In 1991, when the U.S. economy was passing through recession, securitization was booming. A December 1991 article in Institutional Investor said: “The
asset-backed securities market is roaring its way through the recession with record issuance and reliable performance that prove it has come of age.” In 2001-2002, the global economy passed through multifarious problems such as large bankruptcies and terrorism, but securitization markets have continued to grow, and the growth has been widespread across different sectors.
Evidently, more money is being raised by credit card securitization than in the past, which means consumer spending is being propped up by the capital markets. More auto loans have been securitized in 2002 than in the past, so auto sales have been supported by securitization. All this tends to ease the impact of economic recession.
The alchemy of securitization:
Is the sum of parts more than the whole?
An essential economic question often raised is: Does securitization lead to any overall social benefit? After all, securitization breaks a company – a set of various assets into various subsets of classified assets, and offers them to investors. Imagine a world without securitization: Each investor taking a risk in the unclassified, composite company as a whole. So, how does it serve an economic purpose if the company is “de-composed” and sold to different investors?
We have discussed earlier that securitization essentially involves putting a section of investors in a position of priority over others. If there is any advan- tage for these investors, it is at the cost of the other investors, and therefore, the sum of the risk-return profile of these different investors should add back to that of the firm as a whole.
The alchemy of structured finance
Structured finance, generically, relies on the essential principle that there is an arbitrage in risk-reward tranch- ing, and that the sum of the parts is different from the whole. Like the rest of our society, the investor fraternity is made of inequalities all around, such as unequal risk- return appetite, unequal preference to a payback period and pattern, etc. Therefore, structuring – carving out dif- ferent statures or priorities, patterns and preferences for different investors, makes eminent sense.
The most evident example of the alchemy of securiti- zation is arbitrage activity. An arbitrage vehicle buys assets, and finances the same issuing asset-backed secu- rities, thereby making an arbitrage profit in the process.
Obviously, there is no reason for the weighted average cost of the funding to be lower than the weighted aver- age return from the assets, but the market proves 28 Securitization: The Financial Instrument of the Future
Box 1.6 Is the sum of parts greater than the whole?
• The firm itself is a pool and all that securitization does is decompose it into various asset pools.
• The sum of these pools must be equal to the sum of the parts, because logically there cannot be any arbitrage in mere differentiation and integration.
• However, markets are not arbitrage free. Experience proves that there is arbitrage in segmentation.
• This is the same as there are classes for every walk of life.
that there is an arbitrage involved in stratification of the risks in the asset portfolio.
Structured finance
The principle of structured finance believes in structural arbitrage, which may be theoretically disputed but has been practically observed quite clearly.
Professor Steven Schwarcz in his book Structured Finance18 has argued at length that securitization does reduce funding costs for an organization and therefore is not a zero sum game. His arguments essentially hinge on the eco- nomic rationale for secured lending, as any secured lending by definition puts the secured lender at priority to the unsecured one. Also, securitization cre- ates a capital market avenue, and certainly capital market funding is more efficient than funding by intermediaries. The role of intermediaries is impor- tant for credit creation and capital allocation, but funding should come from where it eventually comes – households.
Lower costs due to higher leverage
After the bankruptcy of Enron in late 2001, securitization came into sharp focus and academicians on one hand and investment bankers on the other entered into the popular duel of whether securitization reduces lending costs at all. Rating agency Moody’s released a compendium of its views on securi- tization called Moody’s Perspective 1987–2002: Securitization and its Effect on the Credit Strength of Companies. In response to its own question, Moody’s had the following comment to make:
Does securitization provide access to low-cost funding?
Not really. Many in the market believe that securitization offers “cheap funding” because the pricing on the debt issued in a securitization transac- tion is typically lower than pricing on the company’s unsecured borrow- ings. However, the securitization debt is generally backed by high-quality assets, cash held in reserve funds, and may be over-collateralized. This means that the relatively lower pricing comes at the expense of providing credit enhancement to support the securitization debt.
It is true that credit enhancement by way of over-collateralization or other- wise is an inherent cost for the securitization transaction, but it is important to understand the nature of credit enhancement. In normal corporate funding, the equity of the firm is the credit enhancement for the lender, as equity is the first loss capital of the firm. The extent of such credit enhancement – appropriate leverage ratios for the firm – is in general extraneously fixed either by regula- tion or lending practices. For example, a straight-jacket debt/equity norms of a traditional lender, or the capital adequacy norms of financial regulators, put limits on the leverage. Thereby, firms are forced to require much higher credit enhancements in the form of equity than warranted. In the case of securitiza- tion, the required credit enhancement is related to the expected losses in the portfolio, and so it is directly connected with the risks of the portfolio.
If we believe that equity is a costlier funding source than external funding, the higher leverage require- ments imposed by traditional lending or regulatory capital requirements impose higher-weighted average funding costs on the firm. Securitization allows the firm to leverage itself more, and therefore attain a lower funding cost or attain correspondingly higher returns on equity. However, it is necessary to under- stand that such higher returns do not arise from more efficient operations but from higher leverage.
