27 May 2011

Generating Liquidity via Own-Asset Securitisation

The following is a simplified example of a common practice of banks to generate liquidity out of illiquid (mortgage) assets. When financial markets ceased functioning during 2008/2009 crisis, such or similar schemes were among others promoted by several central banks to inject liquidity into the frozen and frightened financial system (e.g. Bank of England's Special Liquidity Scheme). What we see is essentially an (accounting) trick which contributes to build-up of systemic risks and weakens weak banks even more.

Let’s say we have a bank that has run out of cash and is not able to issue securities or debt instruments on financial markets because it is being considered too risky. The starting point balance sheet of this hypothetical bank looks as follows:

Not very encouraging indeed: almost no liquid assets and a capital ratio at around 3% (300/9,950). Clearly, the bank is very much in need of cash because depositors are willing to use their money and short term debts need to be repaid. Unfortunately it doesn’t have any securities to sell or use as collateral. But no problem: these securities can be created!

The bank sets up a special-purpose entity (SPE), transfers e.g. 5,000 of its loans to this SPE and in return obtains asset-backed securities in the amount of 5,000 issued by the SPE. The resulting bank’s balance sheet is depicted on Figure 2-a. The balance sheet of the SPE is provided on Figure 2-b. On consolidated level nothing has changed compared to Figure 1 above as the SPE is still controlled by the banking group and intergroup transactions are eliminated.



As the name implies, the asset-backed securities issued by the SPE are backed by the loans that have been transferred to the SPE. Further they are sliced and diced in a way that there are AAA-rated senior class securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers (i.e. when some of the underlying loans default, the losses are first absorbed by the junior class securities).

Thanks to the highest possible credit rating the bank can now repo the AAA-rated tranche of the asset-backed securities with the central bank or with some other financial market participant. In plain English this means that the bank transfers the securities to another party (e.g. central bank) in exchange for cash (or treasury bills or some other consideration) with a concurrent obligation to reacquire the securities at a future date for an amount equal to the cash (or other consideration) plus interest. The net result for the bank is retaining the economic interest on the entire pool of loans whilst obtaining cash in an amount equal to the nominal value of the AAA-rated securities less any haircut applied by another party as extra collateral against the repod securities.

Suppose that the bank repos it securities in the amount of 2,500. The resulting consolidated balance sheet is depicted on the Figure below.


Clearly, compared to the initial situation depicted on Figure 1, the bank’s balance sheet now looks much better from liquidity perspective: cash/liabilities ratio is more than 20% instead of to the preliminary 0.5% and the funding sources are more diversified. Short-term problems seem to be solved: the bank is able to satisfy the requests of depositors and fulfill its obligations towards creditors. Capitalisation has not deteriorated.

In good times this is a way for building up leverage and boosting short-term profits while increasing fragility of the financial system. In bad times it is a desperate step for postponing the problems while weak banks will actually be even worse off. They cannot increase their revenue base as equity is scarce. They still are responsible for all credit losses. Interest payments for the repurchase agreements decrease future earnings which makes the banks even less attractive for potential investors. Thus, although a common practice, generating liquidity via own-asset securitisation is either nonsense or a desperate step. It seems absurd that governments and central banks essentially support and defend similar schemes.

2 comments:

  1. Edward C D Ingram11 June 2011 at 19:38

    It is a slippery slope

    ReplyDelete
  2. I never find this article before because I have been read many articles on finance this article was impressed me. All the points are very simple to understand.

    ReplyDelete