Category Archives: Alternative Investment

Alternative Investment related Post

Attracting FinTech and other new Business Models to Malta

There has been a lot of hype over the last years to attract new types of businesses to Malta such as the FinTech (Financial Technology), WealthTech (Wealth Management using Technology), Algo-trades (investing using algorithms) and more recently Investment-based Crowdfunding Platforms. Rightly so, entities such as FinanceMalta have held several seminars and initiatives to attract these types of business and in fact their 2017 annual conference will be focusing on this theme.

Through this post I would like to give a brief description of these types of entities and to also provide some thoughts on the factors which could deter these types of entities from seeking to be registered in Malta. From personal experience of being involved in a start-up Fin-tech, Wealth-Tech and Algo-trading company Novofina I would like to shed some light on the difficulties faced in attaining a suitable license and remaining compliant to rules and regulations which are based on a one size and one type fits all regime.

FinTech/WealthTech/Algo-Trading

FinTech can describe any financial services entity that uses technology to perform its service or offer its products. The technological innovation can be applied in different parts of the process from research, retail banking, investment selection and even crypto-currencies such as bitcoin. Technologies can include things like Artificial Intelligence (AI) that could be applied to investment instruments selection or to research gathering for estimating market sentiment for example.

Originally FinTech referred to technological innovations applied to the back office of banks and investment firms, nowadays it refers to a wider variety of technological interventions in the retail and institutional markets. The level of technology used varies depending on the type of company and the services it seeks to offer. It can range from mobile wallet systems to robo-advisor services. Even within a category of firm types the technologies applied can be wide ranging. For example, if we take the robo-advisory firms, you could have companies that simply use online data entered by the client to determine their risk profile, financial bearability and knowledge and experience in order to offer a bundled Exchanged Trade Fund (ETF) solution. You can also have so called forth-generation robo-advisors that use algorithm based trading in combination with AI in order to trade different investment strategies on behalf of clients.

An Algo-trader would use a mathematical algorithm that would be pre-programmed with certain rules in order to trade large amounts of instruments (example shares) on the market. The algorithm would be programmed to trade a particular trading strategy and configured in a specific way relating to price, position sizing, timing and risk-mitigating techniques. Thus, not all robo-advisors are the same and even more so not all FinTech or WealthTech firms are the same. This makes it even more difficult to fit into the local financial services regulatory framework and categories of licenses.

Investment-Based Crowdfunding

Crowdfunding, as the name suggests involves the process of gathering a lot of small amounts from a lot of people in order to collectively raise a larger amount. This can range from a simple project such as raising the funds to finance the publication of a book to more complex issues such as using the funds to invest into a new FinTech start-up through an equity stake. So far in Malta investment-based crowdfunding is not really possible since the current regulatory framework dose not really provide for this form of investment. However, we have seen some progress here with a donations-based crowdfunding initiative being launched that raises money against donations and can give back certain perks. There has also been a consultation paper issued by the regulator late last year which period had closed in March 2017. So we are beginning to see some progress here. A very interesting article for anyone looking to find more information on investment-based crowd funding can be found on the latest publication of the Malta Business Bureau here.

Barriers to Entry and Operate

It is a great initiative to attract the most technologically advanced financial services companies to Malta. However, there are certain issues that are hindering their entry and once operative, their operational viability. One of the largest barriers is the regulatory issue. Our current regulatory framework was not designed for these technologically advanced firms and the current situation is that these firms either fit themselves into an existing license category or else they are not welcomed. This is a major issue since it could be forcing firms to have in place certain items which are not applicable to their business model, are costly to maintain and would lead to deterring a potential newcomer from setting up shop in Malta.

To put it more simply, if a FinTech company would like to attain a license to provide services A B and C, why does it still have to apply for a license that caters for services A to G? Although there is some flexibility in the license application process and certain derogations may be applied it is still far from being an attractive preposition balancing investor protection and the reputation of the local financial services industry on one side and attracting the right players that could take the Maltese financial sector to a whole new level attracting cutting edge, niche market firms. On the other hand, the current regulatory framework may present certain loopholes for certain types of FinTech companies since the current regulatory requirements may not fully appreciate the different risks such firms pose to investors and the financial sector in general which could be quite different compared to more traditional financial services entities. Having said that, risk management has taken a much more prominent role nowadays.

