If you were to describe an elephant you would probably use words like stable, strong and solid. In the same way that nature created the elephant to exhibit these characteristics, so the financial industry evolved the technology of securitisation.
Designed to withstand a barrage of financial risk, securitisation should offer investors strong protections. However, what happens when you put an elephant on a tight rope? Clearly the picture changes and that once stable beast becomes dangerously unstable. This, metaphorically, was what happened with European securitisation in the run up to the financial crisis. The tightrope was leverage and the predictable outcome of making an elephant walk it was an almighty thud.
It’s now 10 years since the first tremors of the global financial crisis were felt. Over that decade, much of the blame for the crash has been placed on securitisation. This is unfair. In the wrong hands – those of the foolish and greedy – securitisation can be dangerous. But if used responsibly, it is a helpful technology that channels capital efficiently to the economy and offers investors exposure to risks and return profiles that match their investment objectives.
One of securitisation’s most appealing features is its flexibility. It can be used on granular assets like residential mortgages, with slices of many thousands of individual mortgages included in the resultant securities. Or it can be used to finance non-granular assets like commercial real estate loans, with just one to ten loans underpinning the deal. These deals offer very different return profiles.
So why has securitisation had such a bad rap? It’s not because it’s extraordinarily risky in itself. If we look at the performance of European rated structural finance between 2000 and 2016, we see that credit losses over that period amounted to just 0.25%. That’s not per annum – that’s for the entire 16-year period.
No, the problem was not with the assets – which demonstrated the solidity, sturdiness and stability that we might associate with an elephant. The problem was that these assets were used in a desperately irresponsible way, especially in the US. The elephant was forced to walk a tightrope. And the tightrope was leverage.
In the run-up to the financial crisis, investors – most notably structured investment vehicles (SIVs) – saw asset-backed securities (ABS) as stable assets that could be leveraged many times to create outsized “risk-free” returns. The logic was that the credit performance of the asset was likely to be stable and, therefore, the price performance should be stable. In other words, it was the elephant-like qualities of ABS that made them attractive.
But there were two problems. First, SIVs were designed to engage in maturity transformation: funding long-duration assets with short-duration liabilities that were in turn funded by issuing commercial paper. Secondly, SIVs’ leverage agreements had market-value triggers. If asset prices went down, SIVs had to sell assets rapidly to repay leverage. Most SIVs held a mix of US and European ABS. So, when the US market started to crumble, they sought to sell assets with the highest cash price: European assets. This process created a death spiral of indiscriminate selling. And so the elephant tumbled.
What does this tell us? The securitised assets generally behaved as expected. But the dangerous structure of the pre-crisis market set the market up for failure. The lesson? Don’t try and balance an elephant on a tightrope.
The regulatory response to the crisis has been punitive. Banks now have to hold much higher ratios of capital against investing in securitisation – many times those required for comparably rated assets. And it has also become much harder and more expensive for insurers to own securitised assets.
Regulators now appear to be seeing securitisation as a valuable means of getting capital into the economy.
Nevertheless, regulators now appear to be seeing securitisation as a valuable means of getting capital into the economy. Positive regulatory developments include requirements for far greater disclosure and the encouragement of much simpler structures. It is much harder to originate assets solely to securitise them (a contributory cause of the crisis).
The originators of assets must keep capital at risk in deals to align their interests with those of investors. This ‘skin in the game’ provides a degree of comfort. And the ratings agencies have been compelled to become much more conservative and transparent in their assessments of securitised products. Finally, regulation is forcing investors to demonstrate that they fully understand their securitisation exposures.
As a result, the elephant now has all four feet firmly planted on the ground. Securitisation assets are generally attractive compared with other fixed-income asset classes. As a result of the regulatory restrictions on banks and insurers, the investor base has narrowed – though those restrictions may be relaxed as the asset class’s rehabilitation continues. That would allow the technology of securitisation to serve its chief purpose: deploying capital to interesting parts of the economy. What investors must do is ensure that the elephant isn’t led along the tightrope again.