Securitization results in lower-weighted average costs for the following reasons:
• Rating arbitrage: Securitization allows entity ratings to remain unaffected and the transaction to ratings solely on the strength of its assets and the inherent credit enhancements. The best example of this was in May 2005, when the U.S. auto giants General Motors and Ford were downgraded, but that did not reduce their securitization volume; in fact, the volumes increased and the securities received a AAA rating.
In fact, the existing securities from some existing transactions were upgraded to AAA level, essentially because of an increase in credit support levels.
• The rating arbitrage is understandable due to isolation of assets from the originator, bankruptcy risk and underlying credit support in the transaction.
• Because of the isolated pool and the insulation this provides against general entity-wide risks, the inherent leverage of a securitization transaction – the extent of funding built upon economic equity of the transaction is much higher.
• The higher the leverage, the lower the weighted-average cost.
Capturing scale and volume efficiencies
In a capital structure framework, higher returns on equity by taking higher leverage as well as higher risk, – is really no efficiency. Therefore, we seem to be back at where we started – a zero sum game. However, there is also poten- tial for more efficient operations – the larger the scale of operations, which can be particularly significant in retail lending. Certainly, entities active in securi- tization have grown quickly and have attained a size by which they have economies of scale and scope.
Risks inherent in securitization
The Bank for International Settlements in a 1992 publication titled Asset Transfers and Securitizationhad the following to say:
30 Securitization: The Financial Instrument of the Future
Box 1.7 Securitization and leverage
• Behind the sophisticated argument of structured finance, there is a greater urge of raising higher leverage.
• Traditional corporate finance is concerned with entity-wide risks and therefore puts limits on the extent of leverage.
• Securitization structures take a more portfolio- specific view of the risks, and permit higher leverage by requiring lower credit enhancements.
• The result is that entities may build bigger asset bases with a meager amount of capital.
The possible effects of securitization on financial systems may well differ between countries because of differences in the structure of financial sys- tems or because of differences in the way in which monetary policy is exe- cuted. In addition, the effects will vary depending upon the stage of development of securitization in a particular country. The net effect may be potentially beneficial or harmful, but a number of concerns are high- lighted below that may in certain circumstances more than offset the ben- efits. Several of these concerns are not principally supervisory in nature, but they are referred to here because they may influence monetary authorities’ policy on the development of securitization markets.
While asset transfers and securitization can improve the efficiency of the financial system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitization could reduce the proportion of finan- cial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the impor- tance of banks could also weaken the relationship
between lenders and borrowers, particularly in coun- tries where banks are predominant in the economy.
One of the benefits of securitization, namely the transformation of illiquid loans into liquid securities, may lead to an increase in the volatility of asset values, although credit enhancements could lessen this effect. Moreover, the volatility could be enhanced by events extraneous to variations in the credit stand- ing of the borrower. A preponderance of assets with readily ascertainable market values could even, in cer- tain circumstances, promote liquidation as opposed to going-concern concept for valuing banks.
Moreover, the securitization process might lead to some pressure on the profitability of banks if non- bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitized assets.
Although securitization can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial cap- ital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially
Box 1.8 Securitization and sub-prime lending
• One common fear about securitization is that it may, or it does encourage sub-prime (junk) lending.
• Banks generate credits that they would not tolerate on their balance sheets and parcel them off into securitization vehicles.
• Several securitization conduits are administered by investment bankers rather than by the
hardened, older bankers of yesteryear.
• And the ultimate investors who put money into these conduits are unduly impressed by the sophistry of the transaction
structure, with elaborate credit enhancements and rating rationale.
in those countries where banks have traditionally been the dominant finan- cial intermediaries.
The above highlights the risks inherent in securitization. BIS has expressed concern about the relatively smaller capital base of the banking system sup- porting a much larger asset size. From a macro-economic perspective, this is not the only concern, as several other concerns are engaging the attention of banking regulators and academicians worldwide.
Abdication of credit – sub-prime lending created and sold
One of the oft-repeated concerns is that securitization has motivated banks and non-banks to create bad credits. The rationale is simple: Securitization motivates banks to create loans that they would hate to hold on their balance sheet. Given their ability to push junk assets into the capital market with a given amount of credit enhancement (a large part of which is nothing but the banks’ profit in creating the credit, called excess spread), banks are generally seen to have abdicated their prime responsibility – credit.
That banks are eager to securitize their relatively riskier assets is easily established by the extent of sub-prime lending being securitized into manu- factured home loans, sub-prime loans, sub-prime credit card receivables and auto loan receivables, home equity loans and others. “Sub-prime lending can be a pretty sleazy business. Lenders seek out customers with either spotty credit histories or no credit histories at all – typically low-income people – and often charge exorbitant interest rates and fees to compensate for the risk of default. It’s not a new idea, as finance companies were built on sub-prime loans made during the Depression, although nobody used the term then. But once credit cards became a ubiquitous part of American life, and companies improved in use of demographics to target potential borrowers, the business really began to flourish.”19And the fact is that most of the sub-prime lending portfolios finally found their way into the securitization markets.
