In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.
When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans. When the market is cold, though, selling the risky pieces is hard, to say the least. If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.
In that situation, hard choices have to be made. Here are some options:
- If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions. Then if the market turns around later, sell off the risky pieces.
- If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
- Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
- Reprice the risky parts of the deal to make the sale, and realize a loss.
The proper choice will depend on the degree of balance sheet capacity that the securitizer has. Balance sheet flexibility, far from being a waste, is a benefit during a crisis. As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it. Their balance sheets allowed them to buy and hold. They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment. The same thing happened when LTCM blew up. Stronger hands reaped the gains that the overly levered LTCM could not.
In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most. There will come a time in the next five years where it goes from being a luxury to a necessity. Companies that must securitize will have a hard time then. Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle. Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.