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Western EuropeSeptember 30 2007

Securitisation crisis claims casualties

Several financial institutions are on the brink of the abyss caused by the temporary closure of the asset-backed securities markets. Professor Jan Pieter Krahnen reports on the crisis and its first victims.
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Not long ago, the tremendous growth of asset securitisation around the world, coupled with an increasing complexity in structured finance, was widely seen as the rise of a new era in market finance. In this new world, according to many, financial intermediaries would divest themselves of their balance sheets and transfer an ever larger share of originated risks to the capital markets. Using these new tools of structured finance, loans and bonds were repackaged (pooled and tranched) and sold to sophisticated and unsophisticated investors.

Or, as Alan Greenspan put it in a speech on September 27, 2005: “The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage.”

Taking a fresh look at this market today may lead to a more pessimistic conclusion. With the temporary closure of the asset-backed securities (ABS) and particularly the asset-backed commercial paper (ABCP) markets, and with the ensuing funding difficulties, several financial institutions are now facing the abyss.

Crisis looms

While this is a worldwide phenomenon, and the crisis is still looming, the first casualties to date as far as banks are concerned were in Germany. Is there a particular weakness in the German financial system that has led to these casualties? And what can be done to salvage the ABS market and stabilise the financial system?

To answer the first question, a recent CFS research paper by Dennis Hänsel and myself – Does Credit Securitisation Reduce Bank Risk? – shows securitising banks increase their exposure vis-à-vis a broad stock market index. While this is a general feature of all financial institutions that securitise, the effect is found to be stronger in countries with a bank-based financial system, as in continental Europe, and weaker in the capital market-based economies like the US and the UK. The interpretation of this finding, which is based on the analysis of 159 European ABS transactions issued between 1997 and 2004, suggests that banks that are capable of securitising asset pools are expected to raise their risk appetite.

German casualties

This is consistent with what is known about the two troubled German banks: IKB Bank and Sachsen Landesbank. Both were actively involved in rating-cum-yield curve arbitrage via conduits domiciled in Ireland. The business model had been very profitable in previous years, partly because the funding costs were low due to the banks’ own good ratings, which in turn reflected (partial) public ownership, and partly because of inappropriate provisioning for the high level of maturity mismatch. The returns of the conduit business were not risk free.

The banks had extended a Letter of Comfort, which effectively protected the conduit against adverse developments on the commercial paper market. When the conduits drew on this liquidity line in July and August, neither bank was able to provide the required funding from their own balance sheet. Both funds were among the largest such conduits in Europe and the banks were the smallest among their peers in Germany – a bank failure looms large.

On the basis of the available information, the two cases appear to be truly exceptional, and thus not representative of the German banking system at large. IKB Bank and Sachsen Landesbank are partially or fully publicly owned. In both cases, it seems that internal and external control systems have not rung the alarm bells. Although this suggests a need for further study of whether the high level of maturity mismatch can be related to the ownership stake of the state, there is no obvious specific institutional deficiency that makes such casualties any more endemic in the German financial system than in other financial systems. The case of UK-based Northern Rock, which is being bailed out by the Bank of England, is just one more example.

Lack of alarm

Alarm bells around the globe were not detecting the high level of liquidity risk associated with these conduits and similar structures. Credit risk, by contrast, has always been measured with a high degree of sophistication. This raises the question of whether the two risks, borrower-driven credit risk and investor-driven liquidity risk, are connected. There is no well-developed theory on how the one influences the other but the current subprime crisis in the US offers new insights into how liquidity risk and credit risk may interact.

The key innovation in the ABS market is the repackaging of risk. As is widely known, an asset-backed securitisation allows the creation of two distinct classes of bonds from a set of underlying assets: bank loans or credit card loans. The first class is senior debt, which is of very low default risk and can for this reason be held by uneducated investors – investors who do not need to know anything about the quality of the underlying loan. These investors can be agnostic if, and only if, they know (or trust) that someone else will take the burden of monitoring and servicing the underlying loan contract. In an ABS transaction, the monitoring and servicing of the underlying loan is the task of the holder of the junior debt. This holder will experience all of the first losses and therefore has a strong incentive to keep the quality of the loan portfolio at a high level.

Market comparison

This is the textbook case: junior bonds of ABS issues are held by informed investors, for instance the originator, while the senior tranches are held by remote investors who have no particular knowledge about the underlying assets. Now, take a look at the US subprime market and compare it with, say, the German pfandbrief market which, as an institutional model, dominates the mortgage market in Europe. In the former, it has apparently become customary that the originating mortgage bank sells off all senior and junior tranches of its ABS transactions. In other words, in contrast to what the textbook model predicates, the originator typically does not hold on to the most junior piece of the transaction, thereby damaging the monitoring and servicing incentives.

Selling off the most junior tranche (or equity tranche) is an extremely important, though negative, feature of an ABS issue – economists will predict that, everything else being equal, the market value of all outstanding tranches decreases if the equity piece is sold rather than retained. Given the key role of the equity piece in allowing investors to be agnostic about the underlying asset, and given the fact that in most ABS markets, including the subprime market, the whereabouts of the equity tranches remains completely opaque, there is one possible explanation of why investors have become scared about the ABS market: without knowing who is holding the equity tranches, investors realise that they need to be concerned about the mortgage market and about borrower monitoring. This, however, they are neither able nor willing to do, therefore the market collapses.

Rescue lessons

This explanation of why the ABS and ABCP markets collapsed leads to a lesson on how to rescue these markets. Monitoring incentives in the mortgage market (and in other asset markets) need to be restored. These incentives must be widely visible, and easy to understand by any uninformed investor. This is the impending challenge for rating agencies if they want to repair the structured finance market. Future investors in these markets will demand information about who is holding the equity tranche and how large it is. And they want to receive regular reconfirmation that the self-commitment of the originator is met. Who would be better suited to deliver these reconfirmations to the market than the rating agencies?

A look at the German pfandbrief market shows one way to solve the tricky information problem. In the case of pfandbrief issues, the sale of the equity tranche is legally inhibited. Given this feature of its market microstructure, among others, it should not come as a surprise that pfandbrief issues have not been harmed by the current ABS crisis.

A cautiously optimistic conclusion, therefore, is that with some better understanding of the incentive problems embedded in asset securitisations, the market for structured finance products will re-emerge from the current desolate state. The rating agencies are crucial in the restructuring because they will have to provide the additional information on tranche location quickly and reliably.

Jan Pieter Krahnen is a professor at the Centre for Financial Studies at Goethe University Frankfurt, Germany.

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