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. 

The Risks of Debt Investments

The Risks of Debt Investments 

This is my first blog , so my aim is to keep it simple. There are tons of research and professional advice that is available on fixed income ( debt) investments , propagated by brightest of minds in the industry , but my aim is to clear out some basic factors for a common investors buy and hold debt portfolio. 

The material below is focused on an Indian investor..

What are Debt investments

The simplest way to think of this is when you lend money for interest (and principal) and not for a share of the business or venture

Bank Fixed Deposits, Government bonds, Post office bonds , RBI Bonds, Corp Bonds and infact even EPF and PPF savings can be thought of as debt instruments by nature (if not by form)

Why include Debt investments in portfolio - the common opinion

Common wisdom says  debt is low risk compared to ,say stocks or commodities or crypto

While partly correct , this is quite nuanced. Reality is complex and a notion as such like this has the potential to completely disrupt portfolios and long term goals.

In the recent past we have seen several instances of retail investors plight caused by corporate or bank defaults. A lot of these will repeat if we continue to chase higher yield without a proper understanding of the risks facing them. 

Almost all debt investments are subject to various risks and its important for an investor to understand them well. 

Risk Factors Faced by Debt instruments

Credit Risk : 

This is the obvious one. How likely do you think is someone to not return the money you had lend to them. The more that likely hood the more the Credit risk. For e.g. lets say you lend money to a business that is very stable vs one that is new and risky-  surely the credit risk is higher for the latter.

So why would you then lend to a riskier party ? Simply because you will need to be enticed with a higher reward, in form of a higher interest rate. So what i am saying here is , if some debt instrument is offering a higher interest vs another one ( all else equal) then it must be due to poor credit. 

The same logic applies to bank FDs.So if bank X offers a much higher rate than bank Y for a 5 year FD , it will mainly because X is more probable to default (i.e. not return your money). 

So naturally debt issued by central government carry the least credit risk (in India) , and as a result the lowest interest rate vs a corporate bond or a bank FD. 

The EPF , PPF also are government debts , so they carry almost no credit risk , .i.e. there is almost no chance that your PF savings will not be paid to you. But they do carry a higher interest rate ( this is for another time) , so its prudent to invest in them to the maximum extent possible. 

For corporate bonds , a credit score is used as a measure of Credit Risk . The more the AAAs the better the credit (and the lower the interest). CRISIL is a well known provider of corporate credit rating in India. As an e.g. Infosys is rated as AAA Stable vs Shriram Transport Finance as AA+ (CRISIL Long Term rating), which says INFY has a better credit rating (and lower risk), and that the debt issued by INFY may offer a lower interest rate. 

Just focusing on the interest/ yield and completely ignoring the credit worthiness will expose one to undesired credit risk , which is avoidable

Several factors like amount on borrowing  relative to equity, past repayment records , financial strength and performance contribute to determining the credit scoring for Corporates. 

Corporates sometime improve the creditworthiness of borrowing by collateralizing or other credit enhancement techniques to reduce their cost of borrowing

The bottom-line is that there is no free lunch, and an investor is better off staying away from the high yields offered by  a higher credit risk entity , unless one is fully aware of the risk . 

Interest Rate Risk : 

This is often most misunderstood by many , and i will try to explain how it works. 

As a rule of thumb fixed rate debt don't do well in an inflationary environment , or when Central Banks are expecting to hike rates. 

As i write this in 2022, the world around us are all impacted by COVID 19 pandemic and to stimulate the economy the Central Banks have reduced cost of borrowing ( how this works , is something i will cover in a different write-up) , but the bottom-line is rates are at the low end at the moment.                   

Imagine you buy a 10 year Government Bond  which pays you say 4% interest annually. This means for every 100 INR you lend, the government pays you 4 INR every year , for 10 years and then it returns the entire 100 INR. As we had discussed earlier this investment has no credit risk (backed by government is as good as the cash you use), but it surely carry interest rate risk as you will see. 

Now imagine the following happens (which is quite likely) : RBI increases the borrowing rate to 4.5% next year ( Central banks increase rates to control inflation; again a topic for another day). What that will mean is your investment that yields 4 INR is lesser than the current market yield of 4.5 INR. To put it another way your 100 INR principal is worth  96 INR now. 

1.1 Impact of Changing interest rates on Debt Investment

As illustrated in 1.1, a lowering of interest rate has a favorable impact on the initial investment, and a rate hike has an adverse impact. This is classic bond math, and in Finance we use a term called "Duration" and "Convexity" to measure the sensitivity of a bond to changing rates (not to be confused with tenure)

So as you see , the same principles applies to a bank FD/ Corp Bond , but remember that unlike government bonds, they are also subject to credit risk of the issuing bank/corporate

Floating rate bonds revise the interest applicable based on current prevailing rates - contrary to popular opinion this is less risky as its almost insulated not only from interest rate changes but also from inflation to some extent. Instruments are available (GOI floating bonds etc.) which provide these kind of terms. 

The PF investments also get their rates revised every year and in a sense are floating rate - another reason why one should maximize these buckets for the low risk portion of the portfolio.

So the conclusion, is that when economy is facing a recession or slowdown and interest rates are expected to decline in future , is the perfect time to lock in the higher interest rates through FDs or Fixed coupon bonds. When inflation is a bigger worry than growth and we are staring at a rate hike , then its prudent to not get into fixed rate bonds . If one is unsure of future trajectory of rates , then floating rate bonds are the way to go. 

There are several other kinds of risks facing the debt investor like Spread Risk , Country Risk , Term and Liquidity etc. but i choose to avoid them for now to keep it simple for our average retail investor. 

The bottom-line

• Debt investments do reduce risk (measured by volatility of returns) of an all stock portfolio, and an allocation to it is necessary to provide diversification to a retail portfolio
• Debt investments can also provide regular income - in form of interest payments , which can be desirable for income investors
• Credit and Interest Risk are the key risk factors to watch out for, while investing in debt. Remember that "risk" is not a negative term, in fact excess return can only be generated by taking on "risk" in the portfolio. The key is to be calibrated and prudent about taking on risk. 

A quick summary of the risks inherent in debt assets discussed below

1.2 Risks inherent in Instruments

Bank FDs are insured by government of India for investments up to 5 lacs and that is why i consider them slightly safer than a corporate bond (ceteris paribus) , and the EPF/ PPF have their inherent tax advantages , which is why i consider them superior for a retail investor 

That's it for now. Please leave a comment with your feedback and any topic that you want me write more on. 

Manisangsu ( pronounced Manish-anshu  )