The last few weeks have proven to be a tumultuous period for the capital markets, and with it a stark (and painful) reminder has been duly delivered on the impact that they have on all aspects of business and the wider economy. Securitisation has also shown that it is not immune to this turmoil demonstrated by a cessation of primary issuance and a blowout in bond spreads. Amidst this volatility, it is not surprising that parallels are being drawn with the onset of the so-called credit crunch (summer 2007) which later led to the global financial crisis (GFC).
As was the case in the summer of 2007, we are currently experiencing a primary issuance hiatus thanks to the fact that market volatility (namely the sudden increase in yields) has made it near impossible to viably price new primary issuances, which in turn has been exacerbated by a material uptick in the trading of highly rated securitisation paper as investors have been forced to liquidate some of their positions. Securitisation has shown that (unsurprisingly) it is not immune to the ebbs and flows that plague the capital markets, however this is where parallels with 2007 should end, as the markets will inevitably stabilise, and when they do there is no reason why securitisation will not expose its mettle and demonstrate that it has an integral role to play for the greater good of the economy as a whole.
Taking a step back it is important to appreciate that the GFC dealt securitisation a hammer blow, tarring it with the brush of being one of the chief architects that precipitated the GFC. Although a harsh characterisation, it does have some merit given that this vintage of securitisation structures were generally not always fit for purpose. Such a remark should not be considered a surprise given that securitisation technology exploded into life in the noughties fuelled by a favourable regulatory environment and an abundance of cheap debt. Against this backdrop, there was an impressive amount of creativity and innovation which manifested itself with increasing levels of complexity and ingenuity, culminating in the emergence of some hugely impressive structures. Alarmingly, thanks to the overwhelmingly favourable market conditions, securitisation evolved in a vacuum and was not subject to the tests, challenges and scrutiny that a product of this magnitude rightfully requires. In effect, securitisation managed “to run before it could walk”, the corollary of which was that a number of unknown structural issues soon became endemic. With the onset of the GFC, securitised products were subjected to a long awaited litmus test and with it many of the structural shortcomings were soon exposed.
In the aftermath of the GFC, securitisation had not only been tarnished as a financing tool but also it was readily apparent that many of these structures were in desperate need of rehabilitation. In other words despite the need for a financing tool that could plug the funding gap created by the retraction of the banks, securitisation in its then form had little role to play until a number of its structural shortcomings had been resolved. Securitisation products were therefore subject to a period of much needed reform through the implementation of new regulation, best practice principles proposed by trade bodies and investor structural requirements. Indeed, the fact that this new crop of deals managed to weather the COVID storm is testament to the adaptability of the market and the true success of the implementation of these reforms.
Not only the ABS markets, but the wider economy, should take solace that against a backdrop of market volatility and the widespread talk of recession, we today have a new and improved securitisation product that has demonstrated that it is more than capable of weathering an economic storm. The importance of this cannot be under played, as all economies (although maybe not Turkey….) embark on an escalator of increasing interest rates as central banks have the unenviable task of tackling inflation. At least for now, the era of ultra low interest rates is over, and with it borrowers of debt will have no choice but to embrace racier forms of finance in order to boost their returns.
Given its myriad of positive characteristics, it is definitely time for securitisation to step-up and assume an integral role as a financing tool during this new period of escalating interest rates. After all, on a macro-economic level, securitisation is a great way of spreading and diversifying risk whilst at the same time promoting much needed openness and transparency to the financial markets. From an investors perspective, the resultant product not only enables investment in a (relatively) liquid product that satisfies their risk/reward appetite, but also a product that offers a return that will fluctuate in line with interest rates. Finally, from an underlying borrowers perspective, debt that is ultimately financed through a securitisation (either on day one or down the line) will invariably enable them to obtain a cheaper form of debt compared to other more traditional sources of finance. It is this latter characteristic that is the crucial point
,; as interest rates rise there will be strong demand for these cheaper forms of finance and financiers, whether in the form of traditional banks or alternate lenders, will have little choice but to embrace securitisation to deliver on these needs in order to remain competitive.
In the immediate wake of the GFC, securitisation was very much in the doldrums with it not only being lambasted for precipitating the GFC but also the exposure of serious structural flaws. Securitisation is now in a very different place, and this is one of the distinguishing features as we look to ride out the impending economic downturn and beyond. The inescapable reality is that interest rates are on the rise there will undoubtably be a demand for cheaper forms of debt, and securitisation has the unique ability satisfy this requirement. Indeed, if securitisation can deliver on this potential then the repentant villain of the GFC has all the hallmarks of being a genuine hero of the future; now is the time for it to put on its hero cape!