With respect to the ongoing obligations of such entities once they have been licensed it is not logical that their capital requirements should be the same as those of other more traditional firms. To put it simply, certain investment services providers are subject not only to minimum initial capital requirements but also to on-going minimum capital requirements. This capital requirement is not simply a calculation of asset less liabilities, but involved certain amendments to arrive at the regulatory capital requirement. One of the deductions from an entity’s capital figure is its intangible assets figure in its balance sheet. Given that FinTech, WealthTech, Algo-Traders, Robo-Advisors and all the rest of these firms invest heavily in software and licensing of such software, and software is an intangible asset, they are currently being penalised for doing so. So on the one hand we want to attract the most technologically advanced firms and on the other hand we are telling them that their software is worth nothing and must be deducted from their capital. To be clear, this is not simply imposed by the local regulator but comes out of the EU Capital Requirement Directive. Simply blaming the EU legislation is not a solution however and when it comes to these technologically advanced firms it is even more so that we are not simply competing just with other EU countries but the whole world. Being online based makes it even easier to setup anywhere in the world with a decent internet connection.

Another problem we are facing locally is the shortage of talent. The gaming industry has brought many benefits to Malta, however it has also created a shortage in IT developers. Administrative staff is also becoming a problem for some firms, especially since most FinTech firms are start-ups and thus have a higher risk of going bust compared to the larger players in the industry. Another problem I see locally is the lack of promotion and support for being an entrepreneur. This last obstacle may the most difficult to overcome since it could be considered a cultural issue. However, with proper incentives and moral support from a young age there is no reason why we cannot produce more students who desire to become business owners. Interestingly enough, investment-based crowdfunding could be a very good avenue where such budding entrepreneurs could find funding to start off their project until they get to a level where other sources of finance could become available to them.

The Bottom Line 

All-in-all I truly believe that Malta has the potential to become a major player in the FinTech arena. It has already proved itself in the fund industry and the online gaming industry for example and there is no reason why a market for FinTech and other technology based financial services firms should not also be successful. However, to reach such a realisation there must be more support and initiatives for such firms to choose Malta. Some barriers like certain regulatory issues are not entirely under our control. However, if our regulator decides to gold plate an EU directive this would hurt our chances of attaining success in this sector. One such example that comes to mind is the “holding and controlling” of clients’ money requirement locally, when the EU directive speaks only of “holding” clients’ money.

KD

The views expressed are the personal opinion of the writer and do not necessarily reflect the opinion of any entity the author is associated with.

Retirement Planning – a Portfolio Approach

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Retirement Planning – a Portfolio Approach

I would like to start this post by pointing out a very important fact: Planning for retirement does not mean buying an investment called “Pension Fund” or “Retirement Fund”. Many seem to think that in order to plan for their retirement they need to buy an investment that somehow has “retirement plan” of “pension plan” in its name. This is definitely not the case. In order to plan for one’s retirement one must think of all their assets as forming part of one overall portfolio.

The principal aim of retirement planning is to have a decent income once one retires from their employment and for estate planning. It is no secret that the state aid will not be enough for many people to earn an income in retirement that is compatible with the standard of living that they would have become accustomed to during their working life. Thus, it is important to plan in order to earn supplementary income. Does this mean that everyone should start buying income paying products from a young age – NO!

The best way to plan for retirement planning is for one to structure his/her assets in an overall portfolio structure. As with any portfolio investment one needs to plan according to one’s:

  • investment objective,
  • risk tolerance
  • financial affordability
  • knowledge and experience.

It must also be kept in mind that all the above points will evolve over time and are not static. Thus your retirement portfolio must also evolve to reflect these changes.

Investment Objective

For someone who is in their initial years of their working life their investment object is going to be quite different than for one who is close to the final years of their working life. Furthermore, it is not only an age thing, but other factors also have an effect on the investment objective. An initial objective of any investor would be protection. So a wise choice would be to acquire some form of life insurance and if affordable some form of disability insurance.

