The Role of Securitization in Dealing with the Banking Problems
One of the main problems that our banking sector is facing is obviously the incredibly excessive amount of non-performing loans (NPLs) on our banks’ balance sheets that reached almost 50% (about €28 billion) of their total loan portfolio! A number of recommendations/suggestions have been put forth of how to deal with this long-standing issue and a lot of pressure has been exerted on the banks’ management to restructure these problematic loans (unfortunately restructuring until the Fall 2014 was only at a rate of about 12% of the total NPL portfolio).
Just recently, the Governor of the Central Bank of Cyprus (CBC) stressed that reducing the level of NPLs in the banking sector is the number one priority of CBC. One thing is certain and that is that there are no magic solutions that somehow, if used, would just make this problem go away. One suggestion, that was actually part of the latest MoU but received a lot of criticism by the political parties and is now under review, has to do with securitization and the selling of loans to third parties.
The purpose of this short article is thus to explain in simple terms the mechanisms of securitization in the manner that was used in other countries (especially the U.S.), the benefits for the banking sector and society, but also the risks involved.
Securitization is a framework in which some illiquid assets (loans/mortgages in our case) of a corporation/bank are transformed into a package of securities backed by these assets. The process starts with the pooling of loans (in our case, NPLs and non-NPLs) to create a large loan portfolio that would be of interest to large institutional investors. The loans are standardized to make it easier to predict the cash flows from the pool (same maturity, interest rate, amount of loan, etc.) and are also guaranteed (for a fee) by governmental or private entities against default and for the timely payment of the cash flows (credit and liquidity enhancements). Special purpose vehicles (SPVs) are then formed to construct the pool of assets and issue the mortgage (or asset)-backed securities. The reason for the existence of these vehicles is to place some separation between the originators and the pool of assets [if originator (i.e. bank) defaults, it will not affect the pool of loans held by the SPV]. The parties who are investing in these securities are essentially buying “bonds” that entitle them to a share of the cash paid by the borrowers on their mortgages.
Securitization is not new and is something that has emerged in the U.S. in the 1970s in which mortgage originators (banks) sold the loans to agencies which pooled them and created marketable mortgage-backed securities (MBS). Prior to the global financial crisis, there was an unprecedented expansion in the mortgage market (especially the subprime) due to securitization that offered lots of benefits to the society. However, the crisis of 2007-2009 and the bust in the U.S. housing market highlighted the dangers associated with such mechanism. In the case of Europe, securitization is actually something not as widely accepted, perhaps because of lack of relevant knowledge and experience. However in many countries with problematic banks and a need for deleveraging, we see now an expanded usage of securitization which I believe will grow further with time.
Benefits & Risks
Securitization has the effect of improving liquidity in the mortgage market, spreading the level of risk, increasing the amount of credit available in the economy, and making it easier or more affordable to own a house. Certainly this was the impact that we have seen in the U.S. prior to the crisis. Furthermore, the banking sector will benefit by having the capability to deleverage and offload problematic loans from the banks’ balance sheets that will make the banks healthier. However, there are risks involved that certainly should be taken into serious account by the lawmakers and regulating bodies. One risk is that the added complication of securitization will make it more difficult to apply the necessary flexibility and creativity to assist borrowers facing difficulty. Furthermore, the interests of the borrowers might not align with the interests of the other participants (investors, servicers). Even if it is to the benefit of the borrower to have a modification of the loan agreement at times of difficulty, the terms of the securitization agreement or the interests of the other participants might prohibit them in pursuing such an approach.
My final thoughts on this is that we should not prohibit securitization and I believe, if used properly, can have multiple benefits to our society, can bring much needed liquidity and credit to the economy, and help resolve the issues with our banking sector. However, prior to utilizing such a mechanism the right legal framework should be put in place and the regulating bodies (CBC) should provide an efficient supervision.
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