Collapsing global securitisation volumes in the wake of the subprime crisis have raised fundamental questions over the viability of the originate-to-distribute business model.1 Issuance has dropped precipitously in both Europe and the US, with banks keeping more loans on their balance sheets and tightening lending standards as a result (Figure 1). The decline has been particularly sharp for mortgage-backed securities and mortgage-backed-securities-backed collateralised debt obligations. The originate-to-distribute model was thought to have made the financial system more resilient by dispersing credit risk to a broad range of investors. Ironically, however, it became the source of financial instability.
Mortgages constituted the vast majority of loans securitised in Europe in 2006–07. Of these, most originated in the UK (about 54%), followed by Spain (14%) and the Netherlands (11%). Total European mortgage-backed securities issuance dropped from €307 billion in 2007 to €28 billion in the first quarter of 2008. During the same period, collateralised debt obligations issuance plummeted from €471 billion to €63 billion, and asset-backed securities (ABS) issuance dropped from about €124 billion in 2007 to €9 billion in the first half of 2008.2
What went wrong?
In many cases, the risk transfer from securitisation proved to be less complete than believed, and investors to whom risks were transferred were too complacent. The adoption of new international financial accounting standards in Europe forced balance-sheet recognitions of substantial securitisation volumes (IMF, 2008, Box 1.3). Also, the efficacy of some risk transfers (e.g., to asset-backed commercial paper conduits and structured investment vehicles) relied on market liquidity, which broke down in 2007. As a result, banks have had to take back onto their balance sheets assets they had earlier securitised. Some banks also retained supposedly lower-risk collateralised debt obligations and mortgage-backed securities tranches but have been forced to drastically write down these holdings as their market values have fallen and bond insurers have been downgraded.
Investor complacency resulted in over-reliance on credit ratings. Furthermore, the rating agencies’ key assumptions on some risks (e.g., subprime mortgage delinquencies and recovery rates) turned out to be overly optimistic. As credit fundamentals deteriorated, many of the more complex and multilayered securities became nearly impossible to value, and market liquidity disappeared as leveraged investors (primarily hedge funds) reduced their exposures. The disappearance of market liquidity and the reliance on models for valuations triggered uncertainty about losses and loss exposures. The interaction of credit and liquidity risk drove market valuations into downward spirals of mark-to-market losses and forced liquidations.
Road to recovery
Reviving securitisation requires structural change. Investor confidence in the instruments, the originators, and the rating agencies needs to be restored. Originators will have to simplify security structures and improve the disclosure of their underlying assets in a timely and comprehensive manner. Rating agencies will need to provide more information on the models and inputs that underpin their ratings and on the potential for rating volatility.
The American and European Securitisation Forums are engaged in coordinating standardised reporting and originator principles. This process will take many years. Also, the major rating agencies are consulting over whether to supplement rating letter grades with rating volatility and loss sensitivity metrics. However, they have been slow to address the conflict of interest that arises because of their parallel activities as consultancy services.
It has been proposed that originators in Europe retain some meaningful economic interest in the underlying securities, so that their incentives can be more closely aligned with those of investors. A European Commission proposal regarding implementation of the Capital Requirements Directive suggests requiring minimum levels of originator risk retention. However, this proposal could easily make securitisation uneconomic for originators and faces considerable monitoring and enforcement difficulties. It is, therefore, unlikely to restart the market.
In Europe, covered bonds have provided banks with cost-efficient secured financing for over 200 years, and US authorities recently launched an initiative to encourage their use by US banks. Covered bonds are backed by identifiable and legally “ring-fenced” pools of loans. They remain on the balance sheet, however, so that the bank retains the ultimate credit risk and is encouraged to maintain loan quality. Nevertheless, yield spreads on UK and Spanish covered bonds have widened sharply during the crisis, owing to declining housing markets.
Meanwhile, German and French spreads have remained relatively low (Figure 2). Although secondary market liquidity has dried up, issuance of “jumbo” bonds is continuing; however, these are mostly German Pfandbriefe.
Covered bond issuance is expected to remain below trend for some time, but the market is likely to continue broadening. The first Greek covered bond issue is expected in 2008, and the four largest US banks have committed to issuing covered bonds, while an electronic trading platform in Europe is planned. The covered bond market has not been immune from recent turbulence, but it does provide a less complex alternative to outright securitisation.
The risk transfer and capital saving benefits of securitisation, combined with underlying investor demand for securities, should eventually revive issuance. But the products are likely to be simpler, more transparent, and trade at significantly wider spreads.
International Monetary Fund (IMF), 2008, Global Financial Stability Report (Washington, October).