The 1933 Disney animation The Three Little Pigs featured Fiddler and Fifer, who believed their straw houses were safe from a marauding wolf. The movie popularised the song Who’s Afraid of the Big Bad Wolf; as readers will be aware, the pigs’ straw houses were not safe from the wolf, who blew them down.
Fast forward to 2016: fear stalks European legislators, who believe citizens are endangered by securitisation. Some of them are haunted by the words of Warren Buffett, who described collateralised debt obligations (CDOs) as “financial weapons of mass destruction”. To the uninitiated, securitised debt products can seem scary, and the role of collateralised mortgage products as a vector of unsustainable risk in the 2008-09 global financial crisis is undeniable.
Bad decisions were made at every level in the run-up to the crisis. Intermediaries and lenders made loans to unsuitable households, knowing that they could transfer the risk to Wall Street. The banks knew they could transfer the risk to others. The stakes were high and revenues irresistible in a financial architecture that had lost its way. European banks were not immune and taxpayers are still on the hook.
It is understandable that legislators should be wary, particularly when memories of complex products like CDOs-squared are still fresh. Paul Tang, a Dutch member of the European Parliament’s Socialist grouping and the rapporteur for a Commission regulation proposed last year that lays down rules on securitisation, is a sceptic.
Parliament’s Economic and Monetary Affairs Committee has also proposed over 100 amendments to the legislation, including one from Tang to increase the ‘skin in the game’ requirement from the proposed 5% to as much as 20%. There is frustration about the impasse and eight industry associations, including PensionsEurope, have published a paper highlighting the importance of securitisation for jobs and growth. It is estimated that €100bn-150bn in extra funding would be generated if securitisation issuance returned to its pre-crisis levels.
As the Commission has highlighted, default rates of European securitised products have been low, even through the crisis, reflecting a higher quality of underlying assets. Without much sub-prime mortgage lending, there wasn’t much sub-prime securitisation.
Assuming interests are aligned, requiring issuers to hold more than 5% does not reduce risk. It could deter new entrants without the balance sheet capacity to fund the additional exposure.
Securitisation is credited with helping create and finance a number of large US companies. In itself it is neither malignant nor beneficial. It transfers risk exposure from originator to investors; the risk itself resides with the underlying asset and the underwriting process, not the product or vehicle. And not all of the bad decisions made prior to the crisis involved complex products. Many mid and lower-tier institutions simply made bad lending decisions.
To return to the Three Little Pigs analogy, clearly the wolf is to blame. But the pigs share some blame for underestimating the risk and for having sub-standard buildings.
It is worth remembering that Practical, the third little pig, built his house in brick, and it remained unscathed despite the wolf’s attempts to blow it down. Robust structures, with good foundations and a high level of due diligence will continue to be required here. Securitisation may still have a bad reputation but it is a building block for Europe’s future prosperity.