gathering at the origination stage. Reputationconsiderations will mitigate this problem, but will not eliminate it.3.Securitisation also puts information in the wrongplace. Whatever information is collected by theloan originator about the collateral value of theunderlying assets and the credit worthiness of the ultimate borrower, remains with the origina-tor and is not effectively transmitted to the SPV,let alone to the subsequent buyers of the securi-ties issued by the SPV that are backed by theseassets. By the time a hedge fund owned by a French commercial bank sells ABSs (asset backedsecurities) backed by US sub-prime residentialmortgages to a conduit owned by a smallGerman Bank specialising in lending to small andmedium-sized German firms, neither the buyernor the seller of the ABS has any idea as to whatis really backing the securities that are beingtraded.
Partial solutions
The problems created by securitisation can be mitigatedin a number of ways.
1. Simpler structures.
The financial engineering that went into some of the complex securitised structuresthat were issued in the last few years before the ABSmarkets blew up on August 9, 2007, at times becameludicrously complex. Simple securitisation involved thepooling of reasonably homogeneous assets, say, resi-dential mortgages issued during a given period with agiven risk profile (e.g. sub-prime, alt-A or prime). These were pooled and securities issued against them weretranched. However, second-tier and higher-tier-securi-tisation then took place, with tranches of securitisedmortgages being pooled with securitised credit-cardreceivables, car loan receivables etc. and tranched secu-rities being issued against this new, heterogeneous poolof securitised assets. Myriad credit enhancements wereadded. In the end, it is doubtful that even the design-ers and sellers of these compounded, multi-tiered secu-ritised assets knew what they were selling, knew its riskproperties or knew how to price it. Certainly the sellersdid not.There is a simple solution: simpler structures. This willin part be market-driven, but regulators too may put bounds on the complexity of instruments that can beissued or held by various regulated entities. Central banks could accept as collateral in repos or at the dis-count window only reasonably transparent classes of ABS.
2. Unpicking' securitisation.
This 'solution' is theultimate admission of defeat in the securitisationprocess. A number of American banks with residentialmortgage-backed securities (RMBS) on their balancesheets have been scouring the entrails of the asset pools backing these securities and have sent staff to specificaddresses to assess and value the individual residentialproperties. This inversion of the securitisation matrix is,of course, very costly and means that the benefits fromrisk pooling will tend to be ignored. It is an ignomin-ious end for the securitisations involved.
3. Retention of equity
tranche by originator. Whenthe originator of the loans is far removed from the ulti-mate investor in the securities backed by these loans,the incentive for careful origination is weakened. One way to mitigate this problem is for the originator toretain the 'equity tranche' of securitised and tranchedissues. The equity tranche or 'first-loss tranche' is thehighest-risk tranche - the first port of call when theservicing of the loans is impaired. It could be made aregulatory requirement for the originator of residentialmortgages, car loans etc. to retain the equity tranche of the securitised loans. Alternatively, the ownership of theequity tranche could be required to be made publicinformation, permitting the market to draw its ownconclusions.
4. External ratings.
The information gap could beclosed or at least reduced by using external rating agen-cies to provide an assessment of the creditworthiness of the securitised assets. This has been used widely in thearea of RMBS and of ABS. This 'solution' to the infor-mation problem, however, brought with it a whole slewof new problems.
Rating agencies
A small number of internationally recognised ratingagencies (really no more than three: Standard & Poor's, Moody's and Fitch) account for most of the rating of complex financial instruments, including ABS. They gotinto this business after for many years focusing mainlyon the rating of sovereign debt instruments and of largeprivate corporates. They have been given a formal reg-ulatory role, (which will be greatly enhanced under theabout-to-be-introduced Basel 2 Capital Adequacyregime) because their ratings determine the risk weight-ing of a whole range of assets bank hold on their bal-ance sheets.Their role raises a number of important issues becauseit creates a number of problems.
Problems
1. What do they know?
This is a basic but importantquestion. One can imagine that, after many years, per-haps decades, of experience, a rating agency would become expert at rating a limited number of sovereigndebtors and large private corporates. How would therating agency familiarise itself with information avail-able only to the originators of the underlying loans orother assets and to the ultimate borrowers? How wouldthe rating agency, even if it knew as much about theunderlying assets as the originators/ultimate borrowers,rate the complex structures created by pooling hetero-geneous underlying asset classes, slicing and dicing thepool, tranching and enhancing the payment streamsand making the ultimate pay-offs complex, non-linearfunctions of the underlying income streams? These rat-ings were overwhelmingly model-based. The modelsused tended to be the models of the designers and sell-ers of the complex structures, who work for the issuersof the instruments. The potential for conflict of interestin the design and use of these models is obvious. Inaddition, even honest models tend to be useless duringperiods of disorderly markets, because we have too few
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