Securitisation is not dead. By Michael Heise, chief economist Allianz Group/Dresdner Bank


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Crises change markets. The Savings & Loans crisis pushed US banks into securitising mortgages; the European ERM crisis ultimately gave birth to the euro; the Asian debt crisis shifted the policy debate in the emerging markets and eventually strengthened them. These are some examples of past experience. What will change after the latest financial crisis? Or more specifically, what will happen to securitisation?

The economics of securitisation are still valid. From an economist’s point of view, it makes perfect sense to shift credit risks around. It enables banks to originate new loans and it offers investors a new asset class with attractive risk-return profiles. It is a much more efficient way to get exposure to credit risk than, say, by investing in bank stocks or deposits.

However, the subprime debacle made clear that something was rotten in the state of securitisation. The problems start when ever more complicated structures (CDOs and the like) are used to create AAA securities out of patchy assets. Such financial engineering can work if the valuing of underlying assets is done correctly. However, more often than not financial engineering degenerates into “financial alchemy” aimed more at obfuscating the quality of underlying assets. Initially, it brings huge benefits: the higher the rating the lower the capital requirements for holding such securities. Thus, investors can use a higher leverage.

And problems finally get out of hand when such “structured” loans are not sold to real money investors but shifted into the unregulated world of hedge funds, SIVs and conduits. These are leveraged investors sui generis and rely heavily on short-term financing. Their business model is maturity transformation – but without the hack of banking regulation.

In other words, securitisation goes awry if it is not based on attractive risk-return profiles but built solely on leverage. As always, highly leveraged markets are also highly vulnerable, unable to withstand external shocks. And shocks are inevitable, especially if leverage is backed by false risk perceptions as was the case with CDOs. When some securities had to be downgraded, the house of cards inevitably started to crumble. At the very moment investors needed financing, liquidity dried up.

But the question remains: Why did the sound business model of securitisation degenerate into a hazardous game of leverage? The answer is quite simple: razor-thin credit spreads.

Recent years saw a marked decline in risk premiums, triggered by the liquidity splurge of central banks. Earning decent profits in such an environment requires leverage which inflates profits.

Therefore, with the expansion of “leveraging” and “structuring” in full swing, low spreads were no longer painful. Even spreads of a few basis points could be magically transformed into eye-watering profits – if AAA-rated super senior tranches were at hand. But that was no longer a real problem for the financial engineers and their institutions.

The catch: As the techniques to survive a low spread environment gained momentum they became the main reason to drive spreads further down, regardless of fundamentals. Although nearly everybody warned of “mispricing” of credit risks, spreads continued to fall as the securitisation machinery spewed out AAA securities. In the end, the process became a self-destructive race to ever lower spreads and higher leverage.
With the purge of the crisis, the conditions for a replay are gone:

  •  Rating agencies can no longer act as consultants and auditors. Investors paid too heavily for their blind trust in ratings to continue with business as usual. But as it is nearly impossible to reduce the role of ratings in modern financial markets, the only way forward is tighter external oversight over rating agencies. In my view, rating agencies which are an indispensable part of the regulatory framework under Basel II can no longer be seen as mere “opinion issuers”. We need a new “watchdog” to monitor the rating industry, from corporate governance structures to the integrity of models and information.

  •  Investors will no longer provide short-dated funds to vehicles outside the regulated banking world. Access to central banks, the only source of unlimited liquidity in times of stress, will become a decisive argument for attracting short-term money. That undermines the economic viability of SIVs. The process of de-leveraging has already taken place, as the shrinkage of the ABCP-market shows.

  •  Regulators, too, will no longer tolerate the “shadow world” and will mistrust the promises of credit structuring. Expect higher capital requirements for complex securitisations and stricter rules for consolidating special investment vehicles. Hedge funds and other Highly Leveraged Institutions will no longer be able to remain more or less outside supervisors’ scrutiny.

Clearly, tighter regulation will rein in the securitisation frenzy. Hopefully, it will not kill it. In any case, banks’ profits will take a knock in the immediate future. But over time, banks can live without super-sized leverage – if credit spreads are high enough reflecting adequate risk premiums. As the episode of securitisation wizardry closes, a major factor bringing credit spreads down is now absent.

Therefore, in the foreseeable future spreads will not return to pre-crisis levels but stay higher. Banks will revert to old business practices, keep more risks on their books, focus on advising clients and take care that liquidity requirements are met. Like former crises, the subprime crisis will trigger substantial change – but not more financial innovation, rather restoration of some basic principles of risk management.