Understanding ABS
The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:
Another key issue is that people didn't - and to some extent still don't - understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.
It's important for people to realize that the credit crunch was not caused by securitization -- it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.
Another key issue is that people didn't - and to some extent still don't - understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.
Labels: ABS, Securitisation, Tranching
posted by David Murphy at 09:10
2 Comments:
A skeptic would observe that ABS were designed precisely to obscure aspects of risk: that is, by enabling an apparently high level of yield relative to ostensibly comparable instruments, they offered their "manufacturers" the opportunity to skim larger fees than other commoditized income instruments.
Further, there is the little recognized problem of adverse selection. Just which pools of loans or other assets got stuck into the ABS? For the originators, there would be every reason to hold onto the bits that you thought would perform well, and to wrap up the ones of which you were least confident in an ABS.
Thank you for your comment.
I'm usually in the cock up rather than the conspiracy school, and I do think, based on fairly extensive experience of ABS, that the banks were not deliberately trying to hide the risks of ABS. After all, many of them palpably did not understand the risks themselves. That said, there is no doubt that heavy structuring disguises heavy fees, in ABS as in other areas of financial engineering.
You are absolutely right about adverse selection: this is why prudent ABS buyers demand that the originator keeps a decent chunk of the risk themselves.
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