Asset Securitisation and Banking Sector - Coursework Example

Asset Securitisation and Banking Sector What do you understand by the term asset "Securitisation" as it applies to the banking sector? To what extenthas this development undermined the viability of the US banking business model? Introduction to Asset Securitisation Definition: In the process of asset securitisation, the illiquid assets are transformed into a security through financial engineering. For example, the securitisation of a collection of mortgages result in mortgage backed security. The asset securitisation process is structured in such a way that interests in loans and other kinds of receivables are combined, underwritten and finally sold as asset backed securities. History of Asset Securitisation: The history of asset securitisation dates back to 1970s, when the structured financing of mortgage pools was being done. Before entering into asset securitisation, the banks were the portfolio leaders and they used to hold loans until their maturity periods. The loans held by the banks were mainly funded by the deposits of the customers and they were the obligations of the banks. It is important to note that these obligations were not the claim on specific assets. With the development of the housing credit market after the World War II, the financial institutions especially the depository institutions were facing increase demand of housing credit. The increasing housing credit was establishing an opportunity for the banks to increase the sources of mortgage funding. For attracting the investors, the investment vehicle was developed by the investment bankers. This investment vehicle segregated the defined mortgage pools and segmented the credit risk. Finally, the cash flows from the underlying loans were structured by the investment bankers. The mortgage securitisation structures took several years to become efficient structures. Later on, it was realized by the loan originators that this process could be used for the other types of loans. During mid 1980s, asset securitisation became one of the popular growing activities in the capital markets. The sophisticated investors and the advancement in technology contributed to the growing process of asset securitisation. Today, very few banks claim that they are exclusive portfolio lenders. The figure shows that the relative investments in asset-backed securities are the highest as compared to the other securities; however, a great decline in 2008 is noticeable (Figure 1). Figure 1: Asset Securitisation Contribution: Capital Growth Market Source: Benefits of Asset Securitisation The process of asset securitisation is offering various benefits to parties involved. From the originators point of view, it increases the returns on capital by creating an off-balance-sheet income stream from the on-balance-sheet lending account. It also reduces the borrowing costs, improves asset/liability management, credit risk management and releases more capital for investment purposes. From the investors’ perspective, securitisation provides the investors with attractive yields combination. Asset securitisation also increases the secondary market liquidity of the security. It offers more flexibility to the investors because the structure of the payments can be adjusted in consideration to the particular needs of the investors. From the perspective of borrowers, asset securitisation is important because it enhances the availability of credit. The Process of Securitisation Before evaluating the impact of asset securitisation on the US banking business model, the fundamental understanding of asset back securities is very essential. In the Comptroller’s handbook, the process of securitisation has been explained through three steps. 1. Basic Structures of Asset Based Securities The structure of the security is based on the kind of collateral for example, the revolving lines of credit dictate a different structure as compared to the instalment loans. The instalment loans have fixed and predetermined maturity dates and amortisation schedules whereas, the revolving lines of credit do not have maturity dates or amortisation schedules. For the redistribution of risk during the securitisation process, various specialised roles are introduced including credit enhancer, investor, originator, service provider, trustee and underwriter. A particular bank may perform various roles however; it primarily depends on the availability of expertise to a bank. The bank is exposed to the types and levels of risk based on its role in the securitisation process. 2. Structuring the Transaction During the structuring of loans pools, they are converted into securities. The structuring is important because it modifies the nature of the risks and returns for the final investors. In fact, the structuring process results in the differentiation of the loan pools and securitised credit pools. During the structuring of loan pools, the credit enhancement techniques are used for the isolation and distribution of credit risk. Moreover, the tax issues are considered to manage the cash flows. For the evaluation of securitisation process, the structure of security, design and responsibility of each party are taken into account. The four stages of the process of structuring of securities include the segregation of assets, creation of special-purpose vehicle, addition of credit enhancement to improve stability and issuance of interest in the pool of assets. 3. The Mechanism of Cash Flow It is the final stage of asset securitisation process for managing the cash flow. The mechanism of cash flow for instalment loans and revolving asset types differ. The securities that are backed by instalment loans are linked to the loans payment flows and the interest is usually paid on monthly basis. The defined amortisation schedule and prepayment rate determines the principal in each payment. The cash flow mechanism of revolving asset types is different and consists of two phases including the revolving period and the amortisation phase. Asset Securitisation and its Impact on the US Banking Business Model The overall impact of asset securitisation on the banks is considered very beneficial. Securitisation allows the banks to increase the volume of assets while reducing the liquidity risk, credit risk and interest rate risk. It also allows the banks to manage its deposit insurance and reserve requirement costs and to develop customer relationships. Moreover, the ratios like return on assts and return on equity are improved whereas; the exposure of the banks to the risks is reduced. Since, the asset securitisation process is a complex system, therefore, management at some banks commit mistakes and incur problems. The major mistake made by the banks is that they either overestimate the risk transfer of asset securitisation or underestimate the commitment and dedication to effectively manage the asset securitisation