Asset securitization, which has become a major factor in global capital markets, is here to stay.
Securitized markets will continue to evolve, with new assets and structures being created and modified, until these products mature, become more efficient, and see spreads narrow.
Then, as the cycle repeats, new, riskier, or unproven assets will be securitized - with wider spreads.
There's no limit to the range of assets that could potentially be securitized, nor is there any limit to potential sellers.
Reasons for Growth
Three forces that drove the business are still factors: the demand for capital, meeting investor needs, and advances in technology.
And new forces are coming into play, fueling the vibrant market for securitization. Among these are:
* The troubles of the thrift, banking, and insurance industries - coupled with regulatory changes.
* The real estate debacle.
* Reallocation and repricing of available funds for almost all borrowers.
* Credit and default assessment of assets and mortgages.
* The lack of yield in fixed-income markets.
Major Miscalculation
Thrifts, banks, and insurance companies mismatched their assets and liabilities in the past and made loans and investments with inappropriate credit adjustments. In other words, they assumed that asset valuations would never precipitously decline.
That was a fatal mistake. As regulators justly set up capital requirements and investment constraints for these institutions through mechanisms like the Basel accords, massive underlying problems surfaced.
Thrifts were forced out of business because of vast negative capitalization. Banks began selling any asset that could be made liquid and that required high capital standards. And insurance industry officials began to liquefy real estate, junk bonds, and risky assets in a more orderly way.
The Resolution Trust Corp. was the first and biggest entity to begin revamping one category of financial institutions - thrifts. But others will follow.
It is staggering to reflect on what the RTC has done. It has made sales of more than $200 billion by selling institutions with their assets intact, by selling whole loan packages, or by securitizing assets. Asset dispositions of all types have been made, but the single most important factor was that bulk had to be sold. With such a substantial supply of assets, issuers became very creative.
Momentous Change
The Federal Deposit Insurance Corp. and a number of insurance companies and "healthy banks" are also beginning to liquefy a large number of assets. This is a momentous change in the market, affecting all global financial institutions and investors.
As for the real estate debacle, it has also led to a number of changes in securitization.
Investment portfolios are being significantly reduced in value and sometimes sold. With few natural buyers, holders are turning to Wall Street for the same securitization techniques applied to single-family mortgages. Where traditional lenders have turned away, Wall Street is bridging the gap with capital.
And real estate investors, many of whom were burned in recent years, are often turning to mortgage and asset-backed products as investments.
Scarce Capital
As the real estate debacle was occurring, so was the driving force of reallocating and repricing scarce capital. Money or credit are still available to fund assets, but not on the same terms or for the same borrowers. Securitization techniques and access to capital are helping to fill the void.
The need to understand and access information on credit risk has taken on great importance. With new securitized markets evolving, the rating agencies and credit enhancers have assumed unsurpassed influence and importance. They dictate safety levels and comfort zones for clients.
All types of assets are now being sold and rated, including mobile home parks, nursing homes, and underperforming office buildings, among others.
Some products have a great deal of risk and are sold as alternatives to other high-yielding instruments. These alternatives - usually subordinated bonds - are a fundamental part of securitized structures. They are based on troubled or complicated products, can be rated or unrated, and carry varying degrees of credit risk.
The Better Yields
Lastly, in terms of significant new market forces, the current state of yields makes it very hard for investors to achieve high returns in the bond market overall.
Where can investors achieve superior performance? They can speculate on foreign treasury-securities with high currency volatility. Junk bonds are barely double digit - not a great risk-return tradeoff. Real estate and venture capital have often been bad risks in recent times.
But high yielding alternatives do exist in lower-credit subordinated mortgage investments or mortgage derivatives, which offer yield in return for high prepayment and interest rate sensitivity.
Down the Road
All these new influences have changed the securitization market dramatically.
How does this bode for the future?
The current trend in securitizing residential mortgages will continue, but more commercial mortgages and receivables will enter the marketplace in various forms. Many assets still remain unsecuritized. Innovation will continue, because anything with a current or future cash flow can be securitized.
All types of products will be securitized and traded: highly leveraged bank loans, Third World debt, oil loans, sale leasebacks, corporate private placements structured into real estate mortgage investment conduits (known as Remics), hospital receivables, troubled tax-exempt refinancings, and all types of real estate and nontraditional consumer receivables.
Regulators will force more efficiency from corporations and this will spur further selling.
Wide Range of Choices
Eventually, mortgages, asset-backed securities, junk bonds, bank loans, and real estate are likely to be merged into one broad securitization area.
There will be a spectrum of credit, ranging from agency and investment grade on the high end to rated noninvestment grade and unrated products on the low end. There will also be a maturity spectrum.
There will be tailored-risk products - those that meet a particular investor's needs but have limited liquidity. There will be reissuing of old securitized issues, with pieces added or shaved off. Today's deal is tomorrow's collateral for new deals.
Foreigners will get more involved in dollar products through direct investments in securitized products, instead of today's reliance on mutual funds. Also, foreign markets will open up to allow us to securitize overseas as we do here in the United States.
More managed funds such as mortgage and asset-backed junk funds will evolve for individual investors who prefer complex products in fund form.
Possible Pitfalls
Stumbling blocks on the road to securitization could include increased volatility in the overall marketplace; regulatory change causing massive inefficiency in supply or demand; an inverted yield curve eliminating positive carry; or poor information flow, which would prevent understanding and transferability.
These obstacles could make spreads volatile.
But maturing of securitized markets should eventually lead to tightening, which is ultimately good for consumers.
These uncertainties and changes will also lead to enhanced profit opportunities for market participants - not in plain-vanilla Remics or passthroughs, where profit margins are often slim, but in new products.
In summary, with the right analytical strength, information and yield, almost any asset can be bought, studied, refined, packaged, and resold.
Securitization is and will remain perhaps the most important driving force of change in the global capital markets for many years to come.
Mr. Stone is senior managing director in charge of the mortgage and asset-backed securities group at Daiwa Securities America Inc., New York.
