MSc. INTERNATIONAL BANKING AND FINANCE
SECUTIRISATION
INDIVIDUAL ESSAY
Following the sub-prime crisis and the impact of toxic debt is there a future for the securitization of commercial property?
Intriduction:
The term “credit crunch” emerged into common publications since the autumn of 2007
Which reference to the implications that the “credit crunch” is having on the global economy, property prices, stock market values and consumer confidence? The collapsed of the US sub-prime mortgage market was the beginning for recent credit crunch. The billion dollar exposure to mortgage debt and the market fluctuation spread worries across the financial market. The series of default started on mortgages that had been securitized as Collateralized Debt Obligations was the main concern for the downfall. The slow recovery from mortgage lender reduces the value of high risk collaterals. As the collateralised debt obligations was used by many commercial banks, investment banks, brokerages, mutual funds, pension funds, and other financial institutions the value for their portfolios gone down than it book value. Banks started facing liquidity problem and resulted in to failure to meet their regular obligations. Banks were trying to hold more cash and decrease in lending to each other. Scared people withdrew their funds from the bank. The whole banking and financial system got stuck because of lack of liquidity. The central bank worked as a last lender of resort and tried to bail out banks by providing liquidity in exchange for less liquid securities. The banks had lost confidence in the market the financial market went dried and the increased interest rate welcomed the credit crunch. Everyone blamed Wall Street for encouraging unsound lending practices and for developing financial vehicles which did not have full control. The subprime crises rise because of rerating US mortgage debt and it affected to the pricing of other types of assets which made the crises global. Here I have tried to explain that following this sub-prime crisis and the impact of toxic debt is there a future for the securitization of commercial property
Credit crunch and Securitisation
Since last two decades there is a significance growth in number of different new financial vehicles. Financial derivatives and asset backed securities were the important innovations which have helped to improve liquidity and provide global diversified investment opportunity for investors. The increasing use and the value with low interest rate made them more attractive. Asset back securities are good option for institutions to maintain the appropriate leverage. With the developing real estate market the use of mortgage backed securities (MBS) spread worldwide. As a mechanism bank for lender to converts loans into bonds which are sold to investors MBS become very famous in recent years.
The investors receive the payments of interest and institutions raised the required fund, and MBS carry all the risk of defaults. In short MBS helps to spread risk which would otherwise be concentrated in a small number of mortgage originators.
2000s was the peak time for MBS in rising values and increasing debt, Commercial MBS grown drastically from 2002 to 2006 in both US and Europe. The increasing in number of incentives to provide loan products and the low interest rates made lenders less prudent in their lending practices, which brought boom in lending practice to borrowers with poor credit ratings. Financial institutions started new alternatives of lending to be competitive in the market they invented package loans so they could sell more. The banks also pooled the asset backed securities into new units, and divide them in issuing securities.
In the booming lending market the important element was the commercial property which was grown with the help of structure finance instrument securitisation. The commercial property or the receivable from the property have been use to securitised, the existence of a steady income from the commercial property make securitisation more valuable in the competitive global financial market. The majority of asset backed securitisation was supported by the mortgage loans and the true sales transaction starts to increase.
The commercial property securitisation is beneficial for both the originating company and the institutional investors who invest into Real Estate Asset backed securities. Commercial property Securitisation leads to the higher leverage more than traditional finance methods. It reduces the cost of debt for the borrower. And the lower percentage of equity invested raises the return on invested capital. The commercial property securitisation allows non-investment grade companies to access the capital markets. Due to increasing popularity and the tempting benefits investors, bankers and even regulators did not understand the risk behind subprime market. Many took the advantage they borrowed cheap money and thrown in to property market, lenders were flexible with their lending policy which led them to lend billions of subprime mortgages to people with low income or even no income and no job. Finally the problems begin years of lax lending inflated a huge debt bubble. Immediately after the interest rates start to rise, property prices started to plummet and number of default began to go up on mortgage payments. The defaults on mortgage payment created trouble in the financial market as most of the mortgages had been repackaged and sold to investors. The number of default led to the decrease in the value of mortgages and investments which brought huge losses to banks and financial institutions. Banks did not have fund to meet their obligations. The fear spread wide and fast, the panic investors withdrew all their saving and investments from the market which made the crises worst. People lost confidence in commercial property which had been lavish investment initially. Because of the inter-connections and the interdependency pushed every related sector and person in too deep financial crises. Whole economy became stagnant and only uncertainty remain in the financial market. There is debate about how and why the credit crunch emerged, who is responsible for it, the unravelled shocked is all bankers, investors, property developers, house builders, governments, regeneration agencies and public organisations are the part of it. When property investment was doing well everyone did enjoy the bubble, many investors were not aware of the risk as they all were interrelated and relied on each other.
