On the Prospects for Securitization

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A workmanlike piece in the Financial Times, “A re-emerging market?” by Gillian Tett, Aline Van Duyn and Paul Davies gives a cautiously optimistic outlook for the revival of the securitization market.

However, it’s a bit disappointing that the article skips over a couple of key elements. The first is that the explosive growth of securitization from 2000 onward could be depicted as cause or effect of a massive, and in retrospect, unsustainable growth in leverage. Some of this gearing is simply not coming back, and one of the places it is probably not coming back to anywhere near its former levels is securitized products.

The second omission is the degree to which regulators anticipate that more financial intermediation will be done on bank balance sheets in the future. That seems a surprising expectation, given that banks need not only to raise equity to rebuild their capital bases, but will presumably require even more capital to support larger balance sheets. Yet it appears to be the view of regulators that a lot of these fancy financial instruments will not come back to their former levels, leaving a greater role for bank intermediation.

The third is that the article neglects to mention the importance of credit enhancement to certain types of securitized products, particularly residential mortgages. As we have noted before, the loss of monoline capacity is a blow to this market. Credit default swaps (the non-bond-insurer type) are costly due to greater caution on behalf of protection-writers. Moreover, with credit default swaps possibly moving to exchanges (centralized clearing could be a first step in this direction), the resulting standardized contracts might also inhibit securitized deal structuring even after credit markets get on a more solid footing.

Nevertheless, the article provides useful data and a window on how various types of securitized products are faring now. The article is lengthy, so I’ve skipped past the “how we got where we are” bit and focused on the current and forward-looking parts.’

From the Financial Times:

However, the events of the last year have turned this seemingly virtuous cycle into a vicious spiral. Regulators…have …become aware that a lot more of the original loans were kept on banks’ balance sheets than had been thought. “One of the paradoxes of the securitisation crisis comes from the fact that banks held on to significant portions of senior risk [or highly rated bonds] through lending to hedge funds or through liquidity guarantees to off-balance sheet vehicles – and they did so to a much greater degree than regulators would ever have envisaged,” Michel Prada, head of the AMF, the French financial watchdog, told the Cannes conference.

Meanwhile, bankers have discovered that “capital efficiency” can create risks: if banks cannot sell bonds to investors and are forced to hold these on their balance sheet instead, they may run short of capital. In the past few months it has become increasingly difficult to sell securitised bonds, because investors have panicked about the opacity and complexity of these instruments and in effect gone on strike.

While rapid innovation in the securitisation market used to make the products seem exciting, it also meant that the sector grew out of control. More specifically, as subprime losses have mounted, investors have discovered that these products are hard to understand, let alone value – partly because the infrastructure for the market is still weak relative to the complexity of the instruments.

This has had a devastating impact. Back in 2006, or the last full year of activity before the credit turmoil, some $1,800bn (£903bn, €1,141bn) worth of securitised products other than government-backed mortgage securities was issued in the US alone – double the level of 2004. So far this year, by contrast, just $100bn of US products has been sold and considerably less in Europe. Activity in the secondary markets for securitised products dried up as well, as investors stopped trading except if forced into a fire-sale….

Oppenheimer has calculated that since 2000, the volume of US mortgage lending financed by securitisations was seven times higher than the level funded by traditional bank loans. Indeed, in 2005-07 alone…

Some bankers see signs of recovery in the secondary markets, where bonds are traded. “The real money is starting to come in now – and it is encouraging that we are not seeing so much distressed selling,” Greg Branch, a Deutsche Bank trader, told the Cannes {European Securitization Forum] gathering.

More important, some banks are continuing to create securitised products. Bundles of student loans and automotive loans, for example, are still being repackaged and sold to investors in America, albeit on a smaller scale than before. So, to an even more limited degree, are European and American corporate loans…

In addition, declares a team at JPMorgan Chase, the future remains bright for collateralised loan obligations – a $500bn sector that uses pools of corporate loans, often made to companies with low credit ratings, to back bonds. “Despite the throes of the ‘credit crunch’, the future of leveraged loan securitisation is solid,” it has been telling clients, urging investors to view these CLO products as “a buy”.

None of this, however, can dissipate the overall sense of gloom that pervades the securitisation world. In practical terms there are at least three factors undermining securitised finance. One is the widespread loss of investor faith in valuations of securitised products. While investors used to navigate this complex world with the help of credit ratings, the agencies have been forced to downgrade trillions of dollars of debt in recent months, which has badly undermined confidence.

Another problem is the investor base. In recent years some “real money” asset managers, such as pension funds, bought securitised products. However, especially in Europe, a large chunk of demand also came from hedge funds and from off-balance-sheet entities linked to banks.

