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The Good, Bad, And Evil

September 2016

The famous 2007 US housing bubble turned the conventional narrative about securitization upside down. But is securitization that evil after all?

The term Securitization bore the brunt of the blame for the subprime mortgage crisis that began in 2007. Experts world over have highlighted how bankers innovated strategies built on the foundation of securitization and jeopardized investors. In its most basic sense, securitization is the process in which certain types of assets are pooled so that they can be repackaged as interest-bearing securities to investors. While it has come to fore in light of the crisis, securitization traces back its origins to the 1970s, where home mortgages were pooled by the US government-backed agencies.

The process of securitization essentially involves two steps:

• In step one, a company with loans or other income-producing assets — the originator — identifies the assets it wants to remove from its own balance sheet and pools them into what is called the reference portfolio or collateral.

• It then sells this asset pool to an issuing agent, a Special Purpose Vehicle (SPV) — an entity set up, usually by a financial institution.

• In step two, the issuing agent finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio.

The innovation undertaken to this basic model has involved the gradation adopted in the reference portfolio – division of the same into several slices referred to as tranches, based on the level of risk associated with it and is sold separately. Both investment return (principal and interest repayment) and losses are allocated among the various tranches according to their seniority (typically being equity, mezzanine and senior). The equity tranche, for example, is the lowest tranche of a security, i.e. the one deemed most risky. Any losses on the value of the security are absorbed by the junior tranche before any other tranche, but for accepting this risk the junior tranche pays the highest rate of interest. On the other hand, there is little expectation of portfolio losses in senior tranches – however, as the crisis demonstrated, when repayment issues surfaced in the riskiest tranche, the lack of confidence spread to holders of the more senior tranches — causing panic among investors and a flight into safer assets, resulting in a panic sale of securitized debt.

Bluechip-chart-sep-16

What triggered the adoption of securitization in the period prior to the crisis was the lure of a new source of funding, attained by moving assets off one’s balance sheet or by borrowing against them to refinance their origination at a fair market rate. It thus reduced borrowing costs and in the case of banks lowered regulatory minimum capital requirements.

So is it all evil? The simple answer to that is No. As IMF noted in a report, ‘Securitization, The Road Ahead’, when operating efficiently, securitization supports economic growth and financial stability by enabling issuers and investors to diversify and manage risk. By transforming a pool of illiquid assets into tradable securities, securitization frees up bank capital, allowing banks to extend new credit to the real economy, and supports the transmission of monetary policy. However, given its capacity to amplify the flow of credit inside or outside the banking system, increase leverage, exacerbate misaligned incentives in the financial intermediation chain, and, thus, ultimately amplify systemic risk, a strong case exists to make the asset class as simple, transparent, and robust as possible.

The revised Basel III securitization framework (Basel Committee on Banking Supervision, 2016) has proposed significant improvements. Amongst others, the mechanistic reliance on external ratings has been reduced as other relevant risk drivers have been incorporated into the Securitization External Ratings-Based Approach i.e. maturity and tranche thickness for non-senior exposures. In terms of risk sensitivity and prudence, the revised framework also represents a step forward – the capital requirements have been significantly increased, commensurate with the risk of securitization exposures. Moreover, the presence of caps to risk weights of senior tranches and limitations on maximum capital requirements aim to promote consistency with the underlying framework and not to disincentivise securitizations of low credit risk exposures.

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