Securitization isn't dead

Securitization of debt isn’t dead; it’s simply hibernating, this according to a panel of experts at the CFA Institute’s 63rd annual conference.

Despite being identified as one of the bogeymen that wiped out trillions in global assets, the practice of repackaging and selling off debt will return.

The global investment community wants U.S. denominated, AAA-rated risk products, and is willing to pay through the nose to get them, says Sean Sheerin, co-head, asset backed securities/commercial mortgage backed securities group, DA Capital.

He pointed to the soaring prices commanded by U.S. Treasuries, despite the massive supply of U.S. government debt.

Meanwhile, the U.S. housing market is creating trillions in mortgage debt, which, if properly repackaged, can be securitized once again as AAA-rated.

“There’s got to be a way to get these two kids together,” he said.

What led to the credit crisis of 2008 was not the practice of securitization, Sheerin argued, but what was done with the securities.

“Securitization is no more evil than a shovel but if you hit someone in the head with a shovel, they still die,” he explained.

Securitization of consumer and commercial debt did spread risk around and make the financial system more robust, as it was meant to, he said. But after originating the loan, any bank that couldn’t sell the ABS at its desired spread repackaged several ABS as collateralized debt obligations (CDOs) and then bundled this together as special investment vehicles (SIVs).

Too often, each of these steps added leverage to magnify any problems that might occur but the real problem was that the originator now had the original mortgage on their books in three or four different forms. The risk was not spread around as it was meant to be.

In the U.S., ABS issuance peaked in 2006, at about $1.2 trillion, but by 2008, it had already collapsed to just $200 billion, according to Hourican.

The debts that made up this staggering amount included commercial mortgages, car loans, credit cards and yes, the now much-reviled residential mortgages. In 2004, residential mortgage backed securities (RMBS) made up 65% of the overall ABS market. That fell to just 2.2% in 2008, and to nil in 2009 and 2010.

When the market for ABS froze up in 2008, spreads between ABS products and Treasuries soared. Much less reported is that these spreads have now fallen off, and are only slightly higher than before the credit crisis hit.

Luckily, lenders are still able to advance credit, as deposits offer an extremely cheap source, thanks to extremely accommodative monetary policy, of capital, said Tom Hourican, managng director and head of ABS securitization risk management, Société Générale.

While there are repeated calls for Americans to deleverage, Hourican suggests that if lending were to contract, it would result in a dramatically smaller economy.

The disintermediation of risk makes securitization an obvious benefit for loan originators, but there are also benefits for investors, according to Jennifer Quisenberry, asset class specialist, General Re–New England Asset Management.

“From the investors’ perspective, I think the central appeal of securitization is the ability to be very focused on the collateral performance and characteristics,” she said “There is a theory at least that the structural enhancements can be tailored to fit the collateral to make investors comfortable.”

What’s holding up the return of wholesale securitization are the new regulations expected to come down as part of financial reform package being worked out in Washington.

“Now more than ever, the future of securitization is not driven by market forces, but by regulation,” said Jeffery Prince, managing director of Babson Capital Management. “The future of securitization is whatever Washington wants it to be.”

As a result, there will be less securitization by banks, with private placements filling part of the void. These deals would likely prove better for investors – typically institutional investors – as they would be better able to dictate the terms of the debt included in the structured product. Hourican warns these deals also typically bring up more esoteric debt issues, leaving credit cards, mortgages and car loans unsecuritized.

Regulations currently under consideration would require the lenders to keep some skin in the game, retaining 5% of the risk on the loan. Hourican says the move to bring ABS back onto the originator’s balance sheet is a good idea, but the proposal is too simplistic, as it magnifies the risks associated with less risky loans, and minimizes others.

Photo courtesy of the CFA Institute .