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2014-01-14 08:08:00
A much-maligned financial innovation is in the early stages of a comeback
Jan 11th 2014 | From the print edition
IF YOU asked regulators in 2008 which financial instrument they most wished had
never been invented, odds were that they angrily splurted a three-letter
acronym linked to securitisation. The practice of bundling up income streams
such as credit-card and car-loan repayments, repackaging them as securities and
selling them on in tranches with varying levels of risk once seemed like
enlightened financial management. Not so after many a CDO, CLO, ABS, MBS and
others (see table) turned out to be infested with worthless American subprime
mortgages.
Find the same regulator today and he is probably devising a ploy to resuscitate
the very financial vehicle he was bemoaning five years ago. Enthusiasm for the
once-reviled practice of transforming a future income stream into a lump sum
today the essence of securitisation is palpable. In Britain Andy Haldane, a
cerebral official at the Bank of England, recently described it as a financing
vehicle for all seasons that should no longer be thought of as a bogeyman .
The European Central Bank (ECB) is a fan, as are global banking regulators who
last month watered down rules that threatened to stifle securitisation.
Watchdogs will be pleased that, after once looking as if it was heading for
extinction, securitisation is making a recovery. Issuance of ABSs (securities
underpinned by car-loan receivables, credit-card debt and the like) are at
double their 2010 nadir. Issuance of paper backed by non-residential mortgages
is up from just $4 billion in 2009 to more than $100 billion last year. There
have even been offerings of securities underpinned by more esoteric sources,
such as cashflows from solar panels or home-rental income the sort of gimmick
once derided as a boomtime phenomenon. Excluding residential mortgages, where
the American market is skewed by the participation of federal agencies, the
amount of bundled-up securities globally is showing a steady rise (see chart).
The comeback of securitisation is related to the growth in economic activity:
in order for car loans to be securitised, say, consumers have to be buying
cars. Investors desperate for yield are also stimulating supply: securitised
paper can offer decent returns, particularly at the riskier end of the
spectrum. More important, though, is the regulators enthusiasm.
Why are regulators so keen on the very product that nearly blew up the global
economy just five years ago? In a nutshell, policymakers want to get more
credit flowing to the economy, and are happy to rehabilitate once-suspect
financial practices to get there. Some plausibly argue it was the stuff that
was put into the vehicles (ie, dodgy mortgages) that was toxic, not
securitisation itself. This revisionist strand of financial history emphasises
that packaged bundles of debt which steered clear of American housing performed
well, particularly in Europe.
The need to revive slicing and dicing is felt most acutely in Europe. Whereas
in America capital markets are on hand to finance companies (through bonds),
the old continent remains far more dependent on bank lending to fuel economic
growth. Its banks need more capital, and absent that are the weak link in the
nascent recovery because they fail to meet demand for credit from consumers and
small businesses.
This is in large part because regulators want banks to be less risky, by
increasing the ratio of equity to loans. As banks are reluctant to raise
capital, they need to shed assets. This is where securitisation helps: by
bundling up the loans on their books (which form part of their assets) and
selling them to outside investors, such as asset managers or insurance firms,
banks can both slim their balance-sheet and improve capital ratios.
Securitisation airlifts assets off the balance-sheets of banks, freeing up
capital, and drops them onto the balance-sheets of real-money investors, in Mr
Haldane s words. That may not seem urgent now, as Europe s banks are flooded
with cheap money from the ECB and have years before stricter capital ratios
officially kick in. But at some point markets will have to take over financing
banks. Such airlifts would neatly transform Europe s inflexible bank-led system
into something more akin to America s.
Financial watchdogs are also keen on securitisation because they are confident
that they can steer it along a different path from the one that ultimately
wrought havoc in 2008. They believe that regulatory tweaks have made the
practice safer.
One improvement is that those involved in creating securitised products will
have to retain some of the risk linked to the original loan, thus keeping skin
in the game . The idea is to nip in the bud any temptation to adopt the
slapdash underwriting practices that became a feature of America s mortgage
market in the run-up to the financial crisis. Another tightening of the rules
makes re-securitisations , where income from securitised products was itself
securitised, more difficult to pull off. If regulators have their way,
financial Frankenstein monsters such as the CDO-squared a security
underpinned by a security underpinned by a security underpinned by assets are
unlikely to make a comeback.
Perhaps the biggest change, however, is in investors attitudes. Before 2008,
many fell for the sales pitch of the whizzes who hatched CDOs, ABSs and the
like. Reassured by somnolent credit-rating agencies, which backed the bankers
vision of handsome returns at virtually no risk, investors piled in with no due
diligence to speak of. Aware of the reputational risks of messing up again,
they now spend more time dissecting three-letter assets than just about
anything else in their portfolio. Regulators will have to make sure that they
retain this newfound discipline.
From the print edition: Finance and economics