By making credit risk tradable, structured financial instruments—which include asset-backed securities—are fundamentally altering credit markets. In 2004, asset-backed securities worth $900 billion were issued in the United States—for the first time exceeding the total amount of more traditional corporate bond issues. Taken together, asset-backed securities and mortgage-backed securities today represent about one-third of the U.S. debt market. In Europe, securitized issues set a record in 2004 with a volume of $250 billion—three times larger than in 2000.
The benefits of structured financial instruments for issuers and investors are fourfold: they make it possible to unbundle and trade credit risk; are cost-effective funding tools for financial institutions, corporations, and governments; can be used effectively for balance sheet management; and can offer tailormade risk-return profiles that meet investor needs. Salih Neftci (City University of New York and the International Center for Financial Asset Management and Engineering) told participants how—with the help of credit derivatives—new instruments can be created synthetically. Krishna Memani (Credit Suisse First Boston) suggested that such synthetic structured instruments have substantially improved the management and pricing of credit risk. Asset managers and their clients stand to benefit as these instruments expand both their investment opportunities and their risk management tool kit, Antulio Bomfim (Oppenheimer Funds) and Curtis Mewbourne (PIMCO) pointed out.
Not without risks
But there are also potential risks associated with the complexity of structured financial instruments. Most notably, risks stem from difficulties in risk assessments—particularly assessments of the correlation of risks among underlying assets—and thus in the pricing of structured instruments. Janet Tavakoli (Tavakoli Structured Finance) noted that a key issue was managing the conflicts of interest among players involved in structuring transactions and understanding that their complexity creates considerable legal and documentation risks. Furthermore, a single credit rating cannot adequately capture the risk characteristics of structured instruments—one reason why, according to Kimberly Slawek (Fitch Ratings), it is imperative that investors understand the limitations of ratings in making investment decisions. Moreover, because rating agencies derive substantial revenues from structured transactions and advisory services, some participants questioned whether rating agencies were adequately managing their own conflicts of interest.
Do these instruments pose risks to overall financial stability? Participants pointed out that because structured financial instruments facilitate the transfer of risk to institutions outside of the banking system, they may actually improve banking stability. But, at the same time, credit risk may migrate to institutions (including hedge funds) that may be less able to bear it. Risks could also become concentrated in a few financial institutions, though the chance of that happening was deemed relatively small at present.
Colin Miles (Bank of England) saw systemic risk arising possibly from the dynamic hedging of structured instruments. Such hedging relies on continuous access to liquid markets for frequent readjusting of positions. However, in a crisis, market liquidity could dry up and price dynamics in the bond and credit derivatives markets could be amplified. These new instruments have not been tested under market turbulence, and it is unclear how the market will behave over a full interest-rate cycle. Whatever the case may be, credit risk markets, by their nature, are highly opaque and therefore complicate the tasks of central banks, supervisory agencies, and international agencies, including the IMF, in tracking the distribution of risks and assessing financial stability.
A tool for developing capital markets
Beyond transferring credit risk, asset-backed securities and other structured financial instruments may be useful for developing capital markets. As Guillermo Babatz (Mexican Federal Mortgage Society) pointed out, mortgage-backed securities are being introduced because in many countries banking systems cannot meet the financing needs of the housing sector. In Hong Kong SAR, a mortgage-backed securities market is being developed with the help of standardized documentation and underwriting standards, and a government-owned corporation that issues securities backed by bank-originated mortgages, noted James Lau, Jr. (Hong Kong Mortgage Corporation). Innovative instruments are also being developed. In Brazil, for example, remittance flows and loans to small and medium-sized enterprises are being securitized, Amaro Gomes (Banco Central do Brasil) explained.
Structured financial instruments, such as collateralized debt obligations (CDOs), can bridge the gap between the features sought by investors (such as diversification) and issuers’ constraints (such as low credit quality). Lee Meddin (International Finance Corporation) described how institutions such as his have helped increase the supply of high-quality securities in several emerging markets through partial guarantees and investments in mezzanine tranches (subordinated debt securities of CDOs). But the preconditions for liquid markets in structured instruments can be daunting, he suggested. The investor base must be large, and institutions must be able to structure transactions and provide credit enhancements. In addition, rating agencies, sound legal systems to enforce complex contracts, and sophisticated financial regulation and supervision are essential.
Need for more regulation, supervision?
Even in mature markets such as the United States, bank supervisors have encountered problems with securitizations. As Michael Carhill (U.S. Office of the Comptroller of the Currency) explained, in the mid-1990s some banks were substantially weakened when securitizations that ran into problems had to be brought back on their balance sheets. He stressed that such experiences highlighted the need for considerable technical expertise if supervision of securitization is to be effective.
Because different regulations apply to different types of financial institutions, credit risks could flow to institutions that may not necessarily be best equipped to bear them. Should regulations therefore be harmonized across institutions, particularly banks and insurance companies? Although participants did not view regulatory arbitrage as bad per se, they saw problems when transactions were designed primarily to evade accounting rules. Darryll Hendricks (Federal Reserve Bank of New York) argued that complex transactions could not be addressed through rigid rules but required a strong corporate culture of compliance, appropriate incentives for all players, and effective oversight.