SECURITIZATION : EARTHBOUND / THE ECONOMIST ( HIGHLY RECOMMENDED READING )

Securitisation

Earthbound

Mar 25th 2010 NEW YORK
From The Economist print edition

Large parts of the securitisation markets remain stagnant. Not all efforts to reform them are helpful

FOR most capital markets, the financial crisis resembled a stomach-churning bungee jump: a precipitous fall followed by a sharp rebound, albeit not to the heights enjoyed before the turmoil. The big exception was securitisation, large parts of which are still dangling near the ground. Even as it struggles to recover, the market that brought the world the joys of collateralised-debt obligations faces two stern tests: the phasing-out of central-bank support and a raft of tougher rules.

Securitisation’s boom and bust was spectacular. The packaging of mortgages, car loans, credit-card receivables and other debt to sell to capital-markets investors began to take off in the 1980s. By 2006 it was being used to channel around two-thirds of all residential mortgages and half of all consumer credit in America. By distributing loans, banks could cut their capital needs, allowing them to lend more. Hedge funds, insurers and the like gained access to a broader range of credit risks.


As the boom reached fever pitch, however, the quality of the loans being pooled into securities dived, especially in mortgages. When losses started to mount, asset-backed issuance dried up (see chart), forcing governments to take up the slack. In some parts of the market, they are now stepping aside again. The Federal Reserve is winding down its liquidity support for credit-card and car-loan transactions. Some $5 billion of prime, private-label car deals were priced in February. Structured vehicles for risky corporate loans are making a comeback, too.

By contrast, housing markets remain almost wholly reliant on government-backed agencies to package and guarantee mortgage-backed securities (MBSs). No residential MBSs have been sold in America without such backing for more than two years. Europe has seen a few private deals, but these were structured to be highly attractive to investors and acceptable as collateral at the European Central Bank’s discount window. No wonder Ralph Daloisio, chairman of the American Securitisation Forum, talked of an “existential” crisis in his speech to the industry group’s annual conference last month. He even wondered what Jean-Paul Sartre would make of it.

The prosaic reason for the dearth of private issuance is the wide gap between what investors demand and what borrowers will pay. “Jumbo prime” mortgages, decent-quality loans above the price threshold that Fannie Mae and Freddie Mac can buy at, are likely to be the first part of the new-origination market to come back. But it is currently non-economic to securitise these loans, says Laurie Goodman of Amherst Securities. To place a new issue, given the yields demanded by investors, the interest rate payable by borrowers must be 6.85%, a full percentage point higher than current levels. This differential is “the fundamental issue” for MBS markets, argues Tim Ryan of SIFMA, a securities-industry association. Rating agencies’ belated tightening of their methodologies has made this gap even harder to close.

The market for mortgage securities issued by Fannie and Freddie is also about to be tested. The Fed’s purchases of almost $1.25 trillion-worth of such MBSs since last year have helped keep rates near record lows. But this programme is due to expire at the end of March. Most think the effect of the Fed’s withdrawal will be muted, because the move has been telegraphed and because there is money on the sidelines waiting to take the Fed’s place. But rates are still expected to rise at a time when housing demand remains muted: sales of new homes hit a record low in February.
Investors also want the future shape of the industry to be clearer. On both sides of the Atlantic, lawmakers are struggling to strike the right balance between encouraging a revival of securitisation and protecting the financial system from the instability it can produce. Take the bill currently being debated in America’s Senate. Few would argue with its tightening of disclosure requirements, including more information on loan repurchases so that investors can better identify shoddy lenders. Similar calls are coming from central bankers, who want more data on the securities that they accept as collateral.

The benefits of the bill’s requirement that securitisers retain 5% of a deal’s credit risk are less clear. Toughening up the warranties that securitisers sign, agreeing to buy back duff loans, would have the same effect without tying up precious capital. And forced asset-retention could constitute “control” under new accounting rules. If so—no one seems sure either way—issuers would have to hold capital against the entire deal, not just the retained slice.

Another turn-off is the uncertainty surrounding “safe harbour” rules, which were created to reassure investors in securitised assets that they would continue to receive payments if a sponsoring bank failed. Revisions proposed by the Federal Deposit Insurance Corporation (FDIC)—on hold for now—would punch holes in this ring fence, say industry groups.

A more immediate worry is the cacophony of competing interests exposed by the downturn. Banks that service mortgages, for instance, are reluctant to forgive principal, even if that would benefit borrowers and investors, because it would trigger write-downs of second-lien loans on the banks’ own books. One investor likens mortgage securitisation to “class warfare” (although Bank of America’s decision to forgive some principal on a limited number of loans may herald a wider ceasefire).

For many, the most off-putting factor is the question-mark hanging over Fannie and Freddie, which have been in government conservatorship since September 2008. Until their role is clarified, the future shape of the market, and the opportunities for private competitors, are unknowable. In testimony this week Timothy Geithner, America’s treasury secretary, said that he was committed to encouraging private capital back into the market and to shaking up the two agencies. But no details were offered. Amid such uncertainty “only a madman would ramp up securitisation efforts now,” says one banker.

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