asset securitization: revolution, evolution, devolution the rise and fall of the most important...

8/8/2019 Asset Securitization: Revolution, Evolution, Devolution the rise and fall of the most important financial instrument i…

http://slidepdf.com/reader/full/asset-securitization-revolution-evolution-devolution-the-rise-and-fall-of 1/5



| 2 0 0 9 A P R I L

BACKGROUND

Asset SecuritizationRevolution, Evolution, Devolution

The rise and fall of the most important nancial instrument in banking

(USA) Ron Nechemia

The introduction of Asset Securitization, and its evolution over two

decades, has had a profound impact on consumers and nancial institutions

as an innovative product and no doubt, it will continue to remain so. In the

light of recent events it is clear that more and better regulatory approaches

must be instituted in order to ensure that the original model and some of

its innovative iterations reconstitute to the original power and value they

provided. In this manner, the markets will reset, consumers will benet and

Asset Securitization can regain its rightful perch as one of the most valuable

products and nancial instruments in banking history.

Since the Asset Securitizationproduct was rst introduced into theUnited States banking and creditsystem in the 1970s, it enabled theunprecedented growth of markets in both the U.S. and abroad. It furtherset new benchmark standards of innovation and productivity, creditenhancement and risk analysis. Butin the end, left unchecked and to openmarket devices, is what he suggests,contributed greatly to the U.S. nan-cial collapse. Today, many measuresare required to repair what has be-come a badly damaged internationalnancial system and proven dysfunc-tional nancial architecture.

Advance in Contemporary Financial Technology

Securitization got its start in the1970s, when home mortgages werepooled by U.S. government-backedagencies. Then, in the 1980s, other in-come-producing assets also started to become securitized. Since then, secu-ritization technology evolved rapidly

and was adapted to various types of asset class. In recent years the markethas grown and the use of securitiza-tion has likewise increased exponen-tially. Asset securitization has beenrecognized by eminent academics asthe most important engine of reformin our nancial system to emerge in re-cent times; it is viewed as a revolutionin the banking and nancial servicesindustry by industry practitioners. Inits simplest form, it is a process whereill-liquid assets owned by a nancialinstitution are pooled and sold in thelegal or economic sense to a thirdparty referred to as a Special Purpose Vehicle (SPV). The SPV in turn issuessecurities backed by these asset poolsin nancial markets to the generalpublic, usually after obtaining someform of credit quality enhancementto the securities. Securities marketedin this manner are referred to as asset backed securities (ABS).

Asset securitization was initially practiced by nancial institutionsthat securitized home mortgageloans, transforming them to mort-



International Financing

2 0 0 9 A P R I L |

65

gage backed securities. Over time assetsecuritization has emerged as a mainfunding option for commercial banksto redress growing monetary con-straints and acquire diversied sourcesof liquidity. Commercial banks have

traditionally funded themselves on ashort-term basis. However, over therecent three decades, they have comeunder pressure from the customers toimprove their term nancing, as retaildeposits have not always kept up withsurging credit growth of mortgage andconsumer loans.

Aside from senior debt, balancesheet securitization of residential mort-gages, and later on the securitization of retail credit, has become a key mecha-nism to fund the US housing decit.The bank-sponsored securitization of retail asset portfolios, in particular car

loans and residential mortgages has been the main source of supply, withthe biggest securitization asset classesmapping directly how the bank’s majorloan portfolio are comprised.

Since its inception, the basic assetsecuritization process has now beenextended in a variety of ways. Assetsecuritization techniques are now ap-plied to a wide range of different assetclasses, and by a variety of institutionsranging from nancial institutions totrading and manufacturing rms, andeven infrastructure project operators.Non-nancial institutions adopt asset

securitization techniques principally asa nancing technique, and as a meansof enhancing corporate liquidity.

Structured nancing is an exten-sion of asset securitization, which addsa degree of complexity to the basicprocess. In structured nancing thetraded securities created by the secu-ritization process are structured into

several classes of derivative securities with different characteristics and soldto investors whose investment require-ments match those of these particulartype(s) of securities. Structured nanc-ing has added value to the basic assetsecuritization process and furtherserved to develop the growth of asset- backed nancial markets.