However today, securitization of subprime real estate loans is blamed for the recent credit crunch. It has created global liquidity problem. There are several questions in regards to commercial property securitisation coming in to focus. Is securitization of commercial property good or bad? What is their future of it? There are different views on it as still the market is under influence of the crunch or it’s not yet fully recovered. The lesson from the securitised market practice is too much is too bad. Off course securitisation is one of the best innovation in financial market it has many advantages which has already been utilised in the market. The problem was the control and the policies for lending. There is no doubt that market will come back to its previous track or even better position as every recession has its positive impact on the market and certainly this will have. In commercial property market securitisation has a significance role which cannot be ignored. The property market will improve with time and as a need of property market to develop securitisation has been and will be useful tool to use. Securitisation is not only useful to the originators but also to the investor as well. Securitisation is good for long term. Securitisation is a broad concept, as derivatives and structured finance products refer to a wide category of investment. Commercial property securitisations allow an investor to enjoy upside potential on an asset on the other hand many advisors find them too complex and expensive. The recent image and the complicated nature of commercial property securitisation structured products has raised some concern about its future. But the reality is it an important product of structured finance and professional investors are not backing away from it. Even though securitisation has bad reputation at the moment it does not means it’s not a good product or it will be out of market. In recent credit crises there were many things went and only property securitisation is getting blamed.
The recent accounting and financial regularity structure which shaped the commercial property securitisation is important concern while thinking of the future of commercial property development and it securitisation. As we have seen the prices of property will rise in long term and people will start investing in it. The recession could not control because of the various deficiencies in the system. More transparency, necessary amendments and coordination between financial institution and the regularity authorities will help the market to develop again.
To use commercial property securitisation as before there is a need of major changes in the available financial system. The regulations for originator to hold at least part of loan and other change like these will help to generate confidence in the securitisation market. There has to be some restriction in regards to the complexity of loan transfers in the financial system. The finance industry has to sort the problem of complexity of securitisation process as simplicity will give more transfer view of risk and related sides of the process.
The Governments, rating agencies and the monoline insurance are the important aspect of Securitisation process. Rating agencies do build the confidence in investors to invest in particular instrument. But we have experience that the rating agencies have also failed to do their job to guide investors towards right direction. Looking forwards for the development of commercial property securitisation there is a need to some changes in rating agencies work process. We have seen the role of government as the last lender of resort which was not as helpful as it was expected. Certainly there were many reasons behind it. Finally the mono insurance was a supporting back to survive in case of any trouble but today the insurers are not even in sound financial position to cover their customers. Because of the recent credit crunch investors have lost confidence in government , regulators and many other factors, thus the important thing is to bring that confidence back in the market players to keep it going smoothly. The process to re-build the market will take time and it will need a lot of efforts and patience’s with necessary changes in the system.
The subprime crises were initially engaged with residential real estate market and there is a difference between commercial and residential property securitisation.
Wharton real estate professor Joseph Gyourko notes that significant differences exist in the performance of commercial and residential real estate securities. “Securitized commercial property debt will come back once the market calms down,” he says, adding that there has been very little default in commercial real estate finance. “You’ll be able to pool mortgages and securitize them, but almost certainly won’t be able to leverage them as much as you did in the past.”
The residential side, where there is significant default, is more problematic. Gyourko believes the residential market will go back to what it was in the mid-1990s and most borrowers will have to put down at least 10% of the sales price. “We will get rid of the exotic, highly leveraged loans,” he says. “That will lead to lower homeownership, but it should. We put a lot of people into homeownership that we shouldn’t have.”