The banks themselves also bought securities, particularly highly-rated instruments, since regulatory rules made it cheap for them to keep triple-A rated securities on their books. Citibankestimates that banks have accounted for 30 per cent of the triple-A rated market in recent years, while off-balance-sheet vehicles acquired another 20 per cent.

But most of these buyers are currently sitting on their hands. Hedge funds can no longer get cheap credit lines from banks, and many special investment vehicles and conduits have virtually collapsed. The banks are no longer able to support the market, since they have their own balance-sheet woes. “One of our biggest challenges as an industry is how to restore the triple-A investor base for securitisations,” says the ESF’s Mr Watson. “This isn’t just a confidence issue (although that is an important issue) but is an institutional structure issue.”

To make matters worse, the securitisation sector faces rising regulatory pressure. Over the past decade, policymakers have generally supported the “originate to distribute” model and, even now, regulators stress that they continue to see its benefits. “Originate to distribute has merits,” says Malcolm Knight, head of the Bank for International Settlements in Basel.

However, regulators face growing criticism that they have failed to spot weaknesses in the model – and are scrambling to find ways to curtail some of the wilder excesses. Earlier this year, for example, the Financial Stability Forum – a group of international regulators and central bankers – proposed that banks should post higher capital provisions when they create some securitised products. The FSF is also looking for ways to discourage banks from constantly securitising products, over and over again, as they have often done this decade. “Securitisation in its simplest form is a great innovation,” says Imene Rahmouni Rousseau, a senior official at the Banque de France. “But the paradox is re -securitisation. Products such as ‘CDO of ABS’ create problems because of complexity, lack of trust and misaligned incentives.”

Separately, American officials are considering changing the accounting rules to force banks to take many off-balance-sheet vehicles back on to their balance sheets. “The majority of securitised assets are likely to come back on balance sheet,” Citigroup analysts say in a recent note. “We doubt that the proposed changes . . . would mean the end of the securitisation market. However, we do have concerns about some of the changes . . . which could potentially require issuers to raise more capital and keep assets on balance sheets.”

Optimists in the banking world point out that the securitisation business has rebounded from blows before. Back in the 1990s, for example, many thought that the collateralised mortgage obligation market was almost dead as a result of investor losses and scandals, but it was revived in a new form….

“Straightforward securitisation will come back,” says Richard Berner, economist at Morgan Stanley, who predicts that the real attrition will occur at the more complex end of the market, with products such as CDO squared. Or as JPMorgan says in its own CLO note: “For ‘new’ CLOs it’s a case of back to the future: cleaner portfolios, less investor and structural reliance on leverage, and a normalisation of risk-taking all played a part in market recovery after the last cycle.”

Still, this new “flight to simplicity”, as some bankers dub it, has a catch: when products become simpler and more transparent, they also tend to produce far lower fees than the esoteric instruments that have flourished in recent years. That might be good news for investors; however, it will certainly not produce the bonanzas that bankers – and bank equity investors – have enjoyed in recent years.

A “back to basics” campaign in securitisation may, in other words, also mean going back to old-fashioned, and much lower, bank profits.

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14 comments

  1. Ginger Yellow

    I don’t think anybody expects securitisation to return to 2006 levels any time soon. But there’s every reason to think that 2002 or 2003 levels globally are realistic for next year.

    With regard to the monlines, I’m not sure it’s such a big deal. Outside of subprime RMBS (and particularly CDOs of subprime RMBS), monolines just weren’t particularly big players in the latter years of the global SF boom, precisely because spreads were so low and demand was strong across the capital structure. They were important in the whole business/infrastructure securitisation market, and they did a few emerging market deals, but that was more or less it.

    So unless you’re looking for a wholesale revival of the CDO of ABS market, I don’t think monoline capacity is going to have a huge impact on volumes (again, I’m talking globally, where subprime was vastly less important than in the US). You’ll see more infrastructure deals going down the bank route, or trying to sell unwrapped bonds, and fewer securitisations of diversified payment rights, but those were only a small proportion of total securitisation volume and likely to decline because of the credit crunch anyway.

    The big problems, as the article says, are the shortage of AAA buyers, which puts a cap on the size of deals, and the gap between the spreads demanded by investors and those the issuer is willing to pay or the assets can support. Until that gap disappears, through repricing of the assets, realism from issuers, or a recovery in secondary spreads, issuance is going to be very patchy.

    Even now though, securitisation is cheaper for most banks than unsecured funding. If the liquidity crisis has taught us anything, it’s that diversification of funding sources is important, and that long term assets should have long term funding. Securitisation can achieve that. It’s clearly not going to be the primary funding source for most companies, but it still has a role. If you want funding but not capital relief you can just sell the senior tranche, relying on its favourable capital treatment and central bank eligibility to get fairly efficient funding (albeit in reduced volume). If you want capital relief, you can sell the junior tranche(s) to investors keen to take the juicy spreads on offer.