With the advent of credit deriva-tive products, a further innovation inasset securitization processes hasemerged in the form of a product calledSynthetic Securitization. In SyntheticSecuritization, a nancial institution

holding a pool of assets transfers thecredit risk attached to the asset pool toa third party by means of credit deriva-tives, rather than by the direct transferof ownership of the assets. This “trans-fer” might also take place via a creditdefault swap, or a total return swap totransfer the credit risk attached to anasset pool to a third party, rather than by selling the assets.

The popularity of Synthetic secu-ritizations among nancial institutionshas given rise to concerns about theregulatory aspects of addressing therisks associated with synthetic secu-

ritization. Synthetic securitization hasadvantages over conventional securiti-zation because the legal cost associated

with the transfer of asset ownershipis avoided. Determining the capitalrequirements relating to Synthetic Se-curitizations can be complicated due touncertainties regarding the degree of risk transference and the extent of risk

retained by the originator.

The Subprime Implosion of theU.S. Housing Market

Subprime mortgages are pre-dominantly securitized in the form of mortgage-backed securities (MBS).These securities are enhanced withmechanisms to protect higher-ratedtranches from shortfalls in cash owsfrom the underlying collateral (for in-stance due to defaults or lower than ex-pected interest income). These mecha-nisms include various kinds of explicitinsurance, for instance as provided by

mortgage insurers. However, most of the credit enhancement comes fromstructural features such as subordina-tion, overcollateralization, and excessspread.

Until the subprime crisis explodedon the U.S. housing market, the impactof securitization appeared largely to be positive and benign. But securitiza-tion also has been indicted by some forcompromising the incentives for origi-nators to ensure minimum standardsof prudent lending, risk management,and investment. This, at a time when

low returns on conventional debt prod-ucts, default rates below the historicalexperience, and the wide availability of hedging tools were encouraging investors to take more risk to achieve ahigher yield. Many of the loans werenot kept on the balance sheets of those who securitized them, perhaps encour-aging originators to cut back on screen-ing and monitoring borrowers. Thissubsequently resulted in a systematicdeterioration of lending and collateralstandards issued by nancial institu-tions and its impact on markets not justin the United States, but by extension, world-wide.

Government bodies, such as butnot limited to, the US Securities andExchange Commission (SEC) and theFederal Reserve Board of Governorsin Washington DC, together with theinternational organization failed tounderstand the evolution in nancialtechnology, and perhaps were not sureas to which of the government agencieshas responsibility for oversight. This



| 2 0 0 9 A P R I L

BACKGROUND

lack of oversight coupled with a failureto establish new guidelines that wouldmitigate risks associated with evolutionof contemporary nancial technology by imposing stricter safety standardsand higher capital requirements inoverall terms on the nancial institu-tions in developed nancial markets,compared to the previous standardscontributed greatly to the present day global nancial debacle. Both the scaleand persistence of the attendant creditcrisis seems to suggest that securitiza-tion—together with poor credit origi-nation, inadequate valuation methods,and negligently insufcient regula-tory oversight—have severely damagedglobal nancial stability.

The Credit Rating Agencies

Obtaining a Satisfactory Credit RatingOne of the critical factors deter-

mining the success or otherwise of anasset securitization process is the creditrating obtained for the securitized debtsold to the market. The credit quality of the security is directly related to the yield of the issue. The higher the creditquality the lower will be the yield andthe more successful will be the issue.The credit rating must also achieve atleast the threshold investment grade. A lower than investment-grade quality rating will not be favorably viewed by investment funds and other institu-

tional investors, resulting in an unsuc-cessful security issue.

Securitization and the develop-ment of complex structured credit in-struments have undeniably improvedaccess to credit. However, they may also have contributed to greater (andnow in hindsight clearly unnecessary,unwarranted and unsubstantiated)aggregate risk-taking and, instead of resulting in an efcient dispersion of risks, have led to a destabilizing shift of risks toward institutions that could notadequately manage them. Moreoverit has had a counter effect, presently

and dramatically seen in the rever-sion of some of these risks to banksthat had supposedly ofoaded them,and to much more uncertainty aboutthe actual distribution of risks amongmarket participants. In addition, both banks and the off-balance-sheetSpecial-Purpose Vehicles created inthe securitization process have come torely excessively on wholesale fundingmarkets, thus incurring maturity mis-matches without adequate consider-ation of the risks of such funding, that

we have now seen all but disappear. Itis further true that the originating andarranging entities lacked appropriatecredit screening and monitoring incen-tives, with many investors failing tosufciently question such incentivesor examining the quality of the loansunderlying structured products. In-stead, institutions/investors, rightly or wrongly, relied excessively if not osten-sibly, on the reputation of the institu-tions involved and on the credit ratingsof the instruments.

