Securitized Instruments

PRO REGULATION TEAM

Securitization and Regulation

Firstly, bank sells package of its loans (called pool) to SPV (Special Purpose Vehicle). SPV tranches pool, which means that they are classified into a few categories that reflect the quality and risk of included loans. All assets can be securitized so long as they are associated with cash flow, the created instruments are called asset-backed securities (ABS).
The current crisis was also started because of the process of securitization. The reasons were following:
Banks offered mortgages even to clients that were unlikely to be able to commit its liabilities. If banks were not able to transfer risk to somebody else they wouldn’t have done it.

Rating agencies (RA)
Rating agencies relied on information about bank clients provided by these banks – RAs were not able to provide CDOs with valid ratings.
Rating agencies were paid by SPV. They were under pressure to give better ratings than appropriate, otherwise they would not be hired next time. The same RA offered consulting services to banks. There were no limits on the connection between RA and banks.

Proposed Regulation of Credit Rating Agencies
a) Managing and disclosing conflicts of interest at the rating agencies.
b) Differentiating ABS credit ratings from ratings of conventional unsecured debt.
c) Disclosure by the rating agencies of their rating methodologies and the meaning of their ratings, including what risks they do and do not address.

Increasing Transparency and Standardization in the Asset-Backed Securities Markets
The basic problem connected with securitization is the lack of transparency. An investor is not able to evaluate ABS since he does not know the structure of underlying assets. Therefore investors were making solutions that were based on the ratings provided by credit rating agencies. Thus, his willingness or not willingness to buy may be misled by wrong rating of the instrument.
RAs used different systems of rating. Investors were not familiar with differences between these methods which caused that the market was even more nontransparent. In addition, information reliance on banks (as mentioned above) contributed to non-transparecy and arises a question whether the ABS was transparent for RA. Banks could take advantage of this and provide them with inappropriate information.
If we don’t want to make the same mistake again it is necessary to make ABS more transparent or force rating agencies to work more properly, which isn’t possible without some amount of regulation.
There should be improvement and standardization in disclosure practices by originators, underwriters and credit rating agencies involved in ABS and initiatives by market participants to standardize and increase transparency in the legal documents for ABS.

Requiring Originators or Sponsors to Retain Credit Risk
Loan originators and sponsors should retain 5 percent of the credit risk of securitized exposures.
These regulations would further prohibit an originator from directly or indirectly hedging or otherwise transferring the risk it is required to retain under these regulations. The retained interest requirement is meant to ensure that the originator and/or sponsor of a securitization continues to have "skin in the game" in the form of ongoing exposure to the assets' credit risk.

SPV
The problem is, that SPVs work only as a broker between investors and borrowers. Their profits are based only on a provision from sold ABS. So their goal is to sell as much securities as possible. On the contrary, investors demand low risk and high yield securities, which leads SPVs and rating agencies to undervalue risks.
In reality, SPVs choosing assets for securitization were often subsidiaries of banks, or even mortgage companies itself, such as Fannie Mae and Freddie Mac. This fact enabled mortgage bank to withdraw low quality mortgages from their balance sheets and sell them to investors, who are dependent mainly on rating information. In broader context, system started accumulating large amounts of risky mortgage loans, which brought instability into whole real estate business.
Regulation should detach interests of Banks, SPVs and also rating agencies. SPVs should be completely independent on banks creating loans. Secondly, profits of SPVs and rating agencies can not be based on amount of sold ABS.
New standards should also include clear and uniform rules relating to modification of securitized residential mortgage loans.

Conclusion
To sum up, securitization played a leading role in the financial crises that economies face nowadays. It is not possible to state one crucial mistake, which caused that the securitization went wrong. All market participants made mistakes. Banks were providing loans even if they knew that the client wouldn’t be able to repay it. SPV took advantage of their dominant position to rating agencies. These agencies published ratings that weren’t based on an appropriate methods and information. Lack of transparency caused that clients didn’t know what they’re buying and so on.
All these problems could have been identified and solved before the crises started but market participants underestimated possible consequences because of misleading assumption that if something works why shouldn’t it work in the future?

AGAINST REGULATION TEAM

As in other situations, it is important to mention also arguments for less regulation or deregulation of securitisation and securitised instruments. But at the first we should understand the concept of liberalism, as a theory (attitude) of freedom and liberty – and at the end no regulation with no state´s interventions. There are two concepts of liberalism:

  1. Austrian school (Fritz Malchup) – complete refuse of any rules, “absolute freedom”, you can do what you want
  2. Freedom within the boundaries (e.g. Testimony) – state has to set up a legal frame, qualitative, not quantitative. In that case of securitization it means, e.g. the regulator has to say to the financial institutes – you have to have a high-quality model to manage your financial (market, credit) risk – but not to say – you have to this model with this limits and you cannot go over that

Who to regulate??
Rationally-considering economist has to agree with the second concept. Every financial institution is a special organisation with special risk attitude. The less regulation we have the better in terms of strict rules and more space for financial institutions to manage their market risks resulting from dealing with securitised instruments. They know the best, what is the main risk for them (especially for each of them). The main advantage is, they are hard-working on enhancement of their models and do not rely on risk-managing models settled by regulator. This is an EU model of regulation.

New liquidity in the market
There are multiple reasons against regulation of securitized instruments. Securitization allows banks to get rid of less liquid assets they have in their portfolio and therefore invest their money more effectively. In case they own risky assets they do not want to cope with, they are able to transfer the risk to another investor (often risk seeking whose aim is to gain as much profit as possible) by emission of an asset backed security (ABS). There are therefore new securities which bring more liquidity to the market.

Lower cost of capital
The important positive effect of securitization are lower costs of capital. Exchange of risky assets in portfolio for safer ones (money, receivables,…) makes the capital adequacy ratio higher, which enable the bank to use more debts instead of its core capital with the respect of minimum capital requirements. Regarding to lower costs of financing, the bank might be able to implicate these savings in borrowing costs for its clients.

Rating agencies
Securitized instruments are an important instruments that brings many benefits, as described above. It doesn’t itself necessarily create any additional risk, however, some hazard lies in the pricing of these assets. Most investors rely on the information of rating agencies, which proved to be wrong in many cases – the market therefore did not have precise information about the underlying assets of the securities.

Some of the concerns about rating agencies are as follows:

  1. the rating agencies do not have any significant responsibility,
  2. the processes they use to evaluate the risk are not transparent (kept secret), nor identical (different rating agencies use different methods, so the outcomes may be diverse) and
  3. they were often „hired“ by the financial institutions – conflict of interests, „rating shopping“.

Considering the benefits that securitisation provides, making rush decisions to tighten the regulation could be very costly. Instead, it may be more advantageous to focus on the rating agencies to make sure they provide accurate and reliable information, are more transparent and completely independent (from the financial institutions).

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