Misunderstanding of the Subprime Crisis
In early June 2012, asset securitization that had been stagnated for four years due to the US subprime crisis started again. The State Council approved a quota of 50 billion yuan, and the Peoples’ Bank Of China, China Banking Regulatory Commission and the Ministry of Finance jointly issued the Notice on the Relevant Issues on Further Expanding Credit Asset Securitization (hereinafter referred to as the Notice), which explained the new-round of credit asset securitization in details.
The highlight of new plan is the enlargement of the types of the underlying assets, which include national infrastructure projects loans, agricultural loans, small-and-medium enterprises loans and local government financial vehicles (LGFV) loans. If examining the plan thoroughly, we can hardly be cheerful.
The new asset securitization plan made no significant changes in the structure of deals. But with the lessons of the US, the financial regulators emphasized the two principles of risk retention and double rating.
In the past pilots, the originators of credit asset securitization (i.e. commercial banks) were not allowed to invest on the asset-backed securities (ABS) launched by themselves, except the lowest tranches. However the Notice now requires the originators of asset securitization need to hold certain proportion of the lowest tranche of their own asset-back securities. At the same time the proportion shall not be lower than 5% of the total issuance of asset-backed securities. The purpose for this regulation is to cope with the problem of moral hazard, that is to say, if banks do not own the asset-backed securities originated by themselves, then they will only securitize the bad assets and leave the good asset unsecuritized. What underlies the idea is a well-accepted consensus about the US financial crisis: the fact that all major financial institutions adopted originate-to-distribute (OTD) model rather than originate-to-hold (OTH) model is the culprit of the crisis. But if we carefully analyze the behavior of the US financial institutions in this crisis, then we may find that the conclusion cannot stand.
Take the AAA mortgage-backed securities (MBS) issued by financial institutions except Fannie Mae and Freddie Mac as an example. In 2007, in the total outstanding amount of 1.6 trillion dollars, there are altogether 791 billion dollars held by banks (383 billion dollars), Fannie Mae and Freddie Mac (308 billion dollars), and securities firms and investment banks (100 billion dollars), amount to nearly one-half. We may say, with a term coined by Warren Buffett, that the banks really have skin in the game. To be more specific, the root that leads to the crisis is not moral hazard generated by the banks that transfer risks from their balance sheets, but the moral hazard generated by the banks that fail to transfer risks from balance sheets through securitization. To achieve this end, firstly the banks utilize the various explicit and cheap guarantee provided by government, including deposit insurance, subsidies for Fannie Mae and Freddie Mac and the “too big to fail” bailout schemes; and secondly, the banks utilize the flaws in the regulatory capital requirement to carry out the so called regulatory arbitrage. Therefore, banks in fact do not retain too little credit risk but too much credit risk, and these credit risk also concentrate on the real estate market with high systematic risk, as a result, the fall of house prices has triggered the systematic crisis of the whole financial system.
In fact, there is another misunderstanding behind the requirement of risk retention in the new pilot plan. It has been a stereotype that as long as the sale of asset by the banks is allowed, the credit quality of these asset is certainly not good, and thereby asset-backed securities are all low-grade securities. This is not a view without any question. It is true for the asset-backed securities that their default risk is related to the credit quality of the underlying assets in the pool, but what more important is the correlation of defaults among the assets in the pool. As long as the default correlation among the assets in the pool is not much high, we really may make a low-risk security out of a group of high-risk securities through diversification. In the US subprime crisis, the securitized products concentrate on the sector of real estate. Thus, when the mortgage loan default happened and spread, the total financial system fatally encountered huge troubles.
Besides the risk retention, in the pilot of asset securitization, the regulators stipulate to carry out the rule of double rating, which means that the initial rating for securitized products must be made by two qualified rating agencies separately. The credibility of Chinese rating agencies remains questionable and rating shopping still prevails to such a large scale that investors rarely rely on these rating reports. The rule of double rating is intended to address this problem and make an improvement.
For the credit rating agencies, the asset-backed securities and traditional bonds (both governmental and corporate) are totally different in market structure. In the traditional bond market, there are many issuers and types, and the threat of delivering business to anther rating agency has little effect, so the concern of reputation can well check the conflicts of interests facing by the rating agencies. But in the markets of structured products like ABS, MBS and CDO, there are few issuers, thus in the game with rating agencies, the issuers have a much power for negotiation. Besides, the rating agencies also widely participate in designing structured products, the structures of these products are quite complex, their rating technologies are not so transparent and developed as those of traditional bonds. All these factors contribute to much conflict of interests, and the reputation mechanism similar to that in the traditional bond market is hard to play a role. The US crisis indicates that double rating cannot well solve this problem and it seems that the US does not find a good solution either. The Wall Street Reform and Consumer Protection Act enacted in 2010 only let the Securities and Exchange Commission to make an two-year investigation and then determine a mechanism of how to develop a rating assignment system for structured finance instruments.
In recent years, there are few rating agencies in China involved in rating of ABS.at present only three agencies, China Chengxin, Lianhe Credit Rating Co. and Dagong Global Credit Rating Co., therein Chengxin occupies the largest market shares. And for the rating methodologies, they mostly resort to foreign rating agencies. Under such a background, use of double rating to deal with conflict of interests seems to shoot the wrong target. In my opinion, what the regulators should do first is to improve rating methodology and rating quality, and to find a set of feasible methods to reasonably rate the rating agencies.
Finally, in the new pilot plan of asset securitization, the regulators only has approved 50 billion Yuan, while for the urgent need of all major commercial banks on asset-liability management, risk control and liquidity management, such an amount can only be like a drop in the ocean. The regulators also need to fully draw the lessons of the US subprime crisis and understand the status quo of Chinese commercial banks, make reasonable planning for the development of the asset-backed security market, thereby they may better satisfy the needs of commercial banks and investors of different types of institutional investors.
Published on No. 32 issue of Lujiazui Review