Let us assume we have an investor who has purchased their first home, has some form of insurance in place and a decent cash balance for regular expense items. Such a person would have a long term investment horizon and their investment objective would normally be to increase their overall capital. Thus, such an investor would be better off investing in products that focus on capital growth rather than income. The growth in capital possible through equity investing rather than investing in bonds is exponential. Therefore, it would not be wise to invest totally into income paying bonds when one has 30 odd years left until retirement.

On the other hand, someone who is nearing their retirement age should start shifting their portfolio more towards income paying investments. For such a person it would be more important to have something extra coming in rather than possibly doubling their capital in 10 years’ time. So the investment objective is going to have an effect on what investments one should have in their overall portfolio. Moreover, although income is important and normally is the main concern of many investors, if one would also like to leave something extra for their heirs then they should also consider this in their overall portfolio.

Risk Tolerance

This is something very specific to the investor. As a general rule most people are risk averse, meaning that they would rather avoid rather than increase risk. However there is the risk reward trade-off to consider which basically means that the lower the risk the lower the potential return. In general, one who is still a number of years away from retirement would tend to be more able to take on risk for the potential of higher returns compared to someone who is closer to retirement. Even psychologically, investors would be more willing to take on risk when they are younger than when they are older. However, every investor is different in the degree of risk that they are comfortable in taking on. This will affect the type of individual investments that one would put into their overall portfolio. So although a younger person might want to invest in equities to increase their capital in the long term they can buy conservative equities/equity like investments such as an ETF that tracks the overall market, or they could buy a more speculative product that for example moves 3 times the price of oil.

Financial Affordability

Like with anything else in life we should only buy investments that we can afford. The affordability factor should be considered in two main ways. The first is that certain products have a high initial cost. So for example, certain bonds trade in multiples of €100,000 meaning that one needs to buy a minimum of €100,000 in order to buy the bond. The second factor connected to affordability is the percentage of the overall portfolio that the investment will make up. What I am referring to here is the fact that although the investor might afford to buy the asset, he/she would be left too exposed to the one asset if they do in fact invest in it.

An easy way to see how this second factor could be detrimental to a portfolio is to consider investing into property. With interest rates very low and the local rental market doing well we are seeing many people investing into property with a buy-to-let setup. Let us take a hypothetical situation where we have an investor who owns their main residence which is worth around €250,000 at current market rates, has a portfolio of €50,000 in investments, has €10,000 in the bank and is now considering buying an apartment costing say €100,000 in order to rent it out. Without going into the debt factor that this will have, let us assume that the €10,000 will remain on his bank account to cater for unforeseen expenses and act as a buffer. The €50,000 will all be used to purchase the property and the balance will be borrowed from the bank. If this is the case, the assets that make up this persons’ overall portfolio would be €350,000 in property and €10,000 in cash. This would mean that over 97% of this person’s portfolio would be invested into two properties, less than 3% would be in liquid, easily accessible cash and no other investments. Through such an example it is easy to see the concentration risk of going down such a route.

Knowledge & Experience

Another important factor to consider when deciding on which assets to put into one’s overall portfolio is to invest in assets which they are familiar with. This does not mean that one should invest only in things which they have already invested into and not consider anything else. However, one should research investments which they are considering investing into before they actually financially commit themselves. There are many good investment advisors around that can help here, but supplementary research is always a plus. By searching a bit online one will find many avenues where good information can be attained on the assets they are considering investing into. So just like one would consult websites such as booking.com and trip advisor when booking a hotel, investors should also do some supplementary reading before investing their money.

Piggybank and calculator. Isolated on white background
Attaining a Decent Income after Retirement

For many the main goal when it comes to their retirement planning is to secure a decent return after they stop or reduce their main work activity. In my view this is best attained by slowly building a portfolio of diversified assets over the years. The accumulation of income paying products should evolve over time and one is not expected to invest all their money in capital growth products and switch all their money into income paying products on the day they retire. The ideal situation would be to have income coming from different sources so if one of the sources is negatively affected in some way one would have alternatives that they could depend on. So by having some income coming from rental income, some coming from direct bonds and bond funds and some coming from income paying equities one would have different streams of income which are affected by different things.