Wharton emeritus finance professor Jack Guttentag, who runs a Web site called mtgprofessor.com, says the short-term future for residential real estate is “bleak.”
“Secured bondholders have been badly burned. They discovered to their dismay that all kinds of problems are connected to mortgage-backed securities, which they hadn’t anticipated.” Guttentag also points to the failure of ratings agencies, which are already being revamped. The methodologies used to determine ratings were flawed, he says. “They used historic performance over a period that simply wasn’t representative.”
“CDOs are Doomed”
In the future, ratings agencies will need to operate on the assumption that a security rated AAA should be able to withstand a shock as great as the current crisis.
“That will mean that under the best of circumstances, it will be harder to get a triple-A rating, which will reduce the profitability of securities,” Guttentag says. Some forms of securities will die. CDOs are doomed, he adds, because the market has seen they are extremely difficult to value. “In the short term, the prospects are dismal. The market will recover, but I don’t think we’ll ever see CDOs again and the standards will be tougher, so the comeback will be gradual.”
Gyourko notes that the crisis is playing out in a presidential election year, complicating the response. “I think this is the worst time to have this happen. It’s never a good time, but in an election year, you’re more likely to get a bad policy response,” he says. According to Guttentag, while Republican presidential candidate John McCain is taking a laissez-faire stance, the Democratic presidential candidates have focused on using the Federal Housing Administration (FHA) to refinance loans that are in default. The idea is similar to what happened during the Great Depression of the 1930s with another agency called the Home Owners’ Loan Corp. which was created specifically for that purpose.
The problem, says Guttentag, is that FHA is not designed as a bailout agency. “The FHA’s core mission is predicated on it being a solvent operation, actuarially sound, charging an insurance premium large enough only to cover losses. How they would reconcile that is not clear.”
Guttentag says attempts may be made to create a separate bailout agency within the FHA with different accountability. “But the devil is in the details,” he warns, “and the details have to do with exactly who is going to be helped, what the requirements are, what the nature of the assistance is going to be, and myriad other factors that have to be worked out.” The Bush administration has taken some steps to ease the crisis, including encouraging lenders to modify contracts to avoid foreclosure. A strong case can be made for these measures, Guttentag adds. “The cost of foreclosure is often greater than the cost of modifying the contract and keeping the borrower in the house.” One downside is that once some loans are modified for those truly on the brink of foreclosure, other borrowers who could somehow manage to avoid foreclosure may demand the same modifications, shortchanging investors.
In testimony before the U.S. House of Representatives’ Committee on Oversight and Government Reform, Wachter laid out a proposal developed with the Center for American Progress to resolve the current crisis. Under the so-called SAFE loan plan, the U.S. treasury and the Federal Reserve would run auctions, in which FHA originators, as well as Fannie Mae and Freddie Mac and their servicers, would purchase mortgages from current investors at a discount determined at the auction.
Investors would take a reduction in asset value and yield in exchange for liquidity and certainty and the auction process would price pools and bring transparency back to the market. The FHA, Fannie Mae, and Freddie Mac could then arrange for restructuring of loans.
Meanwhile, Allen notes the Federal Reserve has taken some dramatic steps with interest rate policy to resolve the current economic crisis, but that could lead to tension with Europe and Japan over currency valuations. As the dollar continues to fall, U.S. companies are increasingly more competitive
overseas. “The Fed cut the rate at the beginning, and that was fine, but now things are getting way out of line,” he says.
Furthermore, it is not clear that cutting rates is going to solve the basic problem. As rates continues to drop, foreigners may begin withdrawing their money from dollar-denominated investments, driving rates up. “What the Fed is doing is unprecedented,” says Allen. “It is laudable that it is trying to stop a recession, but how many risks should you take to do that? We’re now moving into an area where the Fed is probably taking too many risks. If inflation picks up and long-term rates go up, we’ll be in a situation where we have to raise short-term rates as we go into recession, which is not a happy thing to.”
