Tuesday, July 1, 2008

Securitization: A re-emerging market?

(FT) A year ago, 5,000 bankers crowded into the conference rooms of a water- front hotel in Barcelona for the annual meeting of the European Securitisation Forum. They were there to discuss the corner of finance where debt is sliced and diced into bonds. Business was booming as banks discovered ever more innovative ways to bundle up assets such as mortgages and sell them on.

For the 2008 event last month, the ESF booked an even bigger and smarter venue, in Cannes. But this time round the halls were half-empty, with just 3,000 present. In recent months, activity in many corners of the securitised world has dried up, as investors have fled instruments such as mortgage-backed bonds. "It is a different environment now - we have to recognise that," says Rick Watson, head of the ESF.

The main question for policymakers - not to mention those bankers who are losing their jobs - is just how long this freeze will last. Now that almost a year has passed since the credit market turmoil erupted last August, the state of the securitisation industry has become crucially important not just for the banks but for the financial system as a whole - and for all those borrowers around the world who have been relying on the banks for cheap funding in recent years.

Bankers - and bank investors - fear it will be difficult to return western banks to a state of true health unless securitisation springs back to life. "The financial model where banks originate loans and then distribute those risks through securitisation has to continue," says one industry consultant. "It is impossible for banks to finance the entire economy with their balance sheets alone. The question is what form the securitised market will continue in - and whether there are steps that can be taken to help it return to a more normal state faster than it otherwise would."

Securitisation was developed in America almost three decades ago, when bankers started using mortgages to issue bonds. The attraction of this alchemy was that bonds can be traded much more easily than loans and can be modelled to fit investors' specific tastes. It later spread into sectors such as corporate and consumer debt. Then this decade the idea jumped across the Atlantic and proliferated at a heady rate.

Bankers discovered ways to create bundles of securitised bonds, known as collateralised debt obligations - and then started using these to issue new bonds (creating instruments with names such as collateralised debt obligations of asset-backed securities, or CDO squared).

Changes in regulation also fuelled growth. The Basel capital adequacy rules that were introduced two decades ago permit banks to use their capital far more efficiently if they repackage their loans into bonds that are then sold to outside investors. Thus the traditional "originate to hold" model of banking turned into an "originate to distribute" model.

The shift served many banks, and bank investors, very well. "Executed correctly and in the right market conditions, the originate-to-distribute model allows an investment bank to grow earnings very rapidly indeed," notes Credit Suisse in a research report.

The securitisation boom has also benefited many borrowers. As banks have benefited from this so-called "capital efficiency" - which essentially means the ability to extend more loans on a smaller capital base - they have partly passed this saving on in the form of cheaper loans. More-over, until very recently, many regulators also believed that securitisation had made the financial system safer as a whole, since the practice of spreading risks among many investors was supposed to ensure that losses were never too concentrated.

However, the events of the last year have turned this seemingly virtuous cycle into a vicious spiral. Regulators have discovered that risk dispersal carries drawbacks: it enabled the contagion from American subprime mortgage defaults to be spread across the globe. They have also become aware that a lot more of the original loans were kept on banks' balance sheets than had been thought. "One of the paradoxes of the securitisation crisis comes from the fact that banks held on to significant portions of senior risk [or highly rated bonds] through lending to hedge funds or through liquidity guarantees to off-balance sheet vehicles - and they did so to a much greater degree than regulators would ever have envisaged," Michel Prada, head of the AMF, the French financial watchdog, told the Cannes conference.

Meanwhile, bankers have discovered that "capital efficiency" can create risks: if banks cannot sell bonds to investors and are forced to hold these on their balance sheet instead, they may run short of capital. In the past few months it has become increasingly difficult to sell securitised bonds, because investors have panicked about the opacity and complexity of these instruments and in effect gone on strike.

While rapid innovation in the securitisation market used to make the products seem exciting, it also meant that the sector grew out of control. More specifically, as subprime losses have mounted, investors have discovered that these products are hard to understand, let alone value - partly because the infrastructure for the market is still weak relative to the complexity of the instruments.

This has had a devastating impact. Back in 2006, or the last full year of activity before the credit turmoil, some $1,800bn (£903bn, €1,141bn) worth of securitised products other than government-backed mortgage securities was issued in the US alone - double the level of 2004. So far this year, by contrast, just $100bn of US products has been sold and considerably less in Europe. Activity in the secondary markets for securitised products dried up as well, as investors stopped trading except if forced into a fire-sale.

For the wider economy, this dries up the supply of cheap credit to banks' customers. "As the expression goes, 'A rolling loan gathers no loss', says Meredith Whitney, analyst at Oppenheimer & Co. "The consumer's ability to finance his way out of trouble has diminished greatly."

Oppenheimer has calculated that since 2000, the volume of US mortgage lending financed by securitisations was seven times higher than the level funded by traditional bank loans. Indeed, in 2005-07 alone, securitisations accounted for $2,500bn of American mortgages, compared with a $431bn growth for on-balance-sheet loans. "Securitisations evolved from a footnote in the consumer loan origination market to peaking at 66 per cent of household borrowings in the first quarter of 2007," says Ms Whitney.

Some bankers see signs of recovery in the secondary markets, where bonds are traded. "The real money is starting to come in now - and it is encouraging that we are not seeing so much distressed selling," Greg Branch, a Deutsche Bank trader, told the Cannes gathering.

More important, some banks are continuing to create securitised products. Bundles of student loans and automotive loans, for example, are still being repackaged and sold to investors in America, albeit on a smaller scale than before. So, to an even more limited degree, are European and American corporate loans. HBOS, the big British lender, even managed to sell a £500m ($997m, €632m) pool of securitised UK mortgages last month - the first large mortgage securitisation seen in Europe since the crisis erupted.

In addition, declares a team at JPMorgan Chase, the future remains bright for collateralised loan obligations - a $500bn sector that uses pools of corporate loans, often made to companies with low credit ratings, to back bonds. "Despite the throes of the 'credit crunch', the future of leveraged loan securitisation is solid," it has been telling clients, urging investors to view these CLO products as "a buy".

None of this, however, can dissipate the overall sense of gloom that pervades the securitisation world. In practical terms there are at least three factors undermining securitised finance. One is the widespread loss of investor faith in valuations of securitised products. While investors used to navigate this complex world with the help of credit ratings, the agencies have been forced to downgrade trillions of dollars of debt in recent months, which has badly undermined confidence.

Another problem is the investor base. In recent years some "real money" asset managers, such as pension funds, bought securitised products. However, especially in Europe, a large chunk of demand also came from hedge funds and from off-balance-sheet entities linked to banks.

The banks themselves also bought securities, particularly highly-rated instruments, since regulatory rules made it cheap for them to keep triple-A rated securities on their books. Citibankestimates that banks have accounted for 30 per cent of the triple-A rated market in recent years, while off-balance-sheet vehicles acquired another 20 per cent.

But most of these buyers are currently sitting on their hands. Hedge funds can no longer get cheap credit lines from banks, and many special investment vehicles and conduits have virtually collapsed. The banks are no longer able to support the market, since they have their own balance-sheet woes. "One of our biggest challenges as an industry is how to restore the triple-A investor base for securitisations," says the ESF's Mr Watson. "This isn't just a confidence issue (although that is an important issue) but is an institutional structure issue."

To make matters worse, the securitisation sector faces rising regulatory pressure. Over the past decade, policymakers have generally supported the "originate to distribute" model and, even now, regulators stress that they continue to see its benefits. "Originate to distribute has merits," says Malcolm Knight, head of the Bank for International Settlements in Basel.

However, regulators face growing criticism that they have failed to spot weaknesses in the model - and are scrambling to find ways to curtail some of the wilder excesses. Earlier this year, for example, the Financial Stability Forum - a group of international regulators and central bankers - proposed that banks should post higher capital provisions when they create some securitised products. The FSF is also looking for ways to discourage banks from constantly securitising products, over and over again, as they have often done this decade. "Securitisation in its simplest form is a great innovation," says Imene Rahmouni Rousseau, a senior official at the Banque de France. "But the paradox is re -securitisation. Products such as 'CDO of ABS' create problems because of complexity, lack of trust and misaligned incentives."

Separately, American officials are considering changing the accountng rules to force banks to take many off-balance-sheet vehicles back on to their balance sheets. "The majority of securitised assets are likely to come back on balance sheet," Citigroup analysts say in a recent note. "We doubt that the proposed changes . . . would mean the end of the securitisation market. However, we do have concerns about some of the changes . . . which could potentially require issuers to raise more capital and keep assets on balance sheets."

Optimists in the banking world point out that the securitisation business has rebounded from blows before. Back in the 1990s, for example, many thought that the collateralised mortgage obligation market was almost dead as a result of investor losses and scandals, but it was revived in a new form.

Indeed, many bankers are now trying to find ways to make securitised products attractive to investors again. Banks are exploring how to make these instruments more transparent and more standardised, so investors can feel more confident that they know what they are purchasing. Markit, the London-based data provider, has just declared that it would start publishing new information on European securitised products in an effort to demystify the market.

"Straightforward securitisation will come back," says Richard Berner, economist at Morgan Stanley, who predicts that the real attrition will occur at the more complex end of the market, with products such as CDO squared. Or as JPMorgan says in its own CLO note: "For 'new' CLOs it's a case of back to the future: cleaner portfolios, less investor and structural reliance on leverage, and a normalisation of risk-taking all played a part in market recovery after the last cycle."

Still, this new "flight to simplicity", as some bankers dub it, has a catch: when products become simpler and more transparent, they also tend to produce far lower fees than the esoteric instruments that have flourished in recent years. That might be good news for investors; however, it will certainly not produce the bonanzas that bankers - and bank equity investors - have enjoyed in recent years.

A "back to basics" campaign in securitisation may, in other words, also mean going back to old-fashioned, and much lower, bank profits.

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