Banking regulators have been aware of this risk for quite sometime; in a letter SR 97-21 (SUP) July 11, 1997, the U.S. Department of Banking Supervision and Regulation cautioned: “The heightened need for management attention to these risks is underscored by reports from examiners, senior lending officer surveys, and discussions with trade and advisory groups that have indicated that competitive conditions over the past few years have encouraged an easing of credit terms and conditions in both commercial and consumer lending.”
Yet another fact serves this point: The case of Superior Bank, which failed and was closed in July 2001 (see below).
ABusiness Week article20titled The Breakdown in Bankingsays securitization is a US$7 trillion business today, a large part of which are the loans, credit card debt, sub-prime debt and mortgage loans written by banks that are converted into securities and sold off in the capital market. The spin-off of this process is that banks do not absorb the risks of the credits they create. The authors of 32 Securitization: The Financial Instrument of the Future
the article say: “By selling off their loans, banks were able to lend to yet more borrowers because they could reuse their capital over and over. But it also meant that they made lending decisions based on what the market wanted rather than on their own credit judgements. The wholesale offloading of risk made the banking system less of a buffer and more of a highly streamlined transmitter of the whims of the market.”
“Besides re-use of capital which creates excessive leverage on the whole, there is an inevitable question of moral hazard – the creation of credit without enough at stake. This leads to a temptation for banks to scrutinize borrowers less carefully than when their own money was at stake. The banks abdicated credit judgement and the people to whom they sold the paper had no credit judgement,” says Martin Mayer, a guest scholar at the Brookings Institution and author of The Bankers.
The threat of unhealthy banking assets being pushed into securitization markets became more worrying in 2004 and 2005 as U.S. banks more aggres- sively and increasingly wrote poor quality mortgage loans with features such as optional adjustability, negative amortization and interest-only payment.
Banks were pushing more of these loans into the securitization market.
Trading on thin capital
We have noted earlier that securitization creates for banks an ability to lever- age their existing capital and resources to create more assets. This leads to excessive leverage. Excessive leverage can be compared to a multi-storey civic structure. If you intend to construct the 90-storey Petronas Tower, you obviously need a broad base to build on. The risk capital of a bank is its foun- dation, its base. In physics, a cone resting on its vertex is an unstable equilib- rium; for an object to be stably placed on ground, its center of gravity must be closest to the base. The same rule applies to business entities: There is an imaginary center of gravity in an enterprise based on its size and this center must lie somewhere close to the base, which is the equity capital of the enter- prise. There is no doubt that with the higher leverage attained due to off- balance sheet exposure, banks have become extremely vulnerable to economic cycles.
Off-balance sheet financing
Off-balance sheet assets of leading banks came into sharp focus after the Enron debacle, which was mainly related to off-balance sheet risks. During these discussions, Standard and Poor’s published data about off-balance sheet assets of the 30 top securitizers in the U.S. (see Table 1.3). There were some banks whose off-balance sheet assets exceeded those on the balance sheet, bringing home the point that the retained risks in these transactions might put pressure on the capital of the banks:
Securitization, under its current accounting standards, not only permits but also requires off-balance sheet funding. Off-balance sheet funding became a dirty word in reaction to Enron’s collapse;21there were several investigations into potential misapplication of the concept of SPVs. There is even an attempt to re-define qualifying SPEs for U.S. Accounting Standards whereby the QSPE status will be denied to several SPEs.22
Increases opaqueness of banks
Banks that securitize assets and still retain significant risks get into a serious situation where the assets disappear from the books and the risks stay. There 34 Securitization: The Financial Instrument of the Future
Table 1.3 Off-balance sheet assets of certain U.S. banks
Company Total securitized incl. CP (US$) Assets (%)
Citigroup Inc. 129,452 12.1
ABN-Amro Bank N.V. 92,304 17.8
J.P. Morgan Chase & Co. 80,652 10.1
Bank One Corp. 78,998 29.2
MBNA Corp. 73,534 170.6
Bank of America Corp. 43,066 6.7
Wachovia Corp. 39,757 12.2
Countrywide Credit Industries Inc. 36,032 100.6
Deutsche Bank AG 33,041 6.4
Morgan Stanley Dean Witter & Co. 30,650 6.4
Abbey National PLC 29,255 9.6
Credit Suisse Group 29,097 4.8
Royal Bank of Scotland Group PLC 23,929 4.5
FleetBoston Financial Corp. 19,976 9.9
U.S. Bancorp 18,622 11.1
Westdeutsche Landesbank Girozentrale 17,984 4.6
Rabobank Nederland 17,679 5.6
Wells Fargo & Co. 17,050 5.7
Canadian Imperial Bank of Commerce 15,913 8.4
Bayerische Hypo- und Vereinsbank AG 14,771 2.3
Bank of Montreal 14,002 9.0
Toronto-Dominion Bank 13,007 6.4
Bank of Nova Scotia 11,789 6.2
AmSouth Bancorp 9,196 24.0
KeyCorp 8,052 9.6
GreenPoint Financial Corp. 7,223 36.1
Royal Bank of Canada 6,804 2.9
Zions Bancorp. 6,762 27.9
SunTrust Banks Inc. 6,467 6.3
Mellon Financial Corp. 6,216 13.0
HSBC Holdings PLC 5,071 1.8