  2. foesskewered

    The part that’s most worrying is not the creativity that helped the securitization sector to boom but the creative overdrive that drove re-securitization – for example the CDO squared that funnily enough Yves featured almost 6 months back?

    Rather reminiscent of the olive press, the first press is the best, the next presses produce more acidic products. The problem is how far the creative process extends and how risk is truly distributed instead of (risk)being hidden and multiplied.

  3. Ginger Yellow

    Well, sure, but CDOs squared only ever made up a small proportion of the market (even in the US). Even if they disappear forever, it won’t make much difference to volumes (revenues, maybe). It’ll make placing the mezzanine paper harder, but even there, now that the spreads are so high, it shouldn’t be so hard in the long run. CDOs squared and the like were a function of minimal and declining yields – in a repriced risk environment, there’s no real need for them, even if you could sell them.

  4. Bob_in_MA

    I wonder how much of the positive outlook depends on the ECB and Fed’s willingness to lend against newly minted securities back by loans the banks can’t sell at market?

  5. Ginger Yellow

    “I wonder how much of the positive outlook depends on the ECB and Fed’s willingness to lend against newly minted securities back by loans the banks can’t sell at market?”

    Very little, in the long run. Most people expect the ECB at least to turn off the taps at some point, probably by tightening eligibility criteria. Indeed, there are many who have argued that the ECB in particular has exacerbated the situation in the ABS market, by allowing banks to continue to price their assets at unrealistic prices, which then can’t be publicly securitised.

    Also, if we’re counting securitisations that have just been held for repo with central banks, then 2008 issuance is already far higher than 2002-3 levels. When I talk about a recovery, I mean sale of securitisations to private sector investors.

    In the short run, however, the recovery is indeed very dependent on central bank liquidity. That support means investors can be confident they’ll be able to “sell” a piece if they need the cash, without taking too much of a hit. This makes them more willing to buy with mark to market worries hanging over them. And it applies to banks and non-banks alike – real money investors like to know that they can sell their holding to a bank. That’s going to continue to be the case until banks recapitalise and start buying in large volumes again (and they will – triple-A securitisations are very attractive under Basel II, even on balance sheet), and real money investors get confidence in assets, ratings and valuations, which may take considerable time.

  6. Anonymous

    As a segue with the prior posts re. Broad and KPMG’s outlook, it is me or does it seem that on the Street, hedgies and ’40 Act funds there are a lot less Robert Rubin/senior statesmen types?

    Anecdotally it seems the more gray hairs you have the more worried (justifiably) you are of current conditions.

    In addition to the credit bubble, housing bubble, is there also a hubris bubble? As everyone born after 1965 doesn’t really have a meaningful concept of a serious recession. Perhaps this is coloring the still optimistic earnings estimates and economic forecasts?

    Just some random rhetorically questions that are bugging this thirty-something.

    Cheers.

  7. S

    Check out the ISM…markets are up as it is “better than expected”. Take a look at how it is calculated. it is equially weighted of the sub components. To save you the work, the rise in inventories is what pushed up the index. The prices paid was up as well. Markets are pavolvian. This index was if anything worse than expected. A short post on this might be worthwhile. All data is available on website – including how it is calculated.

  8. Skeptical

    Unfortunately, Ginger, unless the assets that go in structured vehicles are sound, the vehicles themselves hardly matter. So saying securitization will come back with a vengeance – or not – is irrelevant until there is something worth packaging. Hopefully, the investing public won’t get fooled again (realize this may be the minority view as an i-bank employee).

  9. Ginger Yellow

    Up to a point, Skeptical (there have been plenty of securitisations of non-performing loans that have worked out fine, and some that didn’t). My point is that there are still plenty of assets worth packaging. Most countries don’t have Fannie Mae and Freddie Mac. Banks in those countries have to finance prime mortgages somehow. And there are plenty of other assets to choose from – auto loans, credit cards, SME loans, corporate loans, insurance risk etc.

    In a lot of cases, the problem isn’t that people have a problem with the assets, it’s that cashflows generated by the assets wouldn’t support the spreads on a securitisation in the current market conditions. In other cases the assets would support the spreads, but the originator has other funding options. As and when spreads recover (obviously not to immediate pre-crisis levels, but to levels commensurate with the risks involved), those problems will gradually dissipate and you should see a normally functioning, though much smaller securitisation market.

  10. Been there

    Ginger,

    I think you missed Skeptical’s point entirely. Hopefully he won’t mind if I clarify his point as follows:

    “…unless the VALUATION OF assets that go in structured vehicles is sound, the vehicles themselves hardly matter. So saying securitization will come back with a vengeance – or not – is irrelevant until there is something worth packaging…”

    Let me draw an analogy to what happened to the real estate market during the early 1980’s. Back then the “Limited Partnership” structure became a popular vehicle within which to structure real estate deals. Since they were relatively new to most investors, an (ill-informed) implicit understanding came about that these new type of entities were so successful in the early years because the Limited Partnership Structure could somehow turbo-charge the deal (in reality the only thing turbo-charged were the sales of the partnership interests and syndication fees).

