I’ve set myself a challenge; to explain to myself and with luck you how securitisation works in banking and finance.
The problem is securitisation occupies a dull corner in the financial world only slightly more exciting than being an actuary, or maybe not. Most of the time both borrowers and lenders benefit, although the lenders are never going to make stellar profits if they stick to their boring knitting.
When it makes excessive amounts of money alarm bells should ring. Instead the Board is charmed by profits from such an unexpected quarter. Northern Rock found a magic money tree, lending mortgage money for long terms (ten to twenty-five years) at a high interest rate and borrowing at a much lower rate for short terms. The Building Society exploited an anomaly in the market. Nobody thought to wonder what would happen if the market flipped, which it did, and short term rates became higher than long-term rates. That’s a case study in mis-matching a book.
Greensill found a new way to shake the magic money tree. They lent money to businesses hoping to be repaid out of the borrowers’ revenues in the future. This is a good business model so long as the borrower is the right sort of borrower. For example a company that has clients with monthly subscribers, like a mobile ‘phone company, should be a safe bet. Oil and minerals are not a safe bet as an unexpected fall in prices evaporates their revenue stream. I would have said that a car manufacturer like VW would be a good bet but I’d have been wrong when the emissions scandal came along.
I had lunch on Monday with a friend who was in securitisation for a few decades and she told me Greensill broke all the rules, lending recklessly. She expressed surprise that David Cameron joined such a dubious enterprise. I explained he wouldn’t recognise cowboys unless they were in a rodeo and in any case has no background in finance. So Greensill proved incapable of risk testing their borrowers. It’s fair to say that totally sound companies don’t need to securitise; they issue bonds or shares, cheaper sources of finance. So a lender does need to be careful. My friend has over the years lent money in South America but has never been to Uruguay – “the businesses there are too rich”.
After writing discouragingly about Bitcoin in early January it went up rather spectacularly. I suspect market manipulation as Elon Musk announced he’d sell Teslas for cryptocurrency. Now he says he will not and there has been a big fall. I expect he sold his Bitcoin holdings before mentioning this. I think the SEC should take a look – or maybe it’s allowed in the US?
When I had lunch in St James’s yesterday, a famous war correspondent, journalist, editor and columnist was at the next table. A friend lunched in Mayfair and saw David Cameron; no doubt getting a lesson in securitisation. I thought some name dropping might cheer you up after a dull post.
My understanding is that securitisation is the packaging up of a number of assets so that they can be sold as a package in the market. The only restriction on the type of asset that can be packaged is that the assets must be standardised by quality and quantity and this is called commoditisation – for instance loans , mortgages, gold, tin, wheat, barley, property….
The first question this very questionable practice raises is – who would buy a package of unknown assets from somebody making a huge profit from buying them, packaging and marketing them. The answer is that that big investors want to spread their investment risks and profits into areas in which they do not have expertise – for instance, investment banks therefore buy securitised mortgages…….
The obvious risk, which was totally ignored before 2008, is that there is no way of assessing the quality of the underlying assets – for instance the assets could be rotten wheat or non performing mortgages…..
As with all financial transactions, securitisation really goes badly wrong when there are hidden levels of debt!
You are a quick study, Christopher! When my late father (also a banker) was asked what I did at work, he replied ‘something called securitisation. I think it is high-class factoring’. So true.
I didn’t expect to have my post marked by two retired bankers: one from a central bank the other a major European bank.
Max Hastings?
Yes.