The 2008 financial crisis shone a damning light on how securitisation was used ruthlessly by banking institutions in order to pocket profits. As the housing market seemed invincible, investors were happy to throw their cash at various securitised assets, completely ignorant to what would ensue. Eventually, the housing bubble burst and the consequential affects reached every crevice of society.
This all gave securitisation a bad reputation to the extent that it was, and in places still is, synonymous with the ’08 crisis. However, as the global economy has steadily built its way back up, securitisation is once again being utilised – but can it be used without being extorted?
Why Do It?
Securitisation is undoubtedly one of the most complex transactions in the financial services sector. There is a myriad of parties involved and a series of simultaneous transactions which make the overall transaction occur. However, this is seen as a small price to pay given the benefits it provides to those involved.
For the originator (the entity creating the security), securitisation is a fantastic way of raising capital. A singular mortgage, for example, is relatively low yield and thus will not sell for much of a profit. However, grouping several of these mortgages together, in theory, is very low risk given the limited chance of multiple individuals defaulting on their loans.
Another reason why it helps raise capital comes in a situation where the originator’s credit rating is low. This may be because the entity is highly leveraged. This entity would struggle to raise capital via bank loans, and hence securitisation is a good alternative.
Securitised loans are removed from balance sheets and thus so are the risks associated with them. This makes the balance sheet look much healthier which in turn may make the company more attractive to investors. Details of securitised loans need only be outlined in notes to their financial statements.
The Investor’s Perspective
For the investors, securitisation provides options. Given that receivables are tranched (separated into risk categories), an investor can choose which tranche to invest in. So, if the investor wants to diversify a portfolio by adding a more risky asset, choosing a lower-rated tranche would be a suitable option. If used properly (unlike in 2008 and the years prior), the investment should only carry the risk associated with the tranche invested in.
There are numerous other parties involved including but not limited to: the arranger (a bank), lawyers, accountants, rating agencies and insurers. Of course, these entities will all receive fees for their work, meaning money should be earned by everyone involved.
Lessons from the Past
When banks realised they could package loans and sell them on for a hefty management fee, they could not get enough of it – literally. As a result, more and more loans were being dished out to those that could not afford them, but this was not the banks’ problem. As long as they could package and sell them, their job was done.
This was clearly a broken system in which money was being made from money which did not exist. As the number of subprime loans proliferated, the financial system became increasingly vulnerable to collapse. Central to the future of securitisation is, therefore, the regulation of it.
Regulation legislation for securitisation has been around since long before the 2008 crisis. However, it simply was not enforced, and it became all too easy for banks to circumvent compliance. This was the fatal error as it escalated what is actually a sensible means of raising capital into a vacuum of greed.
Since the crisis, legislation in the form of Basel III has been proposed (but not fully implemented) which aims to increase the risk exposure to those selling the securities, thereby reducing the incentive to sell worthless goods. In addition to Basel III, there is a very technical piece of legislation known at the Capital Requirements Directive (CRD) which aims to, amongst other things, support Basel III in regulating securitisation.
The legislation is constantly evolving, although its motive to prevent misuse of securitisation has remained. Given the deep complexity of the transactions occurring, it is often difficult to keep up with compliance in every part of the deal and has lawyers working long hours in the build-up to the completion of the deal.
A Practical Example
An example of how the new legislation works in practice is as follows. The originator of the security will place the loans into different classes (e.g. Class A-D). Class A has the most secure loans, but the lowest yields and Class D has the riskiest loans but the highest yields. Another reason why Class A is the most secure is that payment follows a waterfall structure. This means that the first loans to default, regardless of which class they are in, will affect Class D first.
So if a loan in Class A defaults, it is the Class D category which will take the loss. This way, payment is made to all of Class A investors first and then all of Class B investors second and so on and so forth. However, the new legislation is such that, depending on various factors, a certain percentage of the initial defaults will be taken on by the originator who owns a certain amount of Class D securities. As a result, there is little incentive for the originators to package loans that are likely to default due to the simple fact that if they default, they will take the loss themselves first, not the investors.
This is just one example of how the regulation works. Of course, there are numerous factors to consider when applying legislation given that no two securitisation transactions will be the same. This is fundamentally why it is so difficult to regulate.
In a post-crisis economy that is just about getting back on its feet, the gentle comeback of securitisation will always be a cause for concern to some onlookers. The stigma attached to the transaction is arguably justified. However, this does not mean that securitisation should be ruled out – it is simply too good of a capital raising tool if used properly.
The onus is, therefore, on regulators to keep a sharp eye on developments and take action where necessary. In what is a tricky transaction, the role of compliance will be crucial. It is solely based on this whether securitisation can be used successfully in the future.