process. Lockwood, Rutherford and Herrera (1996) highlight that asset securitisation results in wealth loss of bank shareholders. On the other hand, Thomas (1999) finds that more returns are available to the shareholders after asset securitisation.1 Solano and Guirao also presented the views of different researchers regarding the inclination of banks to asset securitisation. Pavel and Phillis (1986) argue that increasing asset securitisation in banks is because of binding capital requirements of banks. However, Donahoo and Shaffer (1991) believe that banks go for asset securitisation to reduce their reserve and capital requirements. According to Simon Wolfe, four factors can influence the decision of a bank to go for asset securitisation including “the level of deposit insurance, capital adequacy requirements, insolvency risk and the risk of credit enhancements.”2 Although different opinions have been presented regarding the growing asset securitisation in banks however, most important thing is analyse the extent to which asset securitisation has undermined the viability of the US banking business model. The process of asset securitisation has contributed to the expansion of the US mortgage market. It has entirely changed the structure of the value chain within which the financial institutions such as banks used to manage the financial assets, risks and liquidity. As a result, of this modification and sophisticated asset securitised products particularly in the US mortgage market, have increased the probability of mortgage defaults. During the current economic downturn, the destabilized viability of the US banking business model because of the development of asset securitisation has been noticed. No doubt, for about 40 years, the asset securitisation appeared as the most flourishing sectors of the U.S. capital markets. It has been appreciated because of its significant contribution to the growth of the U.S. economy (Figure 2). However, the recent collapse of asset securitisation market of the U.S. has raised the concerns for the organisations. Figure 2: Asset’s Securitisation Contribution: Capital Markets Source: Asset Securitisation Theory and Practice by Dr. Joseph Hu Banking sector is one of the highly regulated sectors. The development of asset-backed securities in the United States was not being closely monitored as it was being done previously. As a result, more and more poorly written mortgages were issued without considering their credit risk. Eventually defaults of the mortgage backed securities increased thereby, threatening the banks and other financial institutions. The U.S. banks, which were issuing asset-backed securities found dryness in the market liquidity. It further affected the banking business by reducing the availability of funds. A typical depository bank business operates on the deposits of the customers and the increasing asset baked securities defaults enhanced the obligations of the banks. During the recent credit crunch, it has found that the US banks were not capable to absorb mark-to-market losses on mortgage assets and impairment of goodwill. Eliot et al. show in their research paper that undermining of the viability and sustainability of the US banking business model is a result of asset securitisation because the US banks work with constricted profit margins and narrow equity cushion in their balance sheet.3 It is also argued that the traditional banking business model of the US banks is more profitable because asset securitisation increases the management and system costs for the banks because of legal fees, rating fees and underwriting fees. Therefore, if the asset backed securities increased the funds availability for the banks, then on the other hand, they have also decreased the profit margins of banks because of expensive securitisation process. The primary aim of developing an efficient business model of the organisations was to achieve cost efficiency. However, asset securitisation has undermined the viability of the US banks because it required large scale structuring and it was not cost effective for medium and small transactions. The US banks, which perform the role of loan originators, do not retain the residual risk for the loans however; they collect considerable fees on issuing the loans and securitisation. As a result, the writing standards are not improved. The assets backed securities are rated to determine their default risks and the banks and financial institutions, which issue these securities, have been also facing losses because of poor credit ratings. The USA’s largest public pension fund has filed a suit in California in July 2009, against the three leading rating agencies. The Public pension fund has argued that the ratings of these agencies have inaccurately rated their asset-backed securities, which caused a loss of $1 billion.4 The trends in securitised assets 2007 show that this year was a year of unprecedented rating volatility because about $300 billion of securities were downgraded.5 The figure is also showing the defaulters in the US Assets-backed securities market (Figure 3). Figure 3: Issuance of US Asset-Backed Securities Falters Source: Deutsche Bank In short, the process of asset securitisation is itself an efficient process however, it requires close scrutiny and monitoring. The lack of this scrutiny in the U.S. financial institutions caused the asset securitisation crisis not only in the U.S., but it has also affected the entire world economy. Moreover, the experienced gained by the U.S. banks because of asset securitisation crisis, offer great learning opportunities to the financial institutions in the other economies. Bibliography Asset Securitization . (1997, November ). Retrieved November 25, 2009, from OCC: http://www.occ.treas.gov/handbook/assetsec.pdf Heilpern, E. e. (2009). When it comes to the crunch: What are the drivers of the US banking crisis? Elsevier Ltd . Securitization. (n.d.). Retrieved November 25, 2009, from Wikipedia : http://en.wikipedia.org/wiki/Securitization#Recent_Lawsuits Solano, M. P., & Guirao, Y. J. (n.d.). Asset Securitization: Effects on Value of Banking Institutions . Retrieved November 25, 2009, from Google Documents : http://docs.google.com/viewer?a=v&q=cache:f_O51PhlVyEJ:www.fep.up.pt/conferencias/pfn2006/Conference%2520Papers/528.pdf+effects+of+Asset+Securitization+on+US+Banking+Business+Model&hl=en&gl=pk&pid=bl&srcid=ADGEEShQuWIx8D2-JybhrbHQl6Ln6C-Ja99K_FS-I3jauFbeY Weaver, K. (2008). US asset-backed securities market review and outlook. Retrieved November 25, 2009, from Google Documents : http://docs.google.com/viewer?a=v&q=cache:RFYKA04fElcJ:www.globalsecuritisation.com/08_GBP/GBP_GSSF08_018_021_DB_US_ABS.pdf+US+asset+securitization+market&hl=en&gl=pk&pid=bl&srcid=ADGEESi4hS0577CD8uDhjtIGFJ5Og0CBNLbO6DrbgpppyVLTxQbMYft4bQHFNFp2coFjETrsKVP Wolfe, S. (2000). Structural effects of asset-backed securitization. The European Journal of Finance , 353 - 369 . Read More