How will securitization shape up?

Cees Maas, IIF: self regulation can work for securitization

"We will carry on with securitization more as a client-driven financing offering rather than a transactional, arbitrage product. Partly for considerations of market perception, banks may run fewer vehicles only in select geographies. Structures will be simpler, with greater clarity on the underlyings. But these are merely adjustments to that business, rather than fundamental changes."

In its report, the IIF recommends that banks conduct the same level of due diligence and credit assessment on assets that they originate for future parcelling into securities and distribution as they would conduct on assets they intend to hold for a long period.

It is very careful that it does not recommend that banks be required to retain a portion of all loans and portfolios that they originate and securitize, as the European Commission has proposed. Partly, the reasoning is that investors should not take comfort from banks retaining such nominal positions, if the banks immediately turn around and hedge those credit risks in the CDS market. Indeed it might be a false signal. Secondly, banks should not be required to maintain economic exposures and be prevented from actively managing their exposures in the same way that all other investors are allowed to.

Banks are fearful that regulators, in their desire to stamp out bad practice, might impose capital charges or holding restrictions that could obliterate a hugely useful financial tool. If the EC’s proposal that banks be required to retain a 10% slice of securitized portfolios carries the day, that will increase capital requirements and, even if it does not close the market down, might well favour the large banks with big balance sheets over the investment banks that have been the leaders in the market to this point.

"Even the large European universal banks that might have seized a competitive advantage here came out against any such proposal," says Cees Maas, honorary vice-chairman and former chief financial officer of ING Group, recalling the working group debates.

Every banker Euromoney speaks to insists that securitization must continue and that there can be no wholesale return to the buy-and-hold banking model of the past where banks build up risk concentrations from their proximity to borrowers in narrow geographic and industry sector buckets. All cite the contribution of securitization and other forms of innovative financing to the funding of world economic growth.

There’s something a little unsatisfactory in all this.

One banker admits: "I have been in deal approval meetings where bankers have said ‘this is not a bankable deal, we would not keep this on our balance sheets so let’s just get it out the door.’ And that was a serious mistake. In part, that is what led from LBO loans being done at leverage multiples of 3.5 times ebitda to being done at eight times ebitda."

Can and should what amounts to self-regulation fix this?

Maas says: "Yes, I think it can. It is important to keep that model alive when you bear in mind the need to mobilize savings from legitimate long-term holders such as insurance companies and pension funds to key parts of the global economy including many corporations and emerging market governments. The world has moved very far on from the days when emerging markets growth was sustained by commercial bank lending." Rick Waugh, CEO of Scotiabank, adds: "Remember there are certain assets that it’s simply improper for banks to hold. Retail deposits may be seen to be stable source of funding but should they really be used to roll over 20-year infrastructure finance loans?"

Maas offers his prescription. "Banks must originate and underwrite these assets as if they were prepared to hold them, or face the risk of being sued by investors if anything goes wrong and those investors say ‘OK where is the documentary proof that you assessed this as you would if you intended to keep it, where is that in the prospectus?’ Investors must take some responsibility too to ask banks if they intend to retain assets, ask about what due diligence they have done and take decisions to buy or not accordingly."

Another incentive might be for regulators, under Basle II, to seek evidence of banks’ due diligence in assessing warehoused credits and applying capital charges if they are not satisfied.

Gerald Corrigan’s group is particularly suspicious of highly structured complex instruments. It suggests a much higher bar for investor eligibility to buy them and demands that term sheets for highly complex instruments must have a "financial health" warning prominently displayed in bold type indicating the potential for significant loss.

Those kinds of health warnings have slowly but surely reduced sales of cigarettes in the developed world. Maybe Corrigan will do the same for complex structured products. He says: "It may well be that one or two classes of high-risk financial instruments fades away. I don’t see CDO squareds playing much of a role in the future… and that wouldn’t be the end of the world as far as I’m concerned."