECB) speech [4] by Dr. González-Páramo, member of the ECB’s Executive Board.

The speech demonstrates the ECB’s interest in reviving investor confidence so as to bring investors back into this market? As the speech notes “the development of transparent, comparable and simple securitisation structures, based on high quality standards of underlying assets, and with at least some market segments characterised by high liquidity, is a sine qua non condition for a return to self-sustaining securitisation markets.” Furthermore, “enhanced secondary market liquidity will make the entrance of new investors more likely. A more liquid market may come as a result of better price disclosures, standardisation and less complex structures.” However, it should not come as a surprise that there is a circularity problem here. Getting institutional investors into the market is itself dependant on active secondary markets which are difficult to achieve without active institutional investors.

The industry itself has been extremely active in thinking about measures to restart securitisation on a sounder footing including;

i. Proposals to address “skin-in-the-game”,
ii. Ratings agency reform,
iii. Increased transparency through improved disclosure on underlying assets, and
iv. A move towards more sustainable forms of securitisation such as “covered bonds”.

A concrete step forward has been taken by the Committee of European Banking Supervisors, CEBS [5], which published the results of the stress tests of 91 banks this summer in the hope of clarifying the magnitude of losses these banks could suffer if there were to be another downturn in the economy. This stress test included all assets, not just securitised ones, and should give some confidence to the market on the banks’ ability to withstand further economic pressure and market price declines. Nonetheless, it will take a combination of increased optimism on economic prospects together with an effort by “market participants and their associations [...] to materially enhance market standards and practices ” [6], for investor confidence to return to these markets.

 


[1] Acharya, V and Richardson, M 2009, ‘Causes of the financial crisis’, Critical Review, vol.21 (2-3), pp.195-210, pp.6

[2] Laux, C and Leuz, C 2010, ‘Did Fair-Value Accounting contribute to the financial crisis’ Journal of Economic Perspectives vol.24, pp.93-118  

[3] HM Treasury and the Department for Business Innovation & Skills, 2010, ‘Financing a Private Sector Recovery’

[4] González-Páramo, JM 2010, ‘Re-starting securitisation’ Keynote speech at the Association for Financial Markets in Europe/European Science Foundation (ESF) and Information Management Network Global ABS (Asset-Backed Securities) 2010 Conference, London

[5] CEBS 2010, ‘EU wide stress testing’

[6] González-Páramo, JM 2010, ‘Re-starting securitisation’ Keynote speech at the Association for Financial Markets in Europe/European Science Foundation (ESF) and Information Management Network Global ABS (Asset-Backed Securities) 2010 Conference, London