Securitization and the Future of Finance

The Future of Securitization
July 10, 2008; Page A15

The deconstruction of the financial services industry this past year has been something to behold. Unfortunately, the responses have been shortsighted, the equivalent of putting a band-aid on a gunshot wound. The blunt fact is that we’re in the midst of a major structural shift in the financial world: Yesterday’s business model has been invalidated.

Securitization as it has been practiced will not be the dominant means of financing it has been for the past decade and a half. And it has been truly dominant – moving from $1 trillion to $12 trillion in annual new issuance, capturing a significant share of all new loans including residential mortgages, commercial real estate and corporate loans, even auto and college tuition loans. Yet securitization will continue to play an important role – if adapted appropriately.

Securitization involves transferring a loan or pool of loans into a trust and then having that trust issue securities, or bonds, that are rated by the large rating agencies and purchased in the institutional bond market. Effectively, through what I will call “risk transference” securitization, whereby the originator retains no ongoing interest in the loan, the bond market becomes the at-risk lender. Implicit in that arrangement, especially at the high volume levels of past years, is the nearly complete delegation of credit underwriting by the ultimate lenders, the bond buyers, to others, mostly the credit rating agencies, and to a lesser extent the banks that originated, repackaged and sold the loans to these bond buyers.

It’s easy to see the model’s appeal over portfolio lending, where the banker held an originated loan to maturity. This limited the potential gross return on equity (ROE) that the loan could generate to something in the mid to high-teens. And from this seemingly unappetizing return, one must still deduct overhead expenses. Further, the bank remained on the hook for any losses during the life of the loan.

In the risk transference securitization model, the potential of significantly enhanced ROE was breathtaking. The originating bank became an intermediary, or a manufacturer of loans. A loan originated and resold within six months for a 2% profit could – when combining the yield spread in the six-month warehouse period with the gain on sale – double the bank’s ROE, while also permanently removing the credit risk associated with that loan from the bank’s balance sheet. Thus large banks shifted from purely portfolio lending to a mix of portfolio lending and risk transference securitization.

The most profound change occurred in the investment banks. Their balance sheets ballooned more than 100-fold as they morphed, from entities engaged primarily in the business of advising corporate America and facilitating access to the capital markets, into gigantic originators and intermediaries of all forms of credit assets. Without the huge fixed costs associated with deposit-gathering that the banks have – and the benefit of nearly double the leverage ratios of their more tightly regulated competitors – risk transference securitization generated staggering gross ROEs that, in the good times, ranged between 50%-100%.

That business model is now being dismantled, and the search is on for a new vision. Financial players need to explain to investors, whose capital they may desperately need to survive this painful transition period that, even in the best case, the ROE upside will be significantly less. Investment banks need to construct a vision justifying their huge balance sheets.

And yet the truth is that securitization, with a simple tweak, is actually something that can and will surely continue to play an important role in finance. This mechanism brings two main attributes to the table that are worth preserving.

First, it is the only method available to the asset originator to finance his position in a loan without incurring a mismatch risk between the terms of his assets and the terms of his liabilities. In the old portfolio-lending model, the bank would make a loan that may have a five- or 10-year fixed-rate term with all sorts of prepayment provisions that could shorten the term, and then finance that asset with deposits or other liabilities that didn’t match the term or the duration characteristics of the loans themselves.

This model created the sort of systemic risk that has caused most of the serious financial dislocations of the past, including the collapse of the Savings & Loans in the 1980s all the way to the collapse of the SIVs in 2007 and Bear Stearns in 2008.

The second significant benefit of securitization is the transparency that it brings to bear on the system. While this is painful in bad times, as the mistakes of the market are more immediately and broadly known, only the most cynical among us would argue that better information is not hugely beneficial to the market at large.

Were a portfolio lending model crafted in which the lender – instead of relying upon shorter term deposits or other liabilities whose terms are uncorrelated to the assets that they are intended to finance – financed his loan inventory through the securitization process, the duration mismatch risk would be solved. The lender would create distinct pools of loans, all of which it would retain on its balance sheet and hold appropriate equity capital against, and then have the trust issue only the lowest risk and most highly rated securities.

Further, in this construct the bond market will not be taking on the full ownership of the loan. Instead it will be providing lower risk leverage to the originator, who will retain ownership. Thus, the bond market will be relying less on the rating agencies and more on the lender’s acumen, and the alignment of interest that results from the originator’s ongoing ownership of the loan. These securities would have payment and maturity characteristics that exactly mirrored those of the underlying loans they were financing, and it would be this perfect match that would serve to remove the heretofore systemic duration mismatch risk that has resulted in numerous bailouts.

I believe the next step for finance in the Western world is to create a system that marries the discipline of portfolio lending with the asset-liability management and transparency benefits of securitization. As in the portfolio-lending model, the originator will be left to hold the loan. The bond-buying community will provide financing to the originating lender by purchasing the securitized debt that is backed by the loans originated.

Equity markets will provide the capital to own assets and will thus discriminate as to which origination franchises deserve the licenses to participate in the business of finance going forward. It will be those franchises that have demonstrated credit underwriting expertise in the areas in which they are extending credit, and clean and understandable balance sheets with commitments to transparent reporting, that will likely dominate in the next cycle.

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