"By transforming illiquid assets into tradable securities, securitisation has helped channel cash flow to borrowers and fund significant economic development. Securitisation has also helped issuers and investors diversify risk across asset classes and across the globe."
A by-product of the 2008 financial crisis, and the sudden halt in the 30-year frenzy of securitisation deals, has been the opportunity for market participants to pause and consider the evolution of securitisation, its role in the financial markets and the way in which the markets have embraced the value of the structural aspects of securitisation. This article will examine the convergence of factors that led to the rapid growth of the securitisation market and will look forward to lessons learned. Given the complexity of the subject, this can only touch on some of the issues and factors.
History of Securitisation
While writers point to the origins of securitisation in a number of precedents, including the farm railroad mortgage bonds of the 1860s, the mortgage-backed bonds of the 1880s and a form of securitisation of mortgages before the 1929 crash, the modern era of securitisation began in 1970. That was when the Department of Housing and Urban Development created the first modern residential mortgage-backed security when the Government National Mortgage Association (Ginnie Mae or GNMA) sold securities backed by a portfolio of mortgage loans.
The modern history of securitisation has its roots in post-war American culture, the growth of the suburbs and the Leave It To Beaver model of mom and dad in a suburban house on a tree-lined street with a car in the driveway. In order to make this American Dream accessible to more people, the government (as a policy matter) sought ways to increase liquidity in the mortgage market. In 1970 Ginnie Mae (which was created under the Fair Housing Act of 1968 when Congress split Federal National Mortgage Association (Fannie Mae or FNMA) into two separate corporations, FNMA and GNMA) issued the first residential mortgage-backed security, which pooled mortgage loans and allowed them to be used as collateral for securities sold into the secondary market. The stated purpose was to channel investment capital from global investors to provide access to capital for affordable housing. In 1970 the secondary mortgage market was also significantly expanded by Congress passing the Emergency Home Finance Act that created the Federal Home Loan Mortgage Corporation (Freddie Mac or FHLMC) to assist thrifts in managing interest rate risk by purchasing mortgages from the thrifts. The Act also authorised Fannie Mae and Freddie Mac to buy and sell mortgages insured or guaranteed by the federal government. In 1971 Freddie Mac issued the first conventional loan securitisation. In 1977 Bank of America issued the first private label residential mortgage pass-through bond.
Throughout the 1970s bankers and lawyers developed increasingly sophisticated securitisation structures. This was aided significantly when, in 1986, Congress passed the Tax Reform Act that included the Real Estate Mortgage Investment Conduit provisions (REMIC) that enabled greater flexibility in structuring bond classes with varying maturities and risk profiles. The appeal of being able to package revenue-producing assets in off-balance sheet vehicles, thereby creating regulatory capital relief for financial institutions and greatly increasing capital available to fund consumer demand for housing and other consumer assets, led to the creation of other types of asset securitisation in the United States and in other countries. In the mid-1980s the first securitisations of automobile loans and bank credit card receivables were done. Commercial banks developed the first asset-backed commercial paper conduits (ABCPs) in the 1980s. These conduits were vehicles to provide trade receivables financing to bank corporate customers. These vehicles were off balance sheet, thereby freeing bank regulatory capital. During the 1980s UK banks began structuring residential mortgage securitisations.
During the late 1980s and the 1990s the securitisation market exploded. This was aided in the United States by the REMIC legislation and changes in SEC rules, and fuelled by the growth of money market funds, investment funds and other institutional investors, such as pension funds and insurance companies looking for product. In the 1990s commercial mortgages began to be securitised. Outside the US, countries including the UK and Japan adopted laws that allowed for securitisation. The vastly expanding global consumer culture, where access to credit to purchase everything from houses and cars to mobile phones and TVs was taken as a given, continued to stoke growth in the volume of securitisations. While originally done by commercial and savings banks, many other players began to enter the consumer credit arena and to finance their activities through securitisations. As unregulated players entered the field, standards for lending were often also loosened. The first securitisations of sub-prime residential mortgages were done in the early 1990s. During the next decade the growth in the volume of sub-prime mortgages that were securitised was huge.
Another effect of the exponential growth of securitisation as a vehicle for all forms of lending was the change in the balance of the relationships between lenders and borrowers. This became very clear post-2008 in the aftermath of the financial crisis. In the long-ago days when banks lent to businesses and people, a bank lent money for a mortgage and took a lien, and if there were problems the individual worked it out with his or her bank. Securitisation and disintermediation of risk changed all of that. Banks sold the mortgages into huge pools where one mortgage would be one of tens of thousands. Small business loans were financed through conduits. The documents and the rating agencies imposed rigid provisions and work-out mechanics because predictable outcomes were critical. Trustees were not given discretion to work out bespoke remedies for different borrowers. The result of this shift was that when problems occurred in a loan or a mortgage there was often no ability to work out a solution tailored to the borrower. The specific path and remedies were built into the documents and were enforced by a servicer and/or trustee working within rigid parameters, or at the command of a majority of the lenders, who were large institutions beholden to shareholders or investors.
Many transactions were also layered with credit support and/or swaps or repos, so it was not always even clear what party bore the ultimate risk in a transaction, also complicating work-out situations. All of these factors have contributed to the post-2008 crisis fallout. Large institutions failed, deals defaulted, bankruptcies proceeded, investors sued and regulators in many jurisdictions proposed regulations to deal with various aspects of the collapse.
What is Next?
I think that most commentators believe that securitisation is here to stay and that it is an efficient and effective way to structure financings. By transforming illiquid assets into tradable securities, securitisation has helped channel cash flow to borrowers and fund significant economic development. Securitisation has also helped issuers and investors diversify risk across asset classes and across the globe. The experiences of the past six years have made all market participants aware of a number of key issues: first, the due diligence needed on the originators of the assets, the assets and the origination practices; second, the enforcement of remedies, how the remedies are meant to work and the often uneven application of remedies; and third, the opaque nature of many transactions and how the risk in the transactions is actually shared. There have been a number of responses to these issues. There have been regulatory responses through proposed and implemented legislation in the United States, the United Kingdom and Europe. There has been self-policing by market participants through internal policy changes within banks requiring different processes for approval of transactions and mandating more stringent due diligence review. And there has been the market reaction in increased scrutiny of deals that are brought to market. Hopefully these measures, along with awareness of past issues, will result in renewed confidence in the securitisation market, stronger transactions and more clarity in the documentation.