Why untangled? Part 1

Securitisation is a funding technique that turns an asset portfolio into securities such as bonds and shares. This allows investors to gain exposures in the entire portfolio rather than individual assets. Securities, due to their fungibility, are also a lot more liquid compared to individual, non-fungible assets. In addition, not all investors have an appetite or ability to manage individual assets. For example, when a loan asset is non-performing, the asset owner may need to take certain actions such as restructuring loan terms or realising collateral. Investors such as pension funds, insurance companies or individuals are often not set up to do that.

That is not to say that securitisation will fit all types of investors. Offering or owning a security is subject to securities laws which are often more stringent than law pertaining to owning a financial asset like a loan. There are also capital adequacy implications such as Basel 3 for banks and Solvency 2 for insurers.

Nevertheless, the benefits of securitisation to investors are clear as evidenced by billions of dollars being issued every year. However, the volume of securisation has not returned to the pre-Global Financial Crisis levels due to:

High Levels of Complexity: Whilst securitisation itself is a relatively straightforward concept, terms such as ABS (Asset Back Security), CLO (Collateralized Loan Obligation), CDS (Credit Default Swaps), CDO (Collateralized Debt Obligation), CDO-Squared, CDO-Cubed quickly get any ordinary investor’s head spin. These products all serve a purpose: the slicing and dicing of the underlying assets to fit different investor appetites. 

Underlying assets are not limited to actual loans advanced to borrowers like a mortgage or a car loan but could include or are composed entirely of other securities. So securitised products could be: 
  • First order derivative: notes and bonds issued on the back of asset portfolios
  • n-order derivatives: securitising securities - a bond on a bond on an asset portfolio like in the case of CDO-Cubed.

As complexity increases, the security loses its nexus with the underlying assets. Borrowers may not be able to repay their loans but investors could still be happy investing in the n-order derivatives so long as they have trust in the issuer and other intermediaries like rating agencies. When that trust is shaken because of worsening economic conditions or other factors, panic selling takes over as no one knows or trusts the value of the security they own. This is the reason why securitisation was often blamed for causing the GFC.  

Lack of Transparency: Complexity makes it difficult to track performance of the underlying assets. Even in the best of times, investors often have to rely on dated information such as monthly or quarterly reports. It was not possible to track performance of the portfolio asset by asset. Lack of transparency also extends to who owns what securities (cap table) and how securities are priced. Allegations were rampant on ‘front running’ i.e. the practice of benefiting an institution or a group of investors at the expense of others due to information asymmetry or insider information. 

High Costs: In order to create trust for investors, in addition to originators of assets and issuers of securities, there are many trusted intermediaries such as trustee, auditor, paying agent, legal counsel, custodian, sponsor/book runner etc. The process of securitisation is highly manual and often requires a lot of reworking, reconciling. Costs of compliance and reporting are also high due to the complexity of securities. These costs easily add 100 - 200bps to funding costs of originators.  
These issues are interrelated. For example, complexity reduces transparency or trust which in turns requires more parties to provide trust. Both of these drive costs. Because of high costs, securitization often does not make sense with large asset portfolios of over $200 million.