BoI seeks to avoid securitization mistakes in creating new market

Securitization became infamous alongside financial tools such as credit default swaps and collateralized debt obligations (CDOs) in 2008.

November 12, 2015 22:45
2 minute read.

Man counts money near currency exchange in Kiev [file]. (photo credit: REUTERS)

Israeli regulators on Thursday unveiled a proposal to boost securitization, meaning tradable financial instruments that pool various forms of debt, while keeping at bay the risks that led to the 2008 financial crisis in the United States.

The report, issued by the Bank of Israel, the Israel Securities Authority, the Finance Ministry, the Justice Ministry and the Israel Tax Authority, provides recommendations that would allow the creation of a tradable securitization market that could help pump credit into the economy.

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“The recommendations included in the report will contribute to increasing the sources of financing in the economy, including for those providing nonbank credit, and will be able to lead to lower costs for credit to the business sector, including to small businesses, while contributing to the continued development of the credit market and to increased competition in the financial system,” Bank of Israel Governor Karnit Flug said.

The recommendations drew from the lessons of the global financial crisis, she said.

Securitization became infamous alongside financial tools such as credit default swaps and collateralized debt obligations (CDOs) in 2008, when the US subprime mortgage market caved, triggering a financial crisis and the collapse of some of the world’s leading banks. The story began with mortgage securitization, in which banks gave mortgages to “subprime” borrowers, bundled the debt up and sold them to other investors.

Thursday’s paper recommended opening securitization to a variety of loans and asset types. But it included a requirement that the original lender keep a 10 percent exposure to the asset.

Part of the problem in the US in 2008 was what economists refer to as moral hazard: The banks giving the mortgages had no skin in the game, because they could bundle and sell the collateralized mortgage debt.

That encouraged them to lend large amounts to risky mortgage takers, knowing they could easily pass on the risk.

Thursday’s recommendations would ban complex securitization such as CDOs.

In 2008, CDOs allowed the bundled mortgages to be sliced up into “tranches,” which were ranked in order of which would receive payouts first. Some of the lowest tranches – the first to default if payments fell short – were given misleading credit ratings, making the riskiest mortgages appear like very safe bets. When the subprime homeowners stopped being able to pay their mortgages, investors suddenly realized the securities they had paid dearly for were worth very little.

Despite the risks, however, well-regulated securitization can have many benefits. If a bank can sell the mortgages (or any other type of debt) it has lent out, then it has more capital available to lend to others, which can lower the price of credit. Other institutions can also have access to a broader variety of liquid, tradable debt.

“The development of the securitization market will bring additional sources of financing into the capital market, will lower the price of credit and will remove entry barriers,” Finance Minister Moshe Kahlon said.

“The team’s conclusions take note of the lessons learned from the 2008 crisis, and the market will therefore be developed cautiously and responsibly,” he added.

In addition to the aforementioned requirements, the paper proposed creating transparent disclosures for investors, so they could properly understand how much risk is inherent in the asset-backed security. It also set out rules to avoid double taxation and required that passing asset to the special purpose entity (SPE) that issues the security will be considered a true sale and not a loan.

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