As one is building their portfolio over the years they should not forget to think of alternative investments to the regular bonds, shares and property mix. Such alternatives would include investing into commodities such as precious metals and oil, investing into art and collectables and also investing into private businesses. A good source where one could attain a good capital appreciation and even income through dividends is by investing into private companies. Many start-ups end up needing additional finance while many other well established businesses also would need extra financing for new projects or to get through a rough patch. It is true that the risk could be lager here than investing into regulated and quoted companies, but if one does their research well and finds a good opportunity they can attain an equity stake in a good company at a decent price which would pay-off in the future. Such an investment could offer good income opportunities and a good asset for the heirs of the person who would eventually take over these shares.

The Bottom Line

The main message I would like to convey through this post is that there is no fixed formula to use when it comes to retirement planning. Everyone has to assess their own characteristics and find the best mix of products that suits them. So called retirement plans are a good start but they are not an end in themselves. Some of these retirement plans do give you a tax break if you use them, but the amount of tax saved per year on them is ridiculously low to have any significant weight.

KD 

Ethical Investing – Where do You draw the line?

tank-iStock

According to Invetopedia.com, the definition of Ethical Investing is the use of one’s ethical principles as the main filter for investment selection. The idea can be applied by either eliminating certain industries altogether, for example gambling, alcohol and tobacco, or by over-allocating into industries that meet one’s ethical guidelines.

There are many funds that use this principle when it comes to choosing the investments (mainly equities) that they allocate their clients’ funds to. But at the end of the day, should one really care where the money is invested, as long as it is profitable? This question will be answered different for every investor since every investor will have his/her own criteria as to what is or is not appropriate. I am just simply trying to ask – where do you draw the line?

 

One may argue that investing in a company that manufactures tobacco or alcohol for example is not a really big issue. People who consume such products know of the negative effect that these products have and they choose to consume them anyway. On the other hand the products are addictive and hence they also have an immoral control over the consumers, especially addicts. Furthermore, it may be highlighted that such firms invest a lot of money into lobbying and propaganda and so they are not really playing fair and thus tricking people into consuming their products. So should I eliminate these companies from my portfolio?

To be honest, shouldn’t we really think the same of fast food producers? They are the cause of a lot of health issues, yet we do not restrict the intake of fast food consumption for people under a certain age as we do for alcohol and tobacco consumption. So should I not invest in the shares of McDonalds or The Coca Cola Company based on my ethical thinking?

With the legalisation of the personal consumption of Marijuana in certain US states one can now invest in companies that produce this product. The same arguments brought up for the tobacco and alcohol industries can be used here. By investing into such a company am I indirectly causing people to consume more of the product?

Reasons to invest in these industries.

Such industries that invest in addictive product such as alcohol, gambling and tobacco tend to be less affected by economic trends. The reasoning is that even in an economic downturn, people will still gamble, they will still smoke and they will still drink. Thus, having equities of companies that offer these products in one’s portfolio will add to diversification and theoretically lead to less of a downturn when the majority of shares are going down.

But this is not the full story of course. Yes these shares can lead to a less risky portfolio and potentially better returns, however they do not come without certain other negative features. If you take the tobacco and alcohol industries these are frequently subject to lawsuits and new regulations that limit their ability to market their products. When we have a new research paper come out that this product or that product causes more harm than we previously thought, these shares will suffer.

On the gambling side, if we take for example casinos, all the large casino shares have interests in Macau which is the “Las Vegas of China” (although it is much larger than Las Vegas to be fair). This means that these stocks are affected by the news coming out of China which is still a volatile market. A quick look at the shares of companies like Wynn Resorts Ltd and Las Vegas Sands Corp will easily allow one to appreciate the volatility of such shares.

Ethics and Profits

What about the fire-arms, ammunition and military supplies industry?

Now let us take it a step further. For argument’s sake, let us assume that with the industries that produce addictive products that have detrimental health issues an investor argues that one cannot save someone from their own foolishness and hence they should not eliminate these companies from their portfolio. In other words, these companies pass the ethical criteria for this investor. What if we now consider arms and ammunition companies? What if we consider companies that develop jet fighters, missiles and other military supplies?

