Securitization : An innovation or a scam

Securitization is another financial innovation that has impacted financial markets arguably more than  anything else in the recent past . It has provided new business models for banks , access to capital to many but has also caused dramatic amounts of systemic risks and pain especially during the housing market crashes

In this article i try to explore the mechanics , benefits and issues with securitization , in simple language. 

What the heck is securitization

What does a bank do:

If you are a bank , then your primary job is to extend credit to your customers . Credit can be in form of different kinds of loans e.g. housing , car, credit card etc. You find the money to fund this loans through deposits from other customers . So a bank essentially transforms excess savings into usable capital . In this way it keeps the economy moving by allocating resources where it generates jobs , business , growth etc.

Risk in Balance Sheet

All these loans are assets in the bank's balance sheet, i.e. they are the source of future income for the bank. However so is the risk associated with these loans. For e.g. if you default on your loan then the bank directly makes a loss. I have explained in my fixed income blog earlier , that is called credit risks. Banks do naturally price a loan considering these risks and as a result will lend cheaper to a credit-worthy individual vs a risky individual . However the risk still remains with the bank.  What if , there was a way in which banks could get rid of this risk altogether ? Surely that will find some takers 

That is where securitization comes in. 

Getting rid of balance sheet risk

What if the banks could sell these assets to individuals (like shares in the stock market) ? The banks could just originate the loan (i.e. lend to a worthy individual and price it based on analysis of risk etc.) and then sell it to investors . Banks could then make money out of these loans , and also get rid of the risk (which will now lie with the investors) . It seems viable , but there is only one small issue - why should an investor buy this ?  What is in for them . The answer is - nothing great , as a small investor i dont want to fund someone else's loans as its too risky and too concentrated. 

However as an investor , if i can get my hand on a security that is highly diversified , i.e. it contains small pieces of loans of several individuals (not a single loan to a single person) , then it reduces my risk - the chance of one person's default is much higher than 100 people defaulting together , and thats the risk reduction achieved through the diversification

So if a bank can break its total portfolio of loans into small diversified pieces - it can create a market for it , to sell them almost like shares of its loan portfolio to other investors . 

This is securitization

Figure 1: How whole loans are transformed to a diversified securitized asset (simplified for illustrations)

How to securitize

This is where it will get complex . We will need to understand what is an SPV - a special purpose vehicle. 

An SPV is a separate entity , which is sponsored by the bank , but is bankruptcy remote - i.e. it is unaffected by any financial difficulty faced by its sponsor . 

The loans the bank originates are sold to this SPV, in exchange the SPV pays cash to the bank . So now the bank has gotten rid of the loans and they have got their money back . But where is this money that the SPV pays the bank comes from ? 

Remember the SPV is a paper entity , so where does it get the cash to pay the bank for the loans it purchases ? Answer is, it issues debt , which is backed by these loans - this debt is the securitized asset as shown in figure 1 . 

So economically an end investor buys secured debt , (which is backed by portfolio of loans) and receives their share of the loan repayments as coupon , its as simple as that. 

Key benefits are as follows

- An SPV structure means the securitized debt has risk characteristics only defined by the underlying loans . It has nothing to do anything with the sponsoring bank. This is credit enhancement and protects the investors from any financial difficulty or bankruptcy of the sponsor. Credit enhancement is also achieved through overcollateralization ( e.g. issues ABS of 90m for 100m pool of loans) and the infamous tranche technique , where senior debt are subordinated by mezzanine and equity tranches providing a further cushion from some degree of defaults

- Breaking down whole loans of big size into small packets of secured debt creates a market for investors. This transforms an otherwise illiquid asset into a liquid one. This also means banks can provide more credit to the economy than otherwise and this provides almost a liquidity injection to the economy 

- Another aspect is risk reduction . The secured debt available to investors is a package with pieces of several loans. This diversification minimizes idiosyncratic risk of any individual borrower. However systemic risk still remains (i.e. a general economic collapse). In a systemic event everybody defaults and the asset is hurt, but this is rarer event than an individual default. This also helps the bank to earn the spread for the idiosyncratic risk , which it receives but do not need to pay out.   

So what's the problem then ?

Like anything - the problem lies with abuse, people have a great record of taking something wonderful and turning it into a destructive weapon ( yes i am referring to nuclear fission  ) , and the financial markets are no exception

Moral hazard

If you are a bank , and you know that on one hand all these loans will be sold to other people and will not be your risk at all and on the other hand , the more of you sell of these, the more money you make - what do you think will it do in terms of due diligence , in terms of checking credit worthiness of the borrower or quality of the collateral. The answer is obvious. You don't care much. Its important to note however that just like the theory of conservation of energy (energy is not created or destroyed, it is just transformed from one form to other) , risk of these loans are not eliminated. What was your problem are now somebody else's problem. However the problem remains , in fact it is exacerbated by the fact that the volume of credit extension  rises exponentially under this originate to distribute model. Now it seems like a ticking time bomb. 

During the housing market bubble this is exactly what happened. I was working as a mortgage broker those days. NINJA ( no income, on job no assets) loans were extended to individuals , who would most certainly default and there were some products like NegAm ( negative amortization, i.e. your principal increases with every installment you pay) , with the hope that these loans will be securitized and be "somebody else's problem" 

Illusion of Being Risk Free

I have highlighted the risk reduction capabilities of these assets , but they are certainly not risk free.

They are exposed to systemic risk , and wrong way risk ( this is for another time) , however most investors considered them as risk free. They were unaware of the inherent risk in these assets especially in a falling housing market or an economic downturn and this caused a lot of pain. This underestimation of risk , meant people made leveraged bets on these assets and in the end got obliterated .  In the peak of the cycle banks started treating these assets as cash equivalents , and lost a lot of money when many of these failed . This created a daisy chain of losses in the economy and ultimately many banks were saved with government bailout

Financial Engineering and Collusion

 

This is another problem , but needs a separate article altogether. Products like CDOs were designed to artificially (and sometimes unethically) enhance credit quality of the Securitized assets , and ratings agencies (who are paid by banks to say how good their assets are) didn't raise any alarm. 

The rise of CDS (credit default swaps) took it to another level , where people started making money betting on the failure of these assets . The Big Short by Michael Lewis tells this story well. 

Final words 

My take on Securitization is that its a great innovation. It only enhances the banks ability to do what its supposed to do - allocate capital in the economy more efficiently. It allows investors to access markets and sectors that it otherwise cannot , and it allows more credit extension in the economy which drives consumption and job creation. 

However human greed trumps everything , and i am almost certain that although great lessons were learnt from the 2007 crash, history is almost certain to be repeated in different forms. 

As an investor it means more due diligence , understanding risk characteristics of assets and not to put all eggs in a basket.