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Emerald Group Publishing Limited
Article Type: Guest editorial From: The Journal of Risk Finance, Volume 15, Issue 4
I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence (Paul Volcker, Former Federal Reserve Chairman).
Paul Volcker once famously suggested that the only financial innovation of the past 20 years had been the ATM machine. It is a pity that at the time he made this statement he was not more familiar with the securitization market. If one accepts that a means of financing commercial activity such as house building – where none was available previously – generates additional output because without said finance the activity would not take place, then I surmise that there must be plenty of “neutral” evidence available, from around the world, that demonstrates that the innovation that has been observed within securitization, as it was first introduced has indeed led to economic growth.
Then again, it may simply have been a matter of timing. The success of the securitization technique was, to a large extent, its undoing. What was a clever, but reasonably simple and straightforward technology, became applied to ever more esoteric underlying cash flows and complex structures; allied to poor quality underlying assets, it turned into a perfect disaster, as investors sucked into what had seemingly looked too good to be true (same rating as US Treasury securities but paying perhaps 50 or 100 basis points more) lost truckloads of capital in the crash of 2008-2009.
Once bitten of course, it was inevitable that the market would contract, but in fact that has been a good thing. A dearth of ready investors for securitized product forced banks to reconsider asset classes and structures and the death of the more complex variants of asset backed security (ABS), mortgage backed security (MBS) and collateralised debt obligation (CDO) (not to mention the extinction of the structured investment vehicle (SIV)) means that today one is faced with simpler, easier to understand issues and less of the financial jiggery-pokery that gave originators and structurers such a bad name.
Six years after the crash is a good time to be revisiting the securitization market, which is why this special edition of the Journal of Risk Finance is so welcome and why it is such a privilege and pleasure to be able to act as editor for it. Western Central Banks including the Bank of England as well as private conference companies have been holding symposiums and seminars on “how to revive the securitization market”, the latter because holding events of interest makes money for them but the former because they recognise, even if Mr Volcker does not, that securitization is a very useful and worthwhile funding tool. Industries ranging from petroleum to telecoms would be smaller today if the market had not had recourse to the securitization technique.
But how would academics and practitioners alike respond to the Central Banks’ question? Actually, it is not a difficult one. The answer is simple: produce products that investors want, and whose advertised risk-reward profile is an accurate one. That means no more complex structures (the simpler the better, in fact) so that investors understand them, and only high-quality underlying assets. If banks remember what the technique was originally designed for, turning illiquid assets into liquid capital market notes and bringing assets of quality to the portfolios of investors who desire them but cannot otherwise access them, then they should not have too much trouble reviving the market. Unsurprisingly enough, many of the transactions that were being closed during 2006-2007 did not fit this description even if the investors were convinced, by their friendly capital markets salesperson, that they did want the issued notes.
As befits a topic of wide-ranging technical issues and controversial impact, this edition of Journal of Risk Finance features a diverse but interesting set of articles. For those such as me who thought that securitization was introduced only in 1979, Bonnie Buchanan’s article is an eye-opener. We also feature pieces that look at the controversial side of the subject, such as the article on securitization and executive remuneration.
The Italian market was one of, if not the, most innovative securitization markets in Europe before the crash (I have fond memories of working on Italian bank-originated structures during my time working at JPMorgan Chase. One such deal, a non-performing loans ABS transaction, perhaps says it all: the underlying assets were loans that were technically defaulted or defaulting. And yet, the deal closed fully subscribed […]). So it comes as no surprise that two of our offerings are about the Italian sector. Francesca Battaglia’s paper is an excellent and incisive piece of research that makes an interesting finding: that banks that securitize are in a better liquidity position than banks that do not. But was it not the use of securitization to fund its growing asset book that did for the UK bank Northern Rock? Actually, for that unfortunate institution, there were other issues at work. So we should not be surprised at this seeming paradox: the act of securitizing generates liquidity and also takes illiquid assets off the balance sheet (ignore issues of consolidation). Therefore, one should expect banks that employ the technique to be in a position of greater liquidity. Just do not expect the situation to remain stable once we do experience a market-wide crash: the technique is only ever as useful as the liquidity of the overall market around it.
Once again, my thanks to the Publishers and the Editors for inviting me to work on this publication. Enjoy the issue.
Moorad Choudhry - Guest Editor