A home for auction: securitized assets, like mortgage-backed securities, create risks and benefits to financial stability (photo: Neville Elder/Corbis)
FINANCIAL STABILITY
Securitization creates a financial instrument by bundling financial assets, such as individual loans, and then selling different tiers of the repackaged instruments to investors. The process transforms a pool of otherwise illiquid assets into tradable securities, enabling investors to purchase a small share of a large asset pool. One example is mortgage-backed securities.
What securitization can do
A healthy market for securitization can confer important financial benefits, and revitalizing this source of financing has emerged as a key area of focus for policymakers, according to new analysis from IMF economists.
As a means of efficiently channeling financial and economic resources, securitization supports economic growth and financial stability by enabling issuers and investors to diversify risk. By opening up new avenues for raising capital, securitization can aid in diversifying the funding base of the economy. Securitization can also help free up bank capital, which in theory allows banks to extend new credit to the economy, the IMF said.
These issues are particularly relevant in Europe where capital markets are underutilized as a funding source for the economy, and banks remain under pressure to deleverage and are reluctant to lend in an environment with so much economic uncertainty.
“Restarting and expanding securitization would create room for banks to fund small and medium-sized enterprises,” said José Viñals, the IMF’s Financial Counsellor and Director of the Monetary and Capital Markets Department.
Maximize the benefits, minimize the risks
However as the global financial crisis showed, securitization can create risks to financial stability. Poor underwriting standards for loans, flawed ratings, and incentives that allowed intermediaries to issue securities without assuming any of the risk were coupled with a fragile and highly-leveraged investor base.
Yet global securitization markets expanded without causing economic or market disruptions in the three decades leading up to the late 1990s, according to the IMF. It was only in the years just prior to the global financial crisis that issuance patterns changed dramatically, once financial intermediaries realized significant fees could be earned by repackaging low quality underlying loans for investment vehicles, without having to retain economic exposure to the loan pool.
Even during and after the crisis, there was a marked variation in the performance of securitized assets. The key implication is that not all securitizations are the same. Regulators should identify the features common to securitizations with a track record of success as a guide for reform.
The IMF’s analysis offers a comprehensive suite of measures targeting both supply- and demand-side reforms to strengthen securitization and mitigate risk.
Prominent among such measures are the strengthening of each element of the financial intermediation chain (supply-side reforms), refining proposals for the labeling of ‘high quality’ securitizations, and the development of a dedicated non-bank institutional investor base (demand side reforms).
Strengthening the chain of financial intermediation
To enhance the supply-side functioning of securitization markets and reduce risks, policymakers can strengthen existing practices in four main ways:
First, beef up the quality of underlying loan origination practices as poor quality loans will always hamper the performance of securitizations.
Second, encourage securitization intermediaries to develop structures that are transparent, straightforward to value, and designed to finance the economy.
Third, put credit ratings to better use. Full disclosure of the ratings process would help to increase transparency and confidence, and the removal of references to external ratings in regulations should be accelerated.
Fourth, ensure consistent application of capital charges across asset classes and borders. Avoiding large step-changes in capital charges (so-called ‘cliff effects’) between classes of assets that do not differ much in underlying quality is likely to be helpful.
Spurring demand for securitization
Other measures also have a role to play in spurring investor demand for securitized assets.
Standardized classifications of the underlying risk characteristics of securitizations, such as the maturity of assets and the ease with which investors can take possession of collateral in the event of default, could help preserve the benefits of risk labels. This will also mitigate the prospect of investors shirking their due diligence responsibilities by relying on an aggregate classification of risk for the overall transaction, as occurred with conventional credit ratings in the lead up to the crisis.
In practice, investors will tend to treat a single aggregate label for risk as analogous to a credit rating. Changes in the overall rating can also force some investors to buy or sell the assets because they cannot hold assets below a certain rating, which could amplify herding behavior by investors.
Policymakers, working in conjunction with industry participants, can also strengthen securitization markets by creating an environment in which a diversified institutional investor base, including non-banks, could develop. This is particularly relevant in continental Europe where non-banks have traditionally played a minor role in securitization markets relative to the United States.
To advance this aim, the development of an institutional investor base will require the pan-European harmonization of loan level reporting standards, documentation standards, insolvency regimes, and the taxation treatment of securitizations.
Policymakers need to address regulatory, institutional, and product design issues, such as extending the maturity of asset-backed securities and easing the hedging of prepayment risk, to invite greater sponsorship from European insurers and pension funds, both of which are underutilized potential sources of long-term capital. Achieving a better balance between bank and capital markets-based intermediation over time will have the added benefit of making Europe’s economy more resilient.
