“Securitisation is essential to the evolving global financial system because it provides a number of important economic benefits. But securitisation has also been a central element of the dynamics of the financial turmoil that began in the summer of 2007, largely caused by inadequate risk management practices and a lack of due diligence on the part of market participants.”
Malcolm D Knight
General Manager, Bank for International Settlements
Everything was hunky dory as long as the U.S. housing market boomed. Traditionally, mortgages were around 70-80 per cent. With prices going through the roof, buyers would put down just around 10 or maybe even 5 per cent. The balance would be put in by the bank. The logic being, since the value of the house was shooting up, the loan would amount to just 75 per cent within two years. As interest rates were low, there was also a surge in home equity borrowing. So when home prices started to fall, problems appeared. As a large number of financial entities had huge exposures to the housing market (either as investors or lenders), the crisis was felt in liquidity markets. The securitised debt, mortgage-backed securities and others of its ilk, boomeranged when individuals started defaulting. The result was a crisis in the credit market.
The ultimate test of any product or a decision is in times of distress. Till the time home prices were soaring, defaults were minimum and all was well. Once prices crashed and defaults increased, the rug was pulled from under the financial institutions. The way this entire episode of such complex financial products has unfurled, pops a questions — Are these instruments - the descendants of American financial aristocracy, managing risk or adding to it?
Have we imported it?
A look at the portfolio of fixed income funds shows a growing fancy of fund managers towards Securitisation and Pass-Through-Certificates (PTCs). The exposure of these funds to PTCs, securitised debt and structured obligations has increased 170 per cent over a year, to Rs 33,937 crore (April 2008) from Rs 12,480 (April 2007). Expressed as percentage of fixed income assets, the amount is 10 per cent, compared to 8.5 per cent, exactly a year ago. Franklin Templeton Mutual Fund had 26 per cent of its assets in securitised debt, followed by HDFC Mutual Fund with 20.77 per cent. In fact, all fund houses increased their exposure to securitised debt by a significant margin, barring LIC MF and ABN Amro. LIC MF declined its exposure to such instruments from Rs 943 crore (April 2007) to Rs 316 crore (April 2008) of its fixed income business. On the basis of absolute amount, Reliance Mutual Fund, HDFC Mutual Fund and ICICI Prudential Mutual Fund, by far, have the biggest exposure to these instruments; Rs 6,067.68 crore, Rs 5,891.92 crore and Rs 3,654.46 crore, respectively.
The reason mutual funds embark on the securitisation drive is due to the higher returns. Securitised instruments are an attractive proposition for funds because of a higher yield of 50-100 basis points (remember, the risk is high too) against paper of similar rating.
Realising the importance of disclosures and the extent of monitoring while dealing with securitisation, ICICI Prudential has set a precedence by giving a complete portfolio disclosure of securitisation and PTCs namely, the obligor, the originator, the rating and the underlying security. A great move which will lead to greater transparency. It will help investors and stakeholders judge and question the portfolio quality, which was difficult to evaluate earlier.
While securitisation, per se, is not the problem, other issues need to be addressed such as underwriting standards, concomitant extension of securitization into increasingly complex and difficult-to-understand structures, and collateralisation by lower quality assets. Going by the U.S. experience, fund managers would do well to learn from it.