With the current tensions around the world following many terrorist attack incidents, the most recent being the Paris Attacks which have led to France declaring war on ISIS some investor are backing companies like Boeing, Lockheed Martin and BAE Systems to do well. These companies sell the supplies that would be used by military and hence the current scenario is looking very profitable for them. So this begs the question – Should I invest in this industry to profit from the conflict in Syria? How much is too much?

The shares of these three companies are up an average of 10% over the past 3 months alone. With tension very high and more countries signalling their intentions to join France the potential for these shares to keep doing well is easy to see. This is not to say that the risk is low with these sort of companies. These is still no clear plans regarding the continued war on terror that the US had initiated back in 2001 following the twin towers events. There is nothing to say that these shares are not already overvalued in the sense that people have already pushed up the prices of these shares in the knowledge of the potential for future profits.

The Bottom Line

The aim of this post was not to argue in favour or against the concept of ethical investing. The aim was to create awareness and make investors question how much they are willing to accept from an ethical point of view when it comes to choosing the products they invest into.

What are ETFs and how should they be used?

ETF

In this post I would like to highlight the characteristics and features of Exchange Trade Funds (ETFs) and more importantly, how they can be used as an investment vehicle as part of one’s portfolio. Although ETFs are considered as a recent financial innovation they have been around since the 1980s. Having said that, their popularity has increased mainly in the last decade or so.

What is an ETF?

The textbook definition  of an ETF  is that it is a fund that tracks indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. but trades like a share. When one buys shares of an ETF, he/she would be buying shares of a portfolio that tracks the yield and return of its underlying index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index (known as active management), but simply replicate its performance (known as passive management). They don’t try to beat the market, they try to be the market. In short, buying an ETF is like buying a fund that trades like a share on a stock exchange.

ETF

Although most ETFs are broad in nature you can also find narrow ETFs that focus on a particular sector or group of related companies. For example, one can use an ETF to invest in the oil industry by buying an ETF that tracks the price movements of companies that operate in the oil industry. By doing so, an investor would be investing his/her money in a wide range of companies and not just into one or two companies, which is especially advantageous if his/her desired allocation of funds to such an investment is small.

ETFs vs Traditional Funds

Since ETFs trade intra-day, meaning that you can buy or sell an ETF anytime during market hours, one can use ETFs for intra-day trading. This is a major advantage that ETFs have over a normal mutual fund such as a regular bond fund (see more about bond funds here). A regular fund would use what is known as forward pricing, meaning that if an investor wishes to buy or sell a mutual fund, the price at which the investment would be bought or sold would be the end of day’s price, which is always unknown.

Another advantage of ETFs over regular funds is their lower costs. Since ETFs are passively managed as they simply replicate a portfolio as opposed to trying to outperform it, they benefit from lower costs. A traditional fund’s expense ratio is usually around the 1.40% per annum level, while that of an ETF is typically more around the 0.40% level. The higher costs of normal funds are due to the following items: a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.

ETFs can also be more tax-efficient than mutual funds because most of the tax on capital gains is paid on sale and completely up to the investor. Even if an ETF sells or buys shares while attempting to mimic the basket of shares it is tracking. This is because the capital gains from in-kind transfers, seen in ETFs, do not result in a tax charge, and therefore can be expected to be lower compared to mutual funds.

Other Features of ETFs

Two other features of ETFs that are important to note originate from the fact that they trade like shares. So like shares, one can buy an ETF on margin and one can also short an ETF. In simple terms, buying on margin means that the investor borrows the money (normally at a fee) with which he/she then buys the investment. Shorting means that the ETF is ‘borrowed’ and sold, with the intention of buying at a later stage. So if for example, an investor is expecting the price of gold to fall, such an investor could short (or sell) a gold ETF and then buy it back at a later date (hopefully at a lower price).

Both buying on margin and shorting are not possible with traditional funds, but whether this is an advantage or not depends on the outcome of the result. For example, if an investor borrows €5,000 to buy an ETF on margin and the value of that ETF subsequently falls and is sold at €4,700 the investor would still have to pay back the broker the original €5,000 plus borrowing and brokerage fees. Shorting could be a bad thing if the price of the ETF actually goes up. If an investor shorted (i.e. sold) an ETF at a value of €5,000, and subsequently the value of the investment goes up to €5,500 when the investor comes to buy it, that investor would have lost €500 from the trade.