Quality of the rating process and conicts of interest

Credit rating agencies haveassigned high ratings to complexstructured subprime debt based onlimited historical data; in some cases,on awed models; and on inadequate

due diligence of underlying collat-eral. Agencies also failed to adequately disclose assumptions, criteria, andmethodologies; they failed to clarify the meaning and risk characteristicsof structured nance ratings; nor didthey address conicts of interest. Fi-nally, nancial institutions did not always sufciently disclose the type andmagnitude of their on-and-off balance-sheet risk exposures, particularly thoserelated to structured products.

Furthermore, shortly after theeruption of the current nancial crisis,and after heavy criticism, the various

credit rating agencies started taking

the necessary steps to revise ratingmethodologies for structured prod-ucts; only now are they taking steps toseparate rating activities from other business activities; delink rating man-agers’ compensation from the nancialperformance of their business unit;enhance the surveillance of the ratingprocess; and strengthen internal over-sight of rating methodologies.

Uses of ratings

Investors should not use ratings toreplace strong risk analysis and man-agement methodologies that would beconsistent with the complexity of theinstruments they buy and relative tothe importance of their holding. In thiscontext, supervisory authorities mightconsider reviewing the use of ratingsin regulations to ensure that such use

does not induce uncritical reliance oncredit ratings as a substitute for inde-pendent evaluation.

A Remedial Approach to Endemic Problems

a. Rating agencies should beturned into single-activity or single-product line rms. They shouldprovide just ratings, not any otherproducts or services, including advice.The programs for Rating agencies vary widely by the type of product, its po-tential risks, and the regulatory powersgranted to the agency.

b. The quasi-regulatory role of the



International Financing

2 0 0 9 A P R I L |

67

rating agencies in Basel II should be elimi-nated or amend.

c. The customer wishing to have hiscompany, country or instrument rateddoes not pay the rating agency, ex-anteor ex-post. Instead he pays the regulator,

who then allocates/auctions the individualrating activity among the population of competing rating agencies.

d. Rating agencies should be paid inpart in the securities they are rating. Suchsecurities should be held to maturity andcannot be hedged by the rating agency.

Conclusion

Asset securitization made the nan-cial system more resilient at the expense of undermining the effectiveness of consum-er protection regulation. In recent months,lending standards have tightened and rat-ings models are being strengthened, butsubprime credit is still readily available—ata price. Potential solutions to the manage-ment of this trade-off should be explored.Policy response should balance greater

consumer protection with maintaining the viability of the securitization model.

When considering future policy changes, regulators and lawmakers needto balance carefully the need to limit futurepredatory lending excesses, while preserv-

ing a model that has successfully dispersedlosses from higher-risk mortgages away from the banking system and maintainingthe ability of stretched but viable subprime borrowers to renance when confronted with reset payment shock. This is a chal-lenging task within a regulatory and legalframework ill-suited to provide consumerprotection in an originate-to-securitizenancial system.

Federal banking regulators shouldtighten guidance on nontraditional andhybrid mortgage lending. It is absolutely necessary to address the very fragmentednature of the U.S. nancial regulation sys-tem where such standards are not uniformin observance and enforcement.

Regulators should establish andenforce compliance by their regulated in-

stitutions on non-bank lenders and loan brokers that are regulated at the state level;such initiatives also rely on consistentstate-level enactment and enforcement.The U.S. Federal Reserve should review its powers to regulate mortgage transac-tions and tighter restrictions, especially concerning the clarity of disclosures to borrowers and the availability of the riski-est loans, appear warranted.

The introduction of Asset Securitiza-tion, and its evolution over three decades,has had a profound impact on consumersand nancial institutions as an innovativeproduct and no doubt, it will continue toremain so. In the light of recent events itis clear that more and better regulatory approaches must be instituted in order toensure that the original model and some of its innovative iterations reconstitute to theoriginal power and value they provided.

In this manner, the markets will reset,consumers will benet and Asset Securiti-zation can regain its rightful perch as oneof the most valuable products and nancialinstruments in banking history. IFM

This is an English-translated reprint of an article from International Finance Magazine - April, 2009.

asset securitization: revolution, evolution, devolution the rise and fall of the most important...

Documents