If you asked regulators in 2008 which financial instrument they most wished had never been invented, odds were that they angrily splurted a three-letter acronym linked to securitizzation. The practice of bundling up income streams such as credit-card and car-loan repayments, repackaging them as securities and selling them on in “tranches” with varying levels of risk once seemed like enlightened financial management. Not so after many a CDO, CLO, ABS, MBS and others (see table) turned out to be infested with worthless American subprime mortgages.
Find the same regulator today and he is probably devising a ploy to resuscitate the very financial vehicle he was bemoaning five years ago. Enthusiasm for the once-reviled practice of transforming a future income stream into a lump sum today — the essence of securitization — is palpable. In Britain, Andy Haldane, a cerebral official at the Bank of England, recently described it as “a financing vehicle for all seasons” that should no longer be thought of as a “bogeyman.” The European Central Bank (ECB) is a fan, as are global banking regulators who last month watered down rules that threatened to stifle securitization.
Watchdogs will be pleased that, after once looking as if it was heading for extinction, securitization is making a recovery. Issuance of ABSs (securities underpinned by car-loan receivables, credit-card debt and the like) are at double their 2010 nadir. Issuance of paper backed by non-residential mortgages is up from just $4 billion in 2009 to more than $100 billion last year. There have even been offerings of securities underpinned by more esoteric sources, such as cash flows from solar panels or home-rental income — the sort of gimmick once derided as a boomtime phenomenon. Excluding residential mortgages, where the American market is skewed by the participation of federal agencies, the amount of bundled-up securities globally is showing a steady rise (see chart).
The comeback of securitization is related to the growth in economic activity: in order for car loans to be securitized, say, consumers have to be buying cars. Investors desperate for yield are also stimulating supply: securitized paper can offer decent returns, particularly at the riskier end of the spectrum. More important, though, is the regulators’ enthusiasm.
Why are regulators so keen on the very product that nearly blew up the global economy just five years ago? In a nutshell, policymakers want to get more credit flowing to the economy, and are happy to rehabilitate once-suspect financial practices to get there. Some plausibly argue it was the stuff that was put into the vehicles (i.e., dodgy mortgages) that was toxic, not securitization itself. This revisionist strand of financial history emphasizes that packaged bundles of debt which steered clear of American housing performed well, particularly in Europe.
The need to revive slicing and dicing is felt most acutely in Europe. Whereas in America capital markets are on hand to finance companies (through bonds), the old continent remains far more dependent on bank lending to fuel economic growth. Its banks need more capital, and absent that are the weak link in the nascent recovery because they fail to meet demand for credit from consumers and small businesses.
This is in large part because regulators want banks to be less risky, by increasing the ratio of equity to loans. As banks are reluctant to raise capital, they need to shed assets. This is where securitization helps: by bundling up the loans on their books (which form part of their assets) and selling them to outside investors, such as asset managers or insurance firms, banks can both slim their balance-sheet and improve capital ratios.
Securitization “airlifts assets off the balance-sheets of banks, freeing up capital and drops them onto the balance-sheets of real-money investors,” in Haldane’s words. That may not seem urgent now, as Europe’s banks are flooded with cheap money from the ECB and have years before stricter capital ratios officially kick in. But at some point markets will have to take over financing banks. Such airlifts would neatly transform Europe’s inflexible bank-led system into something more akin to America’s.
Financial watchdogs are also keen on securitization because they are confident that they can steer it along a different path from the one that ultimately wrought havoc in 2008. They believe that regulatory tweaks have made the practice safer.
One improvement is that those involved in creating securitized products will have to retain some of the risk linked to the original loan, thus keeping “skin in the game.” The idea is to nip in the bud any temptation to adopt the slapdash underwriting practices that became a feature of America’s mortgage market in the run-up to the financial crisis. Another tightening of the rules makes “re-securitizations,” where income from securitized products was itself securitized, more difficult to pull off. If regulators have their way, financial Frankenstein monsters such as the “CDO-squared”—a security underpinned by a security underpinned by a security underpinned by assets — are unlikely to make a comeback.
Perhaps the biggest change, however, is in investors’ attitudes. Before 2008, many fell for the sales pitch of the whizzes who hatched CDOs, ABSs and the like. Reassured by somnolent credit-rating agencies, which backed the bankers’ vision of handsome returns at virtually no risk, investors piled in with no due diligence to speak of. Aware of the reputational risks of messing up again, they now spend more time dissecting three-letter assets than just about anything else in their portfolio. Regulators will have to make sure that they retain this newfound discipline.
© The Economist Newspaper Limited, London (January 11, 2014)