An ETF could also use leverage in order to magnify the returns on a portfolio. So for example, an investor could buy an ETF that trades 3 times the DAX (the DAX is a stock index that represents 30 of the largest and most liquid German companies that trade on the Frankfurt Exchange). This means that for every 1% movement in the level of the index, the ETF moves by 3 times that amount, i.e. 3% in this example. This feature actually adds risk since it magnifies the returns, both the positive ones and the negative ones.

ETF_like_stock

Top ETF Providers

Investors can find ETFs on any investment imaginable, from the more traditional types such as bond fund-like ETFs and stock exchange trackers to more avant-garde options like Fishing ETFs. Something to keep in mind when investing through ETFs is that the more narrow and small ETFs will have the bigger difference from the actual value of the portfolio they track and their actual trading price. It is normally best to stick to the larger based ETFs for more reliable pricing. Below is a list of the top-5 ETF issuers as at July 2015:

Rank Provider No of ETFs Assets (US$ Bln) Market Share (%)
1 iShares 756 1,101 36.7%
2 Vanguard 116 503 16.8%
3 SPDR ETFs 238 449 14.9%
4 Power Shares 179 103 3.4%
5 BD/x-trackers 351 82 2.7%
Source: ETFGI

The Bottom Line

ETFs are a great option to get access to a diversified portfolio of assets at a lower cost than if one had to build their own similar portfolio. One can use more focused ETFs to get a wide exposure to a particular market, such as a Natural Gas ETF if one wanted exposure to natural gas. They have some advantages over more traditional funds, however they are simply passive investments and will not try to outperform the market like traditional funds will.

Like any other investment they still have to be used with caution since certain features can actually increase rather than decrease risk in an attempt to achieve better returns. Like with any other investment it is always advisable to get professional advice from a licensed investment service provider when considering ETFs. If you used correctly and with full understanding of the way they work ETFs can be a good addition to any investors’ portfolio. 

KD

Securitisation and The 2007/09 Financial Crisis

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In the words of George Santayana, ‘Those who cannot remember the past are condemned to repeat it.’ For this reason I have decided to dedicate today’s post to the process of securitisation and how it was at the heart of the 2007-09 Great Financial Crisis. What have we learnt and is securitisation still important as a method of risk management?

I will try to keep the post as simple as possible but at times I will have to use some technical words. For the investment enthusiast the content may be a bit heavy at first but the important thing is to understand the overall picture and not the detailed specifics. For the readers with knowledge and experience in finance it is interesting to refresh your memory on the subject. The post will first attempt to introduce the key elements in a simplified manner and then a short clip will be presented at the end.

What is Securitisation?

Securitisation is the process in which certain types of assets are pooled so that they can be repackaged into interest-paying securities. For example, a bank would package together an amount of home loans (known as mortgages), or car loans or credit card loans or any other asset and then sell them off to a Special Purpose Vehicle (SPV). The interest and principal payments from the assets are passed through to the purchasers of the securities. Thus, the SPV then sells securities to investors which are backed by the assets it would have bought, hence the name Asset Backed Securities (ABS).

Securitisation is not a recent invention and has been in existence since the 1970 when home mortgages were pooled by U.S. government-backed agencies. In the 1980s other income-producing assets began to be securitised, and in the years leading to the financial crisis the market had grown quite dramatically.

Why Securitise?

One might wonder, what is the purpose of securitisation and why would banks in particular use it so much? To answer this question we must first recognise that banks are subject to increasingly strict capital requirements. This means that for any asset on a bank’s balance sheet it must keep or reserve a certain amount of capital. In a way, this reserved capital is an expense for the bank since it cannot use the funds for other profitable uses. Furthermore, traditional bank assets such as home loans are not very liquid, meaning they are not easily converted into cash at short notice. Therefore the bigger the loan book of the bank the more tied up capital it needs to keep on reserve and more the restricted it becomes.

