Suprime: have they learnt their lessons?

SECURITISATION RETURNS: In the wake of the subprime mortgage crisis, and the financial crash it caused, securitised financial products were considered toxic. But they are becoming big business again, with firms trading hundreds of millions dollars in collateralised funds once more

SOME SAY IT was the reason why the markets blew up in 2008, why Bear Stearns and Lehman Brothers collapsed and sent a wave of mass destruction around the world, effectively toppling the Irish banks. So why is the business at the heart of the credit crunch starting to take off once more and have any lessons been learnt?

Securitisation has its origins in the mortgage-bond trading desks of Wall Street in the 1970s. In essence, it is about extracting tomorrow’s value out of an asset today. So, for example, instead of waiting for 10,000 customers to repay their mortgages, a bank can instead securitise these loans, sell them off to investors, and reap the rewards today.

“It’s about meeting the demands of investors for exposure to a particular asset class and to release funding of capital for the originator to be able to continue with their business,” explains Alan Kerr, managing director of Harbourmaster Capital Management, the Dublin-based investment manager of subinvestment-grade corporate loans.

In Ireland, securitisation helped fund the credit boom, as banks securitised their residential mortgages and used the proceeds to lend out again to other borrowers. It got off the ground in 1996 with a £200 million (€254 million) transaction but grew to a €38 billion market by 2009.

Moreover, Ireland’s international financial services sector emerged as a hub for the international business, with debt securities listings exploding on the Irish Stock Exchange, and Ireland becoming the largest location in Europe for special purpose vehicles (SPVs), the structures used to house the loans which were being shunted off a bank’s balance sheet. Ireland now has a quarter of this market.

But while securitisation has its merits as a funding tool, it became a dirty word when layer upon layer of complexity and leverage were built into products based on dodgy US subprime mortgages, which were given out to borrowers with no source of income. When the mortgages started to default, propelling the US and Europe into financial meltdown, securitisation was blamed and the market for it grinded to a halt.

“There’s a perception that all securitisation is bad, but all securitisation is not bad in the same way that all equity investment is not bad,” says Kerr, adding, “there were many bad transactions – but it doesn’t mean it’s a bad thing.”

Indeed Harbourmaster has been an investor in asset-backed securities (ABS) in the past, and between 2002 and 2005 built up a portfolio of €1 billion in “vanilla”, or more conservative securitisation assets, such as car loans and credit-card products.

However, it took the view to reduce its book to about €100 million in 2005 on the grounds that the spreads were too tight, indicating that the risks had become too skewed to the downside.

And while the investment manager did have investment banks knocking on its door to sell it subprime products back in the day, Kerr says they were never attracted to it.

“We didn’t think that the risks were appropriately captured in the returns,” he says.

After the subprime market collapsed, the securitisation market dried up. According to Conor O’Toole, a director with Deutsche Bank in London, the European market fell from €550 billion a year at its peak in 2006, to literally zero in 2008.

Now, however, the market is showing signs of recovery. While the markets officially reopened in September 2009 with a deal by car manufacturer Volkswagen, volumes did not take off, but now O’Toole is forecasting issuance of €100 billion for this year.

Indeed, back in March Northern Rock, one of the pioneers of securitisation in Europe, returned to the market, in a deal that was “well-received”, according to O’Toole, while Investec even got a £128 million (€146.8 million) subprime deal away in the UK market, an important milestone.

If the business continues to pick up, Ireland’s cash-strapped banks could look to securitisation to raise funds. “Once the banking crisis gets resolved, it could be an important funding tool for peripheral banks,” says O’Toole.

And it could be a positive for the international business based in Dublin, given that the stock exchange has seen its debt security listings decline by more than 77 per cent from 2007.

But has the market learnt any lessons from its recent past? Northern Rock, after all, relied on asset-backed bonds for its funding, and when the markets closed in 2007 was unable to fund itself and had to turn to the British taxpayer for a bailout. Is its return to the markets a sign that it’s back to business as usual?

Market players don’t think so.

“The new issue market is only AAA,” says O’Toole, adding that it’s only the less risky, vanilla-type products, such as UK prime RMBS and auto deals, that are taking place, and that we won’t see the same degree of “tranching”, or leverage, that characterised the boom years for some time yet.

In addition, the issuance of more complex structured products, such as subprime collateralised debt obligations (CDOs) and CDO squared, has dried up. “That’s a good thing probably,” notes Kerr.

And there’s no sign of the US subprime market coming back.

“The door on US subprime issuance remains firmly shut for now,” says O’Toole.

Moreover, while the US leveraged loan or collateralised loan obligations (CLO) market may be picking up once more, in Europe the market remains dead, due to the dearth of arbitrage opportunities. Avoca Capital, a Dublin-based CLO manager with a portfolio of about €6 billion, has had to adapt to this change by concentrating on other related vehicles. According to a spokesman for the firm, this has seen it raising funds from large investors such as pension funds to manage the money in an unrated CLO fund. In addition, earlier this year it acquired a credit hedge fund, LionTrust, to invest in high-yield bonds, something it is “very excited” about.

There has also been a dramatic difference in how rating agencies are perceived. Blamed for inaccurately attributing AAA ratings to assets which were anything but risk-free, credit agencies opened up the ABS market to a whole new world of investors, who were otherwise restricted to buying only the safest of securities.

In doing so, they created more demand for ever more exotic products and exacerbated the scale of the meltdown. According to the New York Times this month, 91 per cent of AAA securities backed by subprime mortgages issued in 2007 have since been downgraded to junk status.

“There was an over-reliance on ratings, and investors were effectively buying without due regard to the investment analysis that needs to be done,” says O’Toole.

Now, however, investors are taking more responsibility for their own due diligence, but just because the rating agencies messed up, doesn’t mean they still don’t have a place.

“The banking world does require rating agencies – they won’t go away,” says Kerr, but adds, “maybe three to four agencies isn’t enough”.

And with a much tougher regulatory environment, which requires originators to keep some “skin in the game” by holding on to a percentage of their portfolio, investors are slowly coming back to ABS.

“Investors feel there’s a better alignment of interests,” notes Kerr.

They’re also looking for a decent upside. With yields on government bonds – Ireland apart – and corporate bonds close to record lows, some investors are prepared to take on more risk to get better returns.

Last year, there were just two or three US dollar investors looking at European ABS, but now the figure is closer to 30, notes O’Toole, adding that structured products are looking “quite cheap” compared to other products.

But, while it may be “very vanilla prime paper that is offering an attractive risk opportunity” at the moment, according to O’Toole, the search for yield and greater returns could lead investors to seek out better returns through riskier products.

This time around, however, it will be hoped that everyone has learnt their lesson and there won’t be a repeat of the subprime crisis.