Wednesday, August 26, 2009

The Resurgence of Securitization and CDS

The concepts of securitization and credit default swaps (CDS) have acquired a negative connotation over the last couple of years since they were said to have triggered the global financial crisis during the second half of 2007. More, importantly, the assets involved were sub-prime loans that underwent a process of disintermediation due to which risk perceptions on the underlying assets were altered.

Now, there appears to be a resurgence of these instruments. Copious arguments are being made that it was not the concepts of securitization and CDS themselves that triggered the crisis, but it was the manner in which they were operated. In a column today in the Financial Express, K. Vaidya Nathan extols the virtue of securitization, if done properly.

Prof. Jayanth Varma of IIM Ahmedabad goes a step further and questions the notion that securitiation was responsible for triggering the crisis in the first place. He notes:
In 2007, we thought that the problem was about subprime mortgages, that it was about securitisation and that it was about CDOs (collateralised debt obligations). Now we know that these initial hasty judgments were mistaken. Defaults are rising in prime mortgages, huge losses are showing up in unsecuritised loans, and several banks have needed a bailout.


Over the last two years, our understanding of securitisation has also changed significantly. As global banks released their results for the last quarter, it became clear that bank losses are now coming not from securitised assets but from unsecuritised loans or whole loans.

He posits that securitization may have highlighted the problem early on due to accounting requirements:

It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.
Similarly, as far as CDSs are concerned, K. Vaidya Nathan points out in another column in the Financial Express that RBI has undertaken an initiative to assess the possibility of introducing a CDS market. At the same time, he advocates transparency by introducing exchange-traded products, and states that even where there are over-the-counter products there should be a central registry.

Overall, it appears that there are significant economic advantages through securitization and CDS. They are important mechanisms for hedging and risk-mitigation. However, they can be subject to abuse, as we have seen from the sub-prime crisis. The key role of regulation would be to engender the use of these instruments (albeit with some caution) so that parties are able to obtain the attendant advantages. At the same time, care should be taken to ensure that these instruments are used purely for hedging purposes rather than as a matter of speculation.

2 comments:

Shruti said...

Securitisation surely may help clean up the balance sheets of the assignor. But essentially, it is merely passing the risk of non-payment to a hapless third party who trusts a dubious credit rating agency. This is almost like saving your skin at the expense of another. Are such actions warranted, if the whole world could be potential martyrs to an ostensible judicious distribution of risks? Financial 'mis-innovation' has, but created an unreal world of assets having absolutely no underlying value. Do we really need this, when even the so called experts who are the progenitors of innovation, do not understand the products they create, and finally dub it as "..a failure of the collective imagination of many bright people.."?

Hemant Dujari said...

I have a query regaridng the lock in period of Securitization with the Monetary Policy 2009-10 review

It states that the


"To ensure that originators do not compromise on due diligence of assets generated for securitization, RBI has proposed a minimum lock of one year period for all types of loan before these loans can be securitized and the minimum retention by the originators will be 10% of the pool of assets being securitized."

Is this ruling applicable even for Microfinance Loans where the loan period is generally 1 yr ?? In case it is, it would be a big blow to the firms undertaking this exercise and targeting MFs, Banks etc as investors.