It’s back

GIVEN their role in the 2008 meltdown, and their subsequent branding as toxic sludge, it is not surprising that “securitised” financial products have had a quiet few years. Yet the transformation of mortgages, credit-card debt and other recurring cashflows into new marketable securities is enjoying something of a resurgence. Once apparently destined for the financial history books, the alphabet soup of ABSs (asset-backed securities), MBSs (their mortgage version), CLOs (collateralised loan obligations) and others had a bumper year in 2013. More growth is expected this year (see article).

Not everybody is thrilled. Some observers argue that the risks securitisation poses are too grave. But its revival should be welcomed, for it is probably essential to continued economic recovery, particularly in Europe.

Use carefully

In its simplest form, securitisation is straightforward and beneficial. For example, a carmaker expecting lots of monthly payments from customers who have taken out financing can get investors to fund its business more cheaply by selling them its claim to those payments. A bank on the receiving end of mortgage repayments or credit-card receivables can do something similar: bundle the loans up and sell them, or use them as collateral to get funding, which it can then use to issue more loans. This boosts both credit and growth.

Used recklessly, though, securitisation can be dangerous. It fuelled the catastrophic boom in American subprime mortgages. Some banks, aware that home loans would be sliced, diced, repackaged and sold on, gave up even cursory checks on their borrowers’ creditworthiness. Investors piled in blindly, snapping up supposedly safe “tranches” of bundled-up debt that proved to be anything but. The boom turned to bust and bail-outs.

Yet structured finance cannot bear sole responsibility for the crisis. It was more the conduit for irrational financial exuberance than its cause. Lax lending standards in boom times predate the emergence of securitisation (in the 1970s) by several centuries at least. Most structured products performed well through the crisis, with the notable exception of those related to American residential mortgages. Defaults in Europe remained low despite the recession.

And although there are still risks, securitisation should be safer in the future than in the past because of new, post-crisis regulations to reduce the danger of excesses. The principle that the party creating a new security needs to retain some exposure to the underlying credit (the “skin in the game” rule) should help ensure that underwriting standards do not get too slack. That will hamper the desirable transferring of risk but, given recent history, it is probably prudent to put a little sand in the gears.

Some of the Kafkaesque structures spawned by securitisation—such as collateralised debt obligations (CDOs) that invested in other CDOs that themselves invested in MBSs—have been made prohibitively difficult to recreate. That is also sensible: whereas simple securitisation should be welcomed back, the over-engineered versions that rendered the financial system needlessly opaque should not.

Europe stands to benefit most from securitisation’s return. Lenders across Europe are under pressure to improve the ratio of capital they hold to loans made. One way of doing this is to stop extending credit, which is, unfortunately, what many banks have done. If they instead slimmed themselves through securitisation, by bundling and repackaging loans and selling them to outside investors such as insurance firms or asset managers, they could lend more money to credit-starved companies. That would have the added benefit of spreading risk away from wobbly banks.

Securitisation certainly has a black mark against it, but it is far too useful to be banished for good. Almost all financial innovations, from the humble mortgage to the joint-stock company, have had to re-establish their reputations after a bust at some point in their history. Society benefited from their eventual rehabilitation—as it most probably will from the revival of securitisation.