Overconfidence, greed, and speculation: a mix of ingredients which combined with some misalignment of interests and increasing leverage, created the dish that was too spicy for the financial system to digest, as the recent financial crisis made clear. In the movie The Big Short the story is shown of how the use of securitisation went horribly wrong and contributed to the break-down of many parts of the financial system.
Based on this movie one could easily conclude that securitisation is wrong and that this financial technique should surely not be used any more. But is this really the case? I just watched the Big Short with great interest, especially considering that a large part of my career I’ve been investing in securitisations. I want to share my thoughts on the matter with you …
Securitisation is the process of bringing loans together in a pool and then selling the risk in different packages by issuing securities to investors. The loans are the assets and the securities issued are backed by these loan assets, hence the name Asset Backed Securities (ABS). When the loans are mortgages, the issued securities are named Mortgage Backed Securities (MBS).
If you want to prepare a good dish, you need good quality ingredients. The same applies to securitisations. The ingredients that played a key role in the recent financial crisis are mortgages. Mortgages are backed by houses as collateral, which may give quite a bit of comfort. If the loan is not repaid, you get to own the house! However, how many houses do you want to own at the same time? And how much are these houses worth versus the outstanding loans?
In order to determine how attractive investing in a securitisation actually is, you need to know in detail how the loans came about and understand the characteristics of the loans. Rating agencies were expected to play a helpful role in getting this insight. Unfortunately, in a number of cases they turned out to be more concerned about their own market share. Instead of delivering high quality ratings for the long run, they were focusing on growing next quarter’s earnings and profit.
Mortgage providers originated new loans and sold them on shortly thereafter, transferring all the risk to the investors in mortgage securitisation. Banks structured and sold the securitisation notes, while rating agencies provided a rating for each of the notes. The rating agencies focused on the advantages of high diversification and the increased housing prices to justify the inclusion of increasingly risky mortgages in the securitisation portfolio. All parties earned fees for their services.
It was all too easy and attractive for many to participate in this game of selling houses and providing mortgages, as the risk could be passed on quickly to the end investor in securitisation notes. Consequently, the standards decreased. Loans were given to those who could not afford it. The NINJA loan became a well-known product: NINJA stands for “No Income No Job or Assets” meaning that anyone could get a loan, also if one was jobless without savings or other assets. These NINJA loans ended up in rated securitisation notes and many investors did not question the ratings nor did they assess the quality of the ingredients of the securitisation themselves.
The Big Short makes it very clear how using the technique of securitisation could and has led to bad investments. At the same time, my experience as an investor, is that you can play an important role to ensure securitisations result in sound and solid investments. And not just investors, many other participants in the securitisation chain can do so and – despite what prevails in people’s memory - have been doing so!
Sound loan underwriting is where it all begins. This boils down to common sense. Ability to repay – in other words, having a stable reliable income – and knowing the value of any property used as collateral, also in times of economic hardship. These are just logical checks.
Are the parties that play a role in getting the securitisation executed in it for as long as the investor? The originator of the loan, should be willing to hold that loan on its balance sheet for the life of that loan. Thinking in terms of participating in a securitisation, the originator should be willing to hold a meaningful share in the risk of losses on these loans to ensure alignment with the investors.
As the originator of the loan can be expected to have much more information about the borrower than the investor in the securitisation, it makes sense that there is a quality check on the loans just before they go into the securitisation portfolio. Fresh fish, please! If the chef does not want to eat the fish soup he’s just prepared, why would you? It seems obvious, skin in the game, making sure the interests of different parties – originators of the loans and investors in the securitisation - are aligned is so important.
My experience is that investing in securitisations is not something to do quick and easy. It requires intensive due diligence as you need to understand what you are investing in. This applies to the characteristics of the underlying loans, the reason they exist and the legal contracts arranging the securitisation in effect.
Many securitisations are used for legitimate purposes: to help banks and other financial intermediaries to lend to their clients such as small, medium and large enterprises, consumers, home owners, renewable energy projects and many other parts of the real economy.
By using common sense, ensuring high standards are maintained, the financial technique of securitisation can offer attractive investment opportunities, so you can achieve a sound portfolio of investments that add value and risk diversification to the portfolio of your client.
Want to read more?
Position paper on Simple synthetic securitisation
The Benefits of Securitisation