However, if the bank had to somehow find a way of getting these slow moving assets off its balance sheet it would not have to keep any capital against them, plus it would have the cash to buy/create more profitable assets like new loans. Keep in mind that banks make commissions form new bank loans from the fees they charge, so the more bank loans they create, the more fees they earn. Therefore, one of the major advantages of selling off existing loans by securitising them is that the bank has more capacity to make new loans and earn new commissions.

Another advantage of using securitisation for a bank is that it can limit its risk exposure to a particular sector. Imagine Bank XYZ Ltd was specialised in construction loans in a particular geographical region. If the construction sector of this region had to slow down for some reason or another, bank XYZ Ltd would lose income and risk having more bad debts or defaults on its existing loans. Therefore, in order to be less dependent on these types of loans bank XYZ Ltd could securitise an amount of these construction loans and sell them off its balance sheet. By doing so  it is transferring the risk attached to these loans to someone else, plus it is getting new money to make new investments with.

How Securitisation Works

The table below helps us to understand better how the securitisation process works in more detail:

Securitisation

 

In essence the securitisation process involves just two steps:

Step 1 is for the bank to identify the assets (e.g. home loans) it would like to remove from its balance sheet and pools them into what is called a reference portfolio. This portfolio of pooled assets is then sold off to an issuer, such as an SPV which is normally set up by a financial intermediary specifically to purchase these portfolios and transfer the assets off-balance sheet.

Step 2 the issuer finances the purchase of the portfolios of pooled assets by issuing tradable, interest-paying financial products that are sold on to  investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the bank that originally made the loans keeps servicing them in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee.

The reference portfolio is not divided into assets with the exact same characteristics, however such assets form part of several slices, called tranches, each of which has different risk and return parameters associated with it and is sold separately. The more senior tranches would be the less risky ones, however they would also pay the less returns (mainly interest). The senior, least risky tranches would have first call on the underlying assets if something had to go wrong. Therefore, if there had to be a number of defaults in the reference portfolio first the senior tranches have to be paid off and then the least senior ones.

The conventional securitisation structure assumes a three-tier security design—junior, mezzanine, and senior tranches. In such a structure the junior tranche will be the one to suffer the first losses, then the mezzanine and finally the senior tranche. The senior tranches were regarded as very safe and unlikely to suffer any loss of value, and hence where often classified as AAA rated by the credit rating agencies. See more about credit rating agencies in one of my previous post on Bonds vs Bond Funds.

What went wrong?

In theory securitisation is a good thing both for banks and for people seeking loans. Banks, as we have seen, are able to make more money through fees by securitising loans and making new ones. On the other hand the people seeking out loans would find it easier to obtain credit since the banks are more able to lend them the money. So as long as banks are making more loans to individuals or entities that are of good quality and can actually afford the loans the whole economy will be better off.

The problem however is that when banks realise that they do not really have to keep any capital against the loans they make, since they are selling them off to some other entity, they may become more lenient and less interested in the quality of the borrower. This is exactly what happened in the 2007-09 Financial Crisis. As banks created more and more loans the amount of good quality borrowers who needed to take out a loan started to shrink. As a consequence, banks started to relax their screening and monitoring of borrowers. This eventually resulted into a system-wide deterioration of lending and collateral standards.

This means that more and more sub-prime (i.e. more risky) borrowers were finding it easy to obtain cheap money. As long as house prices keep rising and the banks can keep selling off these loans to investors the banks will keep earning more and more commissions. The problems will occur (as the they did in 2007-09) when the housing market no longer keeps rising and when (inevitably) the borrowers who could never afford the loans that they made in the first place will eventually default.

As any home-owner knows, a property can take a few weeks or years to sell off. If many borrowers are defaulting then the banks would have taken over the properties which were set as collateral for the loans. The situation would be that banks would end up with a lot of properties on their balance sheet which they cannot hold and would like to sell off quickly. Since the supply of properties is so high the prices have to fall. In turn, as prices keep falling the housing market gets worse and even more people would end up defaulting. Thus a downward spiral is created which then affected the entire economy.

An easy way to understand better all the above is by seeing the cool visual presentation below:

I hope you enjoyed the trip down memory lane, which is a lot easier to accept now that we have recovered from the lows of 2009!

KD