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:
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