    I had clients during that period who (were normally conservative) bought into a few of these deals without any idea of the quality of the underlying assets. With the benefit of 20/20 hindsight it became clear that these folks would have never invested if the had a clear picture of the quality of the assets, cash flow potential , the huge upfront costs incurred to acquire the assets and structure the deal, etc. Some of them admitted they might have been mesmerized by the excitement of owning an interest in a LP. Granted there were other significant factors that finally crashed the real estate market back then such as 1986 tax Reform Act. However, it was also a previous case of lack of transparency of underlying assets in the partnership deals that helped led to that real estate bubble.

    Ginger, back to your assertions “….My point is that there are still plenty of assets worth packaging. Most countries don’t have Fannie Mae and Freddie Mac. Banks in those countries have to finance prime mortgages somehow. And there are plenty of other assets to choose from – auto loans, credit cards, SME loans, corporate loans, insurance risk etc…”

    I agree that there are probably plenty of assets worth securitizing. But clarity and simplicity will be the theme for US deals. People will become much more proficient at seeing through the structure of the deal, and be able to judge the quality of the assets, risks an terms of a deal regardless of structure (as they have with LP’s). Logic tells me that this will reduce or eliminate most of the opportunity for middlemen to tack on anything but minimal fees. Possibly in other less regulated markets (that don’t have GSE’s and their associated rules and regulations these structures may provide higher profit potential. But that’s not a selling point of which one should be proud.

    BTW- Did you hawk real estate syndication deals in a past life?

  11. Fledermaus

    In the past few months it has become increasingly difficult to sell securitised bonds, because investors have panicked about the opacity and complexity of these instruments and in effect gone on strike.

    OMG, whocouldanode that offering junk bonds with a bullshit moody’s AAA rating would lead to suspicion of all bonds.

  12. Ginger Yellow

    “But clarity and simplicity will be the theme for US deals. People will become much more proficient at seeing through the structure of the deal, and be able to judge the quality of the assets, risks an terms of a deal regardless of structure (as they have with LP’s).”

    Of course, and that’s a very good thing indeed for the industry. I’ve said time and time again that investors not doing their homework was the single biggest cause of the crisis.

    “Logic tells me that this will reduce or eliminate most of the opportunity for middlemen to tack on anything but minimal fees. “

    Again, I’m not sure why this is a problem. There was a thriving market in perfectly transparent deals before the crisis, and there’ll be a market of sorts for them after it. People seem to have this idea that the whole of securitisation is based on smoke and mirrors and exists only because investment banks make huge profits from it. That may be true for a minority of structured products (again, on a global basis), but the rest of them have solid reasons to exist from both the buy side’s perspective and the sell side’s. Banks already work on securitisations where all the hard work is done already (most large UK lenders, for example, structure their own deals and just hire the investment banks to sell them). Margins aren’t very big in the corporate bond market or the senior unsecured FIG market either. People still do deals. Why should securitisation be different?

    “Possibly in other less regulated markets (that don’t have GSE’s and their associated rules and regulations…”

    Not having GSEs doesn’t mean that they are less regulated markets. The UK regulates mortgage brokers, for instance, and every lender is obliged to demonstrate a loan’s affordability (how this works in practice is another matter). Other markets regulate prime mortgages far more tightly than the US or the UK, but simply don’t have a secondary finance system. The point is not one of regulation, it’s that in many jurisdictions, there is no cheaper way to finance mortgages (outside of short term solutions such as deposits or central bank repo) than securitisation. That’s changing as covered bonds become more widespread, but only a handful of countries, almost all in Western Europe, have legislation for them.

  13. Been there

    “Again, I’m not sure why this is a problem. There was a thriving market in perfectly transparent deals before the crisis, and there’ll be a market of sorts for them after it.”

    Why?

    A. There were thriving real estate and automotive markets during the early years of this decade, creating a large pool of collaterizable assets. That’s history now.

    B. The word of the ratings agencies, a key component of the process, was still sacrosanct at that time- forget about that.

    C. Without the opportunity to earn big fees, much of the push from the sell side(don’t worry, we’ll figure ut a way to make your income look better) will evaporate- that’s a good thing.

    “…Again, I’m not sure why this is a problem…”

    Hmmmmm, seems obvious to me.

  14. Anonymous

    Gosh, JP Morgan, one of the biggest loan originators in the world, says that CLOs are a Buy.

    Could JPM possibly be talking its own book? Just maybe? If the CLO market is substantially damaged, so is JPM’s main business.

    The FT should have mentioned that.

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