Financial Market Trends No. 74

Trends and Developments in Securitisation* I. Introduction and overview In normal market parlance, the term “securitisation” has had two primary meanings: Initially, the term was applied to the process of disintermediation, or the substitution of security issues for bank lending. More recently, the term has been used to refer to so-called “structured finance”, the process by which (relatively) homogeneous, but illiquid, assets are pooled and repackaged, with security interests representing claims to the incoming cash flows and other economic benefits generated by the loan pool sold as securities to third-party investors. Such asset-backed securities (ABSs) may take the form of a single class offering, in which all investors receive a pro rata interest in the incoming revenues from the asset pool, or a multiclass offering, whereby two or more classes or tranches are granted different (and, in some cases, uncertain) claims, each with its own pay-out and risk characteristics. The term securitisation is usually applied to transactions in which the underlying assets are either removed from the sponsor’s balance sheet, or never appear there after origination. Unless otherwise stated, this is the definition employed herein.1 However, it should be noted at the outset that, in some jurisdictions, originators can achieve similar objectives by “ring-fencing” or segregating the assets, which for accounting purposes remain on balance sheet. A number of OECD countries in Europe have well-established systems of “on-balance sheet” securitisation, whereby specialised lenders fund themselves long-term by issuing bonds. The bonds may be backed by a range of assets, but residential mortgages are the most commonly used collateral. Historically, the most extensive markets have been found in Denmark, Germany, and Sweden, but similar markets in asset-related bonds also exist in Austria, Finland, France, Italy, the Netherlands, Spain, and Switzerland. A lot has changed in the ABS market over the past few years, in terms of who is issuing, what is being issued, and who is investing. Recent trends include a * This article has been prepared by Senior Economist Stephen Lumpkin, Financial Affairs Division. 25 Financial Market Trends, No. 74, October 1999 blurring distinction between structured finance and corporate finance, increased use of derivatives and securitisation in the same transaction, increased use of securitisation to convert insurance risk into capital market risk, and, on the ratings front, an increase in the number of downgrades. There also have been marked changes in the legal and regulatory environment, including in some instances, a loosening of restrictions on acceptable investments by pension funds and life insurance companies. In some countries, the basic legal, regulatory, tax, and accounting infrastructure for securitisation has been implemented for the first time, while in others, certain refinements have been introduced to existing securitisation legislation to better facilitate balance sheet restructuring. Recent years have also witnessed the growth and development of sophisticated tools for assessing and managing credit risk. This has led to increased liquidity in swap and hedging markets, which has facilitated growth in some types of ABS instruments.2 Issuance of asset-backed securities has registered strong growth in recent years and recent developments suggest that growth should remain strong going forward. More importantly, securitisation is being used increasingly to implement portfolio re-balancing strategies. As the yardstick for investment performance moves closer to a global standard, increased emphasis is being placed on such performance-based measures as return-on-assets and return-on-equity. In response, banks and non-financial corporations as well have turned to securitisation to improve their financial ratios by removing selected assets from their balance sheets. In Europe, banks have turned to securitisation as a tool for improving profitability by freeing up capital allocated to low-yielding assets, a strategy that appears to have started in the restructuring of the market in the United States in the late-1980s. In Asia, the technique is being used primarily to provide immedi- ate capital relief. More broadly, the global economy is contributing to a new wave of mergers and acquisitions. Securitisation is being applied to many of these transactions in combination with traditional bank financing; as a consequence of these hybrid transactions, the distinction between loans and securities has become blurred. This study examines the recent economic, structural, and demographic factors that underlie the marked changes in the ABS collateral pool, the expansion of activity in emerging markets, as well as other major developments in the interna- tional ABS market. Of particular interest are developments associated with the ongoing consolidation in the financial services area and the increasing institution- alisation of savings. The study is organised as follows. Section II looks at common structural elements of ABS transactions; it provides a template against which recent developments are analysed. Section III explores the benefits of securitisation to issuers and investors. Section IV briefly examines some of the regional vari- 26 ations in securitisation activity. Trends and Developments in Securitisation II. Structuring 1. Types of assets In order for asset pools to be feasible for securitisation, they must be of relatively identifiable, though not necessarily low, default risk. Securitisation techniques rely heavily on the development of extensive historical databases that record the loss experience of many comparable assets. In the absence of adequate information on credit performance, loss probability distributions for different types of borrowers, businesses, or loans cannot be reliably estimated. Loan originators who specialise in evaluating loan proposals can usually distinguish better credit risks from poorer ones, but this assessment of quality is often subjective and somewhat difficult to quantify. Faced with this information asymmetry, ratio- nale investors would add a sizeable discount to the implicit price at which the underlying assets are purchased to compensate for the increased uncertainty regarding the credit risk of the assets in the pool. The issuer can reduce the size of this discount by securing the assets with collateral that can be valued with relative certainty, or by including substantial credit enhancements in the securitisation. Of course, high levels of credit enhancement add significant costs to the securitisation of an asset pool and can render the transaction uneconomical. As a consequence, securitisation has often been used for assets for which the costs of acquiring and distributing information to rating agencies and investors about loans and borrowers is low, a result of standardised loan underwriting criteria and advances in information technology, which have made it easier to estimate default probabilities and payment patterns under a variety of economic conditions. The process of pooling such assets into large homogeneous groups facilitates an actuarial analysis of their risks, which enables credit rating agencies and, in some cases, third-party credit guarantors, to review and validate the lender’s initial credit underwriting decisions. Among asset classes, residential mortgages are the dominant form of collateral for ABS in most jurisdictions, because they are generally more homogeneous, easier to pool and easier for the rating agencies to analyse than other asset types. The first mortgage pass-through securities were issued in the United States in 1970, making single-family mortgages the first loans to be securitised off-balance sheet.3 Owing in part to the implied guarantees and loan purchase programmes of the mortgage-related government sponsored enterprises in the United States, underwriting guidelines for one-to-four family mortgages have been sufficiently standardised that they can be insured on an actuarial basis at relatively low cost. The issuers of mortgage-related securities add some supple- mental guarantees, but most of the assurance is inherent in the underlying collateral and the ability of mortgage insurers to guarantee the ultimate payment of 27 Financial Market Trends, No. 74, October 1999 interest and principal, while the servicers and issuers assure the timeliness of payments. This has substantially reduced the cost of pooling and securitising the underlying loans, and has led to strong growth in issuance. In the United States alone, there currently are approximately $2.0 trillion of securitised mortgages outstanding. Residential mortgages also account for a large share of asset-backed deals outside the United States. There tends to be a natural progression to growth and development of the ABS market: residential mortgages tend to be securitised first for the reasons cited, after which come mortgages on commercial properties, consumer receiv- ables and then other asset classes.4 Over time, the collateral mix backing ABS has expanded considerably, particularly in the United States, where off-balance sheet techniques for securitisation have progressed the furthest. But even in less devel- oped markets, the application of securitisation techniques has become more widespread. Recent years have witnessed the emergence of a variety of new asset classes and structures, an expansion in the investor base, and a marked increase

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