The Rules, Part XV

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.  Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.  Do investors want ultrasafe investments?  Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.  The remainder should be rated AAA (Aaa if you speak Moody’s).  Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?  What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?  Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.  Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.  Well, guess what?  Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.  If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.  And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.  They do not have to worry that money will run away from them.  The promises that these entities make are long duration in nature.  They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.  Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

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But what of my first point?  There are securitization trusts, and there are financial companies.  During a boom phase, the securitization trusts can finance assets cheaply.   During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.  Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.  Having a real balance sheet with slack capital has value during a financial crisis.  Securitization trusts follow rules, and have no slack capital.  Losses are delivered to the juniormost security.

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Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.  In 2005, with a few exceptions, the life insurance industry stopped buying them.  AIG was a major exception.  The consensus was that the extra interest spread was not worth it.  Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.  When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

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During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.  That allows the economy to grow faster for a time, but there is no free lunch.  Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.  Usually a tranche offering credit support will tend to lose all of its principal, or none.  (Leaving aside early amortization and the last tranche standing in the deal.)  For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.  But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.  First, originators weren’t retaining much of the risk, so they could be more aggressive.  Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.  Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).  What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.  Debt levels increased, and made the system less flexible.   Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

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Securitization has been a mixed blessing to investors.  It is brilliant during the boom phase, and exacerbates trouble during the bust phase.  And so it is.  As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.  Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.  It’s not a hard calculation to run.

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Off-topic end to this post.  I added Petrobras to my portfolio today.  Bought a little Ensco as well.  I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.  Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV