IMFSurvey Magazine: IMF Research
GLOBAL ECONOMIC CRISIS
Revive Securitization to Speed Exit from Crisis, says IMF
By John Kiff
IMF Monetary and Capital Markets Department
September 21, 2009
- Failure to restart markets may mean less credit and more financial stress
- Reduce incentives for relying on credit ratings, improve disclosure and incentives
- Study combined impact of policy proposals to ensure reforms will work
Restarting securitization markets, particularly in the United States, is critical to limiting the fallout from the economic crisis, and to eventually withdrawing central bank and government support, the IMF said.
Since the crisis began, investors have shunned securitization products, such as mortgage-backed securities, and central banks and governments have taken up the slack with various programs to support securitization markets, the IMF said in a chapter of its latest Global Financial Stability Report, issued on September 21.
While many question whether it would be worthwhile to restart the market for securitized assets, the IMF argued it is necessary, although with reforms to guard against the excess that caused the markets to implode. If private investors return to the business of securitizing loans again, central banks and governments can withdraw from their role as “buyers of last resort,” which makes restarting these markets important to exit strategies, the IMF said.
Securitization allows less liquid, income-generating assets, such as home mortgages, to be packaged into securities and sold to investors. The latest round of reforms and the IMF report are focused on securitized instruments that are “tranched,” which means they are divided into portions, making payments first to the “senior” tranche holders, then to “mezzanine” tranche holders, with “equity” tranche holders getting whatever is left over. They allow risks to be split up and distributed to a more diversified set of holders. In Europe, covered bonds, a form of securitization in which the originator retains an economic interest in the loans, also play a key role in financing mortgage lending (see box).
A covered bond is a secured debt obligation collateralized by a dedicated portfolio of assets (the cover pool) that is kept by the issuer on its balance sheet. Because issuers of covered bonds are fully liable up to their registered capital, there is a double layer of protection for investors—the assets and the issuer. Most covered bonds are issued under special laws that set prudential standards for product structures and the credit quality of the cover pool, to limit incentives for excessive risk-taking and slippage in underwriting and monitoring standards. In Europe, covered bonds have long been the preferred method of capital market-based mortgage funding. But covered bonds do have a downside: They do not provide the balance sheet leverage and regulatory capital relief commonly associated with securitization in which the pool of assets backing a bond is moved off the issuer’s balance sheet.
Before the crisis, securitization was a key source of support for consumer lending, including student loans, car loans, credit cards and mortgages, according to the IMF.
Restarting the market
The IMF report puts forward a number of specific policy recommendations, to address the shortcomings of securitization, which include:
• Reduce incentives to rely excessively on credit rating agencies and rating-related regulatory requirement gaming. Rating agencies should disclose their methodologies and publish their rating performance data. Regulators and other rulemakers should reduce reliance on ratings.
• Improve securitization disclosure and transparency standards—at the product level to facilitate more investor do-it-yourself risk and return analysis, and at the issuer level to produce financial statements that more accurately reflect their securitization-related exposures.
• Provide incentives for securitizers to retain some exposure to the performance of their products to better align their interests with those of investors, including basing securitizer compensation on the longer-term product performance.
• Simplify and standardize securitization products to improve liquidity, and reduce valuation and risk management challenges
The IMF report says that not only is it important to reform accounting standards and prudential regulations, it is equally important to evaluate how they might interact before any are implemented. Impact studies should be conducted to ensure that, in combination, they promote sustainable securitization, the IMF said. If not, there is a risk that they could further impede, not help restart securitization, by inadvertently making the process too costly.
End of “high octane” markets
Prior to the crisis, securitization market growth was fueled increasingly by “high octane” products that made little economic sense except to those collecting fees, the IMF said. These included resecuritizations, such as collateralized debt obligations of collateralized debt obligations, known as CDO-squared, as well as collateralized debt obligations of mortgage-backed securities backed by subprime mortgages. Some of these products were effectively disposing of tranches for which there were no buyers, and designed to exploit holes in credit rating agency methodologies. Had investors been able to see the flaws in the rating methodologies with more information about the underlying risk exposures, they could have insisted on additional credit enhancement, but the complexity of many of these products made it difficult to detect how credit ratings were assigned.
The impact of this over-reliance on credit ratings was exacerbated in many cases by a paucity of information regarding the underlying risk exposures, according to the IMF. Moreover since the need to maintain high credit ratings was well entrenched in various regulations, when downgrades did occur, they spread quickly through the financial system with devastating effects.
Securitization encouraged additional financial players, interested in the fee-making opportunities, to participate in the process. In the old, bank-dominated mortgage lending business model, borrowers dealt directly with lenders. But the new “originate-to-distribute” model inserted numerous fee collecting firms between the borrower and the ultimate creditor. For example, credit rating agencies that earned the bulk of their revenue from securities issuers were not properly motivated to look out for the final investors, who had come to rely on their ratings. The compensation of investment banks and dealers was based on sales volumes, with little regard for the longer-term performance of the securities.
Furthermore, accounting rules and regulatory standards allowed financial institutions to play “shell games” with various securitization-related operations. As a result, market participants and even the authorities were shocked at the domino effects that followed the breakdown in the U.S. subprime mortgage markets.
In contrast, the market for covered bonds has weathered the storm fairly well (see box).
Andy Jobst, Michael Kisser, and Jodi Scarlata also contributed to this report.
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