The basic purpose of securitization is to reward the comparative advantage of a bank to originate loans, compared with its ability to service the loans and its ability to bear the risk associated with those loans. In securitization, banks sell a pool of loans (assets) to a special purpose vehicle (SPV) that in turn issues claims or securities on the underlying pool of loans.
SIVs (structured investment vehicles) typically invest in long-term securities issued by SPVs at a higher interest rate compared with the lower interest rate paid by SIVs on their short-term commercial paper issuances. As early as the beginning of 2008, Citigroup, Dresdner, HSBC, Rabobank and Société Générale were some of the banks that had bought their sponsored SIVs or their sponsored SIV’s assets. By doing so, these entities allowed an implicit recourse by the SIVs to their sponsoring banks. Formally, the sponsoring bank is required only to make available the credit enhancement promised by it. To be sure, ad hoc liquidity support on a temporary basis has often been provided by the sponsoring banks well before the onset of the current financial crisis. This implicit recourse violated “true sale” that had allowed the banks to take the SIVs off their balance sheet in the first place.
By virtue of their relationship with both SPVs and SIVs, originators were in effect also investors in securitized paper of other originators. Also, originators directly invested in securitized paper. This implies that an originator that securitized its own assets took a view about another originator’s originated assets relative to its own originated assets. Say banks A and B originated and securitized their assets. Further, bank A invested in the securitized assets of bank B while bank B invested in the securitized assets of bank A. So, clearly, neither bank A nor bank B has a comparative advantage in the origination of assets (loans).
Further, bank A was taking a view on bank B’s securitized assets relative to its own securitized assets. Why else would bank A go short (securitize its own assets) and go long (invest directly or through an SIV) in the securitized assets of bank B. Bank B, too, was doing something similar. So were banks C, D, E... This began a race to the bottom.
And the race was rewarded perversely—because to short one’s assets and to long on the other’s made sense if you are worse at originating assets! And that is something securitization should never reward.
The rating agencies played the role of a catalyst in the originators’ race to the bottom. The rating agencies did so by attracting gullible investors on the basis of their spurious ratings.
New legislation that enforces the following is required:
l No relationship between a originator/sponsor and SPV/ SIV should be allowed—not even temporary liquidity support.
l An originator should not invest (or service) the securitized assets of another originator.
l The rating agencies should be nationalized. Worldwide, rating agencies paid less than 2% of the $687 billion in taxes paid by the commercial banks and savings institutions in the US alone during 1992-2007 (source: US Federal Deposit Insurance Corp.). Surely, the rating agencies caused more than just 2% of the damage. They are perhaps the most extreme manifestation of “privatizing profits and socializing losses”.
Securitization should never again become a race to the bottom. It can serve its basic purpose of rewarding a comparative advantage in the origination of assets.
A.M. Godbole is working as an adviser with A.V. Rajwade and Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comment at email@example.com