by Graham Andersen
The opportunity in mortgage securitisation is to develop a modern digitised origination and funding platform. Securitisation can be streamlined so that borrowers are funded “direct to market” using transparent data and simplified structures in a modern IT environment that brings efficiency and cost savings to borrowers and higher yields to investors.
Securitisation has been used in the US and Australia since the 1980s to fund loans which are secured over residential property. It was a highly successful technique which competed successfully with incumbent lenders and expanded the ability of borrowers to get a mortgage to buy houses and it also accompanied a period of strong house price growth. The success was also followed by notable failures, as evidenced by the US sub-prime crisis of 2008 and 2009 where mortgage securitisation structures and ratings failed abysmally and effectively brought down the global financial system.
Despite the failures, securitisation markets are still significant in many parts of the world including Australia. Nevertheless little innovation has occurred and securitisation structures and methods remain essentially the same since the 1980s and 1990s.
So what’s now wrong with traditional securitisation?
Securitisation of mortgages was invented in the 1980s so that institutional investors in the capital markets could invest in low risk, high rated securities secured over pools of mortgages owned in special purpose corporate or trust vehicles. These securities are referred to as Residential Mortgage Backed Securities (“RMBS”). In order to create high rated ie AAA securities, RMBS were issued with different payment priorities so that losses were taken first by lower rated securities. A process called tranching. These special purpose vehicles with complex payment structures also required service providers, trustees and trust managers, to calculate and make payments and represent the interest of RMBS investors. Credit rating agencies would then provide their credit opinions to rate each tranche of an RMBS, AAA, AA, A, BBB etc.
These complex securitisation structures with third party service providers provide a workable solution but were and are expensive in the cost of management and the cost of funds due to the payment priorities of the tranched RMBS. Payment structures favour paying down the low risk, low cost AAA tranches first and so the cost of funds increases over time.
Lastly, except for certain statistics available over the mortgage pool, data was generally not available for buyers of the RMBS on an ongoing basis so that these buyers could analyse mortgage risk. Therefore RMBS investors needed to rely heavily on the credit rating agencies and the tranching process for risk analysis at the expense of yield. As demonstrated in the semi-doco “The Big Short”, those analysts that made the big effort to get data, analyse it and work out where the risk was and how bad is was, could gain a significant advantage on the rest of the market which just relied on credit rating opinions.
So in summary the tranching priority payment structures of traditional securitisations were necessary to meet RMBS investor risk requirements in an environment where data and analytic tools were not readily available and manual management processes were necessary. A funding solution which may have lasted the test of 30 years of successful funding (except for the financial crisis of 2008) but perhaps now could be said to be costly and lacking efficiency, ensuring that both borrowers and investors do not get the best deal.
What’s now available that drives the opportunity to improve the securitisation process?
Put simply, technology now allows for the free and accurate provision of data and analytic tools to understand risk and value as well as block chain and smart contract technology that can validate and automate the whole payment process. Technology allows the removal of complexity and external costs for the benefit of borrowers and RMBS investors.
Whilst data may be difficult to obtain and somewhat unreliable for traditionally structured RMBS, the fact that central banks in Australia and other parts of the world have standardised data requirements and definitions, means that innovators can create and make available standardised, reliable and cost effective analytic tools to investors using the data standards. MARQ is an analytic platform that is one such solution. Using MARQ delivered real time through the internet, an RMBS investor or any analyst can understand the risk and risk adjusted valuation of the mortgages in any securitisation structure without the need to rely on credit rating opinions.
Transparent data and standardised analytic tools allow the simplification of securitisation tranching structures removing to a large extent the inefficiency of the cost of funds over time. Manual trustee and trust manager processes can now be digitised using smart contracts and block chain technology, making the trustee and trust manager obsolete. Payment processes can be automated on an undeniably reliable platform, significantly reducing costs and errors. Smart contract and block chain technology exists and is available to develop a proprietary digitised securitisation funding platform.
Data, analytics, IT delivery, smart contracts and block chain allow for a mortgage borrower to be funded direct to market. The opportunity is here now to create a direct to market mortgage securitisation platform and deliver a better deal for borrowers and RMBS investors.