By JOHN SPIERS 20/10/2006
Almost everywhere you look there seems to be too much money chasing too few assets. Property markets around the world have been booming, fine art auctions have set new records and there seems to be virtually no limit on the size of acquisitions that private equity funds can complete. After several years of strong global economic growth
and modest capital expenditure organisations naturally feel wealthier, but there is another factor at play - the securitisation of loans.
Prior to securitisation, banks were constrained by their balance sheets in the amount they could lend. The ratio of loans to capital is closely monitored by central banks to ensure stability of the financial system. Once a bank reaches its limit it either has to cut back on new lending or raise more capital. Capital is not always available at an acceptable cost and that was why banks used to imply they were doing you a favour by offering a loan. Securitisation allows banks to pass on the risk on their loans to another party, thereby freeing up their balance sheet for more action, whilst pocketing juicy fees on the way. The result is that there’s virtually unlimited lending available and margins have narrowed markedly.
UK securitisation volumes in 2005 of around £100bn are equivalent to over 7 per cent of total bank lending in sterling to UK residents. In the US the trend has been similar but the figures even larger.
| "I suspect that the value of Equity Tranches often does not allow properly for the risk of default." |
How securitisation works
In simple terms, bankers put a number of loans together in a package which is then split into various components of risk.
- the Senior Tranche is rated ‘AAA’ because it has the first call on all of the cashflows from the loans. This is a far less risky proposition than lending to a single blue chip company and so it will be priced on a very tight margin. This security will be attractive to many institutions such as banks because it offers a slightly higher return than gilts and has only a modest requirement for capital.
- the Mezzanine Tranche is entitled to the next portion of the cashflow. It is riskier than the Senior Tranche and priced accordingly but in most circumstances should deliver a positive return.
- the Equity Tranche is the final security which takes the first hit on all defaults. It requires a much higher margin but it’s usually possible to offer a gross return to investors (before allowing for defaults) of perhaps 14 per cent.
Now 14 per cent is a tempting return, especially when the bank’s salesman can demonstrate consistent excellent returns net of defaults over the past decade. Numerous hedge funds and other organisations are desperate to find assets that generate those returns without any stockmarket movement. However, the value of assets cannot be changed by altering the structure of the securities. Either loans are overpriced to borrowers or the values of one, or more, of these tranches are too high. I suspect that the value of Equity Tranches often does not allow properly for the risk of default.
Many of the people running hedge funds have never experienced a recession (in the UK you now need to go back 16 years to see what can happen, so ten years of back-testing is clearly inadequate). Furthermore, a few hedge fund managers may be allowing their financial interests to override their judgment. As long as the defaults don’t happen in the near future, the hedge fund can post good returns and the managers earn juicy performance fees. There are also concerns about how these securities are actually valued. One other aspect also worries me. When the bank is lending its own money it has a powerful interest in making sure that it gets it back. However, once a loan has been securitised the bank is simply acting as an agent. Will it drive such a hard bargain when it is not ultimately liable? I think not. So losses from defaults could actually be higher than they were in the past.
| "Some hedge funds will post big losses." |
Implications for investors
Sooner or later, investors in Equity Tranches will be tested by rising default rates. When that happens some participants will withdraw from the market, reducing global liquidity. That may exacerbate the economic downturn that first caused default rates to rise. Central Banks would likely respond by slashing interest rates but this may not have much impact on demand if there is only limited credit available and/or borrowers have lost confidence. Quality bonds should perform well but spreads on junk bonds will widen. Some hedge funds will post big losses.
When will this happen? That’s hard to call but the present slowdown in the US housing market just might be the trigger.