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Securitisation: The pantomime villain of the financial crisis?

 

27 March 2009

This is one in a series of articles exploring the theme of financial regulation and reform, written by Allen & Overy's legal experts.  

In the current pantomime of financial regulatory turmoil, the villain of the piece is easily cast – securitisation. Even the relative obscurity of the word has added to its perceived villainy. A difficult word to pronounce for the uninitiated, it has been booed and hissed at by politicians of all sides. 

The Turner Review, published on 18 March 2009, firmly places securitisation – at least in its more complex forms – at the heart of the current banking crisis. But does it deserve its reputation?

What is it?

At its heart, securitisation is a simple concept: a repackaging of financial cashflows into a tradable investment. Instead of buying, for example, a share of a loan made by a bank, it allows an investor to buy a share of several loans.

The underlying loan can represent a safe and secure investment – or it can be a poor investment. And as with any investment, buyers have to take sufficient time to understand where they are putting their money. The real danger arose when overly-excited investors met less secure underlying investments. And securitisation acted as an easy vehicle for that unhappy combination of factors.

So the blame – if that is the right word – attaches both to investors and to the sponsors of these securitisations. The regulatory response therefore has to address failure on both sides. It's no good blaming banks for selling investments clearly labelled as risky if the investors failed to heed the warnings.

Current criticisms

Will the suggested remedies work? What are they? Politicians and experts daily talk of the need for increased transparency, greater accountability, and a closer alignment of interests between investors, shareholders, banks and executives.

"Complex securitisation reduced transparency" is an accusation levelled by the G20 participants. But greater transparency would not necessarily have had any effect on investors' exuberance in the search for yield. That search has led certain investors to overlook the dangers of riskier investments, to focus too much on a hoped-for handsome reward and to avoid taking the time to understand properly the investments they were buying.

The concept of transparency in this context is, at its heart, again simple. It requires that the true underlying financial story is told, warts and all. Significant regulatory intervention in the field of transparency has been happening for many years.

Issuers of financial products to the public markets are already under strong legal obligations to explain in great detail the nature of the financial products, such as commercial mortgage backed securities, and the nature of the underlying assets.

So a more detailed assessment of the risks by investors is required. They must not rely simply on credit rating agency analysis. Investors have been heard to complain that they don't have time to properly examine new investment opportunities. 

Whatever else they do, they must do this.

Good old-fashioned banking

Transparency is also used as a byword for simplicity. A return to "good old-fashioned banking" is advocated by many. This makes a good sound-bite for the politician but would represent startling naivety were it seriously to be pushed as the way forward. Does anyone really expect a return to the days of the bank manager lecturing his first time buyers?

The boundary between "normal" banking and more esoteric investment banking was broken down in the 1990s by the repeal of the Glass-Steagall Act in the US. Although some voices speak up in favour of aspects of this model (for example, Paul Volcker, a former U.S. Federal Reserve Chairman), there are few in positions of influence who are suggesting that restoring the distinction is the way forward. 

Securitisation is just one part of the huge range of complex financial products available to international investors. Lord Turner is clear in his report that the future for financial markets will include, in his view, a "significant role for securitised credit" and that this will involve banks which operate across the traditional Glass-Steagall divide. So securitisation is needed, and is here to stay.

And complexity will not disappear. The challenge is to design a regulatory system (both as regards preservation of capital and supervisory oversight) which recognises this complexity and addresses the risks in a structured rational way. The regulatory response must, however, be flexible. It must be able to treat differing banking activities in different ways. There is no "one size fits all" solution. It would be dangerous and short-sighted for the regulatory reforms to stifle innovation because of a lack of understanding. 

There would be no better way to delay the return to prosperity.

Originate-to-distribute

At the same time, the "originate-to-distribute" model has come in for much criticism. A system where banks take on liabilities which they expect to shift to some other investor, leaving the profit at the bank and the risk with the investor. 

This, recent experience has shown, was far more difficult to achieve than was planned. But this model is not inherently flawed.

Where a limited amount of capital is set aside for this type of activity, and regularly turned over, the banks involved have managed to keep their exposures (and therefore losses) lower. Banks who took on too much debt without an adequate plan to distribute this in a less benign credit environment have been stung most of all. The roll call of banks in this category is already well known.

Lessons

The lessons to be learned here are threefold. First, we cannot turn the clock back. Bankers, regulators and investors must work together to appreciate and evaluate the risks inherent in complex financial transactions – there will always be a degree of risk. Second, calls for transparency and the like must be used properly and lead to informed choices.

Buzz words alone will not achieve the alignment of interests between banks and investors. And finally, those involved in the evaluation of risk must be educated to understand that the buck may stop with them – not every risk can be offloaded to someone else.

Further information

View the webcast: Philip Wood on what really caused the financial crisis and what needs to happen now.

 

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