A Securitzation Incentive Might Backfire

There is no public market for securitization transactions in Israel. This Article (restated below) argues that a too strict risk retention rate requirement, which the Israeli Securities Authority seems to have adopted in its recent incentivization of public securitzation offerings, may unnecessarily limit credit extended to borrowers. The Article is also available in Hebrew, as published in Globes, here.

The Securities Authority recently published a policy paper entitled Developing the Securitization Market: Public Issues of Asset-Backed Bonds. The title reveals it all—Israel does not have a public market for securitized assets, and it needs one. The Authority published the paper to outline the features of a simple securitization transaction, which the Authority says it will process in a normal timeframe. Truly, congratulations to the Authority, but unfortunately, the Authority’s drive for simplicity may actually put the brakes on the development of a public securitization market.

Securitization is a process by which an owner of receivables, such as a bank that make loans, converts the future payments it is to receive into immediate cash.   The conversion is done by way of a sale of a large number of the loans—which are assets to its owner—to a special-purpose entity, the activities of which are limited to purchasing and holding the assets. The special-purpose entity purchases the assets at a discount to their face value they and raises the money for the purchase by issuing securities. Often, these securities are debt obligations divided into different “tranches”, that is classes of securities correlating to different levels of risk.

The special-purpose entity finances the purchase typically by issuing debt securities. The return on investment in these securities depends on the collection on the debts of the borrowers, as the special-purposes entity has no source of income other than the loans. In this way, the investors acquire exposure, for good or for bad, to a specific portfolio of receivables 

The global financial crisis of 2007-2009 exposed many instances of mispricing in the asset-backed securities markets in the U.S.  Critics blamed the structure of securitization transactions, pointing to informational asymmetries between investors and parties earlier in the securitization chain.  For example, originators can know things about their customers, from transactions other than the ones giving rise to the securitized assets, that they do not share with investors.

In response, the U.S. and Europe, each in its own way, now require securitizers to retain 5% of the risk in the securitized assets.  Risk retention refers to a meaningful participation in the credit risk of the securitized assets, without selling or hedging for a certain period of time.  The idea behind risk retention is to force tighter underwriting standards by securitizers. The rationale for precisely a 5% rate of risk retention, however, is unclear. Nevertheless, the Authority, by referring to a 2015 inter-ministerial committee for the advancement of securitization report, which addressed risk retention, has signaled a doubling of the rate to 10%, for simple securitization treatment. This rate could be too high. 

On the face of things, a variable rate of risk retention that adjusts for quality of assets, loss expectation and even economic cycle, makes more sense than a fixed rate. After all, a valuation of assets will vary among originators, industries and economic environments. Nevertheless, and at least because of the apparent difficulty in measuring these dynamic factors, the Authority, like regulators abroad, has opted for the simplicity, uniformity and predictability of a fixed rate.  

Risk retention requirements that are too stringent, however, could unduly limit credit.  A recent U.S. study shows that borrowers under commercial mortgage loans made from 2014-2018 paid significantly higher interest rates and obtained markedly less favorable terms when the loans were slated for securitization under the U.S. risk retention rules than when the loans were not.  This suggests that a mandatory fixed rate of risk retention can make securitized loans relatively safe for investors, but at a significant cost to borrowers. 

A mandated risk retention rate that exceeds the rate that originators would otherwise choose when balancing their need for liquidity and their interest in lowering the discount at which they sell their assets imposes an additional cost on originators. Apparently, some of this additional cost will find its way to the borrowers.  Certainly, improved underwriting can justify higher costs to borrowers, but to a point. When originators retain risk only at a level required by regulation, and not more, the rules may impose excessive risk retention, read unnecessary cost. A regulator-imposed 10% rate of risk retention has more potential to drive up borrower costs unnecessarily than a 5% rate.

By heightening the risk retention requirement for efficient review of a securitization transaction to twice the international convention, the Authority risks increasing costs to borrowers far more than is necessary. This could prove a limiting factor in the development of a public market for asset-back securities, the opposite of what the Authority intended.