Risk Retention May Backfire in Down Market, Says IMF
While both covered bond and securitization markets provide the financial system with cost-effective, capital-markets-based funding, tranching in the securitization market creates more credit growth because it allows for more options to align risks with investor desires. The return of activity to private-label securitization markets will be a crucial part of economic recovery, but going forward, new measures must be put in place to ensure the markets positively contribute to financial stability and sustainable economic growth, according to the International Monetary Fund’s (IMF) Global Financial Stability Report. But not all regulations under consideration will be effective, the report said. US and UK proposals to better align the interests of securitizers and investors by requiring securitizers to retain some of the credit risk exposures — have more “skin in the game” — could backfire. “While equity tranche retention is a useful incentive mechanism when the quality of loans is high and the economy is doing well, this is not true for low-quality loan portfolios in a recessionary environment,” the report said. “A securitizer that is forced to retain exposure to an equity tranche backed by a low-quality loan portfolio when an economic downturn is highly probable will have little incentive to diligently screen and monitor the underlying loans, because the chances are high that equity tranche holders will be wiped out, irrespective of any screening and monitoring.” Instead, coordination is needed across those responsible for setting accounting standards, capital requirements, and retention schemes to ensure that structuring a securitization promotes greater attention to risk, both explicit and implicit, but does not introduce requirements so burdensome as to eliminate securitization altogether, the reported continued. While government initiatives like the Term Asset-Backed Loan Facility (TALF) and the Public-Private Investment Program (PPIP) will be helpful in clearing out toxic “legacy assets” that are clogging the market, the return of private-label securitization products — those not issued or backed by governments and their agencies — is necessary to curb the fallout from the credit crisis and draw an end to central bank and government interventions, the report said. But the report noted in the reemerged securitization markets, some products should not and will not return, like collateralized debt obligations (CDOs) backed by CDOs, asset-backed securities (ABS) and mortgage-backed securities (MBS), known as CDO2. The key is getting “real money” investors — insurance companies, and mutual and pension funds — to establish a broad and stable investor base that can transfer credit risk outside the banking sector, the report said. While acknowledging that investor over-reliance on credit rating agencies is a weakness in the securitization market, since regulatory bodies have embedded credit ratings in various regulations, the report said its “inevitable” that credit rating agencies will play a key role in the markets. Improved regulation of credit rating agencies would improve transparency and cut back on rate shopping by securitizers looking for the best rating on a product. Write to Austin Kilgore.