Prerequisites for a Standalone Securitization Market

Crises are a period of rebirth. Indeed, nearly all securitized asset classes have experienced crisis at one time or another in their development and have responded by changing their securitization methods and contracts in response to the revealed weaknesses.

It can be argued that TALF, scheduled to end March 31, 2010, lowered the cost of the crisis to many issuers and therefore should reduce the depth of industry responses. It is interesting to ask, therefore, what changes would have occurred absent the TALF subsidy. One way to infer such a counterfactual is to look at industry responses to previous crises in other asset classes.

Increased Credit Enhancement

If collateral cycles demonstrate higher-than-expected loss rates, greater credit enhancement becomes necessary. Still, that doesn’t mean that greater enhancement is necessary across the industry, only for the affected asset type.

Consider the case of subprime credit cards. In the 2001 recession, it was reported that subprime loss rates rose to levels as high as 23%, while prime loss levels remained muted. As a result, subprime credit cards became a sector distinct from prime cards, carrying higher initial credit enhancements than prime cards.

Something similar should happen as a result of the present crisis. One of the selling points of the new mortgage products was that they were, well, mortgage products. Of course, we now know that these were very different mortgage products from the historical conforming prime mortgages with which market participants were so familiar.

Simple Structures for Complex Collateral

Of course, recent mortgage products also contained more complex pay structures than traditional mortgages. At the extreme, a pay-option ARM mortgage is more similar to a credit card than a traditional mortgage, subjecting investors not only to discreet prepayment risk like an ARM, but posing negative amortization risk, like a credit cards, as well.

Of course, the success of securitization hinges on not the level of losses, but the predictability of losses. That is why complex collateral like credit cards has historically used very simple securitization structures, while simple collateral like traditional mortgages could use fifty-tranche structures replete with IOs and PAC bonds.

Arguably, even six-pack private-label structures were too complex for newer mortgage loan products. Given the market disruptions, traditional mortgage issuers should be talking about the interplay between standardization and market liquidity, segmenting their traditional lines as a stable (semi-)liquid plain vanilla asset class. But while groups like the American Securitization Forum are trying to force a discussion, myriad sources of pushback remain.

De-linked Issuance

In the 1998 Russian Crisis, spreads widened and securitization was shut down. The problem was especially acute in credit cards, where issuance shut down completely for a period of time.

It didn’t take long, however, for cards to realize that the problem was not collateral or structure, but just market movements. Moreover, while the cards sector cold sell triple-A rated securities in any market environment, the wider spreads on the mezzanine had made the deals uneconomical.

As a result, the cards sector developed the “issuance trust” structure, which allowed mezzanine sold today to count against triple-A sold tomorrow (as long as the triple-A maturity was less than the remaining mezzanine maturity). In that way, credit card ABS issuers could hedge their exposures to adverse market conditions and at least buy time in the event of a temporary disruption.

The strategy seems to have worked well. While issuance fell in all categories in the present crisis, it fell the least in credit cards. More importantly, the credit card sector has therefore come the farthest in terms of addressing exogenous market stability issues in securitized funding.

Conclusion

In past securitization crises, sectors have either improved or gone away. In response to this crisis, we may see neither, representing the moral hazard cost of TALF.

Still, the effects don’t have to be all bad. If we recognize that engendering market stability through subsidized programs like TALF removes the same market discipline that improves securitization, can’t we can replace that with enlightened regulation can make up for some of the lost ground? If that is the case, regulatory reform should focus on robust stability for established markets, coupled with constrained development in less-established markets.

We can’t end crises, but can avoid repeating the same crises.