By Felipe Ossa April 18, 2016
A scene from the film, The Big Short.
Last year’s hit film The Big Short brought financial esoterica into the mainstream. Or at least it tried. The movie tells the behind-the-scenes story of the subprime housing loan racket that set the 2008 global financial crisis in motion. To explain the most difficult bits of financial wizardry, the movie enlists celebrities to offer primers. For instance, starlet Margot Robbie, sipping champagne in a bubble bath, dishes up details on the true meaning of subprime.
It didn’t work for everybody. Friends of mine—a few in the media—told me they left the film still scratching their heads about the mechanics of mortgage-backed securities (MBS).
That’s too bad—not just because well-informed citizens ought to understand the forces that sparked the biggest global economic collapse since the Great Depression. It’s too bad because while Dodd-Frank regulations in the U.S have arguably made it more difficult for a similar mortgage crisis to happen again, the process of creating MBS matters even more for some non-mortgage sectors of the economy than it did eight years ago.
That process, securitization, is simply a method by which certain kinds of illiquid financial assets—generally ones that are tied to a future income stream—are bundled together into a bond that pays interest to investors. Some reporters, in fact, write only about securitization. I used to be one of them. If you want to cover business, understanding how securitization works can be a great asset.
The Trivia
Ever heard of Bowie Bonds? Yes, David Bowie securitized the royalties—present and future—on a catalogue of his songs in 1997. In exchange, Bowie received $55 million up front. Other musicians, like James Brown and the Isley Brothers, followed suit.
The list of esoteric assets that have been securitized is long and wildly varied, from the remittances sent home by workers living abroad to film rights.
I covered one cattle head-backed bond in Colombia in 2003 in which the ranch owners sold the “assets” to a financial trust that subsequently issued bonds (standard practice in a securitization).
David Bowie securitized the royalties—present and future—on a catalogue of his songs in 1997.
The deal ran into trouble when a couple of these cowboys were caught selling the securitized assets. This constituted fraud since they were now only caretakers, and not owners, of the cattle. How did their double dipping come to light? The cows were branded with the insignia of the trust and so were easily spotted when they popped up at other ranches.
But assets far more familiar to many Americans are also bundled into bonds: not only mortgages, but auto loans, student loans, and credit card receivables are securitized as well.
The History
Securitization has been around a long time. Some say as early as the 1850s, when railroad companies issued farm mortgage bonds in a financial scheme that some compare to the subprime-loan debacle of over 150 years later (and which played a role in another crisis, the Panic of 1857.) Modern securitization started taking shape in 1970, when Ginnie Mae, a government agency, guaranteed the first securities that passed the interest and payments on mortgages through to the investors in those bonds.
Today, more than 64% of U.S. residential mortgages are in securitizations.
Why Securitize?
For one thing, it gives investors—big institutional players as well as smaller, specialized asset managers—the opportunity to gain exposure to the performance of a bundle of assets that otherwise might be too costly or complicated to purchase. For an originator—the entity that generates the assets in question—securitization can free up the balance sheet so that it can do more business. For instance, a bank securitizing a pool of its mortgage loans will sell them to a securitization vehicle. It can use the proceeds from the sale to make more mortgage loans or lend in other ways, which helps keep credit flowing.
The Regulation
In the financial crisis aftermath, European regulations made many kinds of securitization uneconomical by, for instance, requiring banks and regulated investors to hold more capital against these kinds of investments. But now many of the continent’s policymakers believe the more stringent approach to securitization contributed to the economic slowdown. For instance, they would like to see more securitization funding loans to small and medium companies (yes, they’re securitized too), which, would in turn, encourage financial institutions to make such loans.
Regulations set up to prevent another crisis are, of course, a good thing. Regulators in the U.S. and Europe have required financial institutions to meet risk retention thresholds, for instance, which means they have to maintain a stake in the performance of the assets that they sell off to securitization vehicles. During the bubble, mortgage originators that knew they weren’t going to keep the loans on balance sheet were often careless or blatantly lied about key aspects of those loans and the borrowers who owed them. The hope is that having “skin in the game” will keep them more honest.
Gathering String
Great stories can be hidden behind trends in securitization. A big acceleration or slowdown in the securitization of a particular asset might tell you something about that asset’s future prospects.
The online marketplace loan industry is facing some headwinds. ©401(K) 2012
Take online marketplace, or “peer-to-peer,” loans. According to The Economist, the volume of loans peer-to-peer firms sold in securitizations has fallen dramatically in 2016 versus last year. That slowdown reflects underlying trouble in the industry.
Indeed, marketplace loans, which have been bundled into securitizations since late 2013, started to face serious legal and regulatory challenges last year. A court ruling that called into question the legality of marketplace lenders charging interest rates that break usury laws in some states. The finance industry has appealed. More recently the Consumer Financial Protection Bureau has announced it is accepting consumer complaints from the sector.
But there is not always a direct correlation between securitization and industry growth. As of late March, the value of all solar energy securitization deals closed year-to-date had totally eclipsed the entire value of solar energy securitization deals for 2015. But in this case, it might just be that people are adopting one funding channel in place of another. (Solar tax credits are expiring, while yieldco’s—a competitor to securitization—have not been performing well.)
To figure out whether securitization figures in a wider issue, just perusing the advocacy page of the trade association Structured Finance Industry Group can provide clues. If they have a view on a particular industry, you can read about it there. Analysts at rating agencies are also excellent resources. In addition to deal-specific reports that might contain more industry-wide information, agencies put out reports on the performance and outlook of an asset class in general. They will also discuss how their assessments differ from their rivals (an analyst might explain, for example, why her agency is more cautious than the others on a particular class of assets.).
Non-agency securitization analysts who work for large banks, boutique shops or consultancies can also provide good background information. Though there’s a caveat here: a new SEC rule has lead at least one bank to stop distributing debt research—including research on securitization—to reporters.
There are still plenty of other kinds of sources—traders, lawyers, and current and potentially future originators (a colleague of mine told me that in the late 90s she’d cold call banks to see if they were up to any securitizations, even if they’d never done one).
And there are always the industry conferences, which are a big deal in the securitization world. The last annual ABS Vegas conference, in Las Vegas, drew a crowd of more than 6,000 attendants. A lot of those people, no doubt, had stories to tell.