Vulture Capital
The private sector has begun to show signs of willingness to get back into the fray. A number of vulture funds have begun to form to take advantage of distressed real estate prices. BlackRock and Highfields Capital Management have announced they will raise $2 billion to buy delinquent residential mortgages. The companies have hired Sanford Kurland, the former president of Countrywide Financial , to run the new venture called Private National Mortgage Acceptance, or PennyMac. “Many distressed funds will come in to discover prices,” says Gyourko.
Wharton real estate professor Peter Linneman offers an intriguing prescription to bring prices down to the point where the industry can start to rebuild. He suggests that the government tell banks that if they want to maintain their federal insurance, they should fire their CEO by the end of the day, and the government will pay the CEO $10 million in severance. Ousting the former CEOs gives the new bank CEOs an incentive to write down all the bad assets immediately, so that any improvement will make them look good going forward. That would speed the painful process of gradual price declines.
“There’s plenty of money out there waiting for these assets to be written down to bargain prices,” says Linneman. In another quarter or two, the lenders would have new cash and be ready to lend again. Meanwhile, he says, the government should tell bankers it will keep interest rates down but raise them after the end of the year. “That says, ‘Get your house in order in the next nine months because the subsidy ends at the end of the year.'” Linneman figures that 1,000 CEOs are accountable for about 80% of the current lending mess. If the government were to spend $10 billion to restore liquidity to the market in nine months with only 1,000 people losing their jobs, it would be the best investment it could make to restore the economy. “I’m only half-kidding,” he quips.
Linneman also argues that concerns about moral hazard — or the tendency to take greater risks because of the presence of a safety net — because of a bailout are not valid. Those concerns, he says, already exist and have been in place since the U.S. government agreed to insure bank deposits. “The minute you say to somebody, ‘No matter what you do I’ll give your people their money back,’ you’ve created moral hazard,” he says. “Now it’s only a matter of how often and how much they will have to spend to settle up. If you go through our history, every eight years to 15 years we have had an episode.”
Indeed, Wachter cautions that while the plan she outlined for the Congressional committee might halt the current meltdown, it would not prevent a replication of the crisis in the future. “The ultimate question before us is do we want a system that produces risks such as those that we have seen in the current market. It is clear that Wall Street will underwrite any risk,” she testified. Wachter told the committee that adding financial risk to the home-loan market not only poses potential problems for borrowers and investors, but it also exposes all homeowners and the overall economy to increased house price volatility and risk. “We, as a society, will have to decide whether we wish to encourage such financially vulnerable funding as backing to the asset we also call home.
Conclusion:
There is no point of arguing in that higher the risk the higher is the profit and lower the risk the lower is the profit but one thing which compiles to this that everything should be visible in the current case it seems the risk was taken in the higher proportion as it was invested in those people who were highly like to default i.e. starting from the point from where it is quite evident that it’s going to be a loss and then to help securitizing it and selling to the market till point it seems fair enough even though the authorities would have intervene in the first place and tried to stop this.
If something goes bad, in the current scenario though it was worse, it does not mean that the system is wrong. The fact is that securitization is a way with which cash could be available early rather than waiting for the investment to be paid off, as long as there is true sale the concept is perfectly dine and securitization of commercial property has a very bright future but the important thing to note is that they should be properly managed. All the concerned bodies should be performing their functions well. Let us suppose if the mortgages would have given to the people who were credit worthy or even if the loan was given to the subprime they would have been proper documentation this crises would not had been such and the MBS would not had gone worse. The credit ratings if would have performed well people would had known the creditworthiness of these MBS and they themselves would not had been performing so aggressively as the people thought that the house prices in the US is in boom so their value will increase rather than decrease people along with different institutions bought these toxic debts which caused all this and they lost all. But again this does not mean that the securitization of commercial property has no future. Other countries like Australia, Ireland and some European countries also had these MBS but they were not that much vulnerable as the supply and demand was quite to match, the problem occurred in those countries was to largely due to the fact that many institutes in their own countries had heavily purchased these MBS. In short and simple if the authorities play their role well and also keep an eye on officers that they are not providing credit or giving mortgages on the basis of incomplete information specially to the subprime for the sake of commission, where the rating agencies are fully performing their roles well securitization is good otherwise in years, though the world will recover itself from this crisis soon, there might be another crisis and then to there will be nothing but blaming to each others.