Restarting Securitization

Last week, the IMF released an advanced chapter from its Global Financial Stability Report (the full report is due out on Oct 1). The released Chapter 2 of that report was on Restarting Securitization Markets: Policy Proposals and Pitfalls. According to the IMF, the secutization process remains a useful means of mobilizing illiquid assets, reducing credit costs and spreading risk. The problem, as has become widely recognized, was the slicing and dicing of the securities into highly complex transaction where the risk became almost unknowable, and then hiding that risk in off-book entities.

The report goes on to discuss various proposals to reform and restart the securitization market. These include the now standard items of credit rating agency reform, improving transparency, realigning regulatory capital requirements, and originator retention requirements. On this last point, they argue for careful implementation of policies requiring more "skin in the game" as those "can have dramatic effects on the incentives to improve loan screening, in some cases with the unintended effect of making some types of securitization too costly to execute, effectively shutting down these markets."

On the issue of transparency, the reports notes that American Securitization Forum has a Project on Residential Securitization Transparency and Reporting (Project RESTART) which is focused mostly on the mortgage backed securities process. That is a good step, but I strongly believe that such efforts are not enough.

There is another recommendation called for the report that would greatly strengthen the market: more simplification and standardization:

Most products could usefully be standardized at least to some extent. This should increase transparency as well as market participants' understanding of the risks, thus facilitating the development of liquid secondary markets. Although there will always likely be investors that demand bespoke complex products, securitization trade associations and securities regulators should encourage standardized building blocks for securitized products. It would also be useful if some standardization could be imposed on the underlying assets to maintain higher quality pools or at least verifiable pools (see the covered bond discussion below).
Valuation difficulties could also be alleviated if securitization products were simplified. Some of the product complexity was well intentioned, such as excess spread traps and triggers designed to bolster the creditworthiness of the senior tranches. Others, such as micro-tranching, were designed to game rating agency models. In any case, this product complexity has made some securities extremely difficult to value and risk-manage, and to the extent that regulation or market practices encourage such complexity, these components should be eliminated.

Those are good objectives: "facilitating the development of liquid secondary markets" and "alleviate valuation difficulties." The IMF report notes that the American Securitization Forum is also working on legal documentation standardization, but not on product standardization. Maybe they should.

For the intangible asset securitization process, simplicity is the key. Intangibles are already view with suspicion. As I have argued before, we need some plain vanilla transactions to make that case that these are not overly risky. With patents are becoming more accepted investment asset class (see earlier posting), maybe a few basic patent securitization deals could help get the market going again.

Basic, plain vanilla, uncomplicated. That is a formula for re-starting a market previously see by many (and with good reason) as rather dubious.