IMF issued the Global Financial Stability Report on 21st September, 2009, which would give the securitization market and the industry analysts a reason to cheer. The chapter 2 of the report on ‘Restarting Securitization Markets: Policy Proposals and Pitfalls’ summarizes the rise and fall in the securitization market, analyses the recommendations made so far for the revival of the securitization market and lays emphasis that restarting of the securitization markets would be important for financial stability globally.
The Chapter brings out the flaws of the market before crisis that ultimately led to the debacle. Banks started holding the least risky tranches, originated by other banks including the sub prime exposure which reduced the risk dispersion that led to the market fallout. The report also talks about the ‘alphabet soup’ where demand for various structured products was instigated by the rating agencies willingness to give away their highest ratings coupled with the investors dependence on the ratings provided to these securities and inadequate information to assess or adjudge the ratings. The numbers prove the flaw where the report says that of all the ABS CDO tranches issued from 2005 to 2007 that were originally rated AAA, only 10 percent are still rated AAA by Standard & Poor’s, and almost 60 percent are rated single-B or less, well below the BBB-investment-grade threshold.
The report also recognizes that though most people were talking about what went wrong it was imperative to revive ‘sound securitization.’ The report stresses that the restarting private label securitization is vital to end the financial crisis. The report welcomes the changes brought with regard to securitization and presents its recommendations on implementation of the suggestive changes. Some of the recommendations are as below:
- Credit Rating Agencies: Chapter 2 says that so far the investors had placed too much of reliance on the credit rating provided to the securitized products and under the issuer pay model, interest of the investors were ignored. The report recommends that as credit rating agencies have a vital role in the securitization process, elimination of the issuer-pay models, disclosing preliminary ratings to reduce ‘rating shopping,’ publishing performance data to enhance due diligence and competition among credit rating agencies be increased
- Retention of risk by the originators: The report says that these requirements adopted by both US and European authorities should not be standardized. For diligent loan underwriting and monitoring, the report welcomes that there should be more “skin in the game” but the report says that the requirement should not be standardized and both size and the form of retention should be more flexible to achieve the broad based incentive alignment. The flexibility could be brought about by basing the retention policy on type and quality of the underlying assets, the structure of the securities, and expected economic conditions
- Changes in the accounting standards and regulatory requirements: The report recommends that disclosure and transparency standards should be improved. Accounting standard changes brought in by FASB on elimination of gain on sale accounting treatment was welcomed by the report as it meant disclosure of income as and when received and not upfront, but the report also cautioned that the changes in the disclosure requirements should not be such that would burden the securitizers and investors. Loopholes of the Basel II regulatory capital requirement should be plugged too.
- Standardization of the securitized products: To avoid problems relating to valuation and risk analysis the securitized products should be simplified and standardised. The report also mentions that some of the complex products like CDO2 should not re-emerge.
- Covered Bonds: Covered Bonds are viewed as an alternative to risk retention policy adopted by both EU and US, but the report views covered bonds as a complementary form of capital market based funding and not as an alternative to securitization.
While the report is appreciative of the recent changes brought about but also state that if new rules are not implemented well it could have its side effects on the market and would slow down the market rather than reviving it, thereby defeating the purpose. The new regulations should not throttle the markets but should facilitate maintaining a firm ground and sustainable growth.
In times where securitization is looked upon as a taboo or a jinx of sorts, the reprot gives securitization its due.
[Reported by: Nidhi Bothra]