Revive Securitization to Speed Exit from Crisis, says IMF

• Author: John Kiff
• Position: IMF Monetary and Capital Markets Department

Since the crisis began, investors have shunned securitization products, such as mortgage-backed securities, and central banks and governments have taken up the slack with various programs to support securitization markets, the IMF said in a chapter of its latest Global Financial Stability Report, issued on September 21.

While many question whether it would be worthwhile to restart the market for securitized assets, the IMF argued it is necessary, although with reforms to guard against the excess that caused the markets to implode. If private investors return to the business of securitizing loans again, central banks and governments can withdraw from their role as "buyers of last resort," which makes restarting these markets important to exit strategies, the IMF said.

Securitization allows less liquid, income-generating assets, such as home mortgages, to be packaged into securities and sold to investors. The latest round of reforms and the IMF report are focused on securitized instruments that are "tranched," which means they are divided into portions, making payments first to the "senior" tranche holders, then to "mezzanine" tranche holders, with "equity" tranche holders getting whatever is left over. They allow risks to be split up and distributed to a more diversified set of holders. In Europe, covered bonds, a form of securitization in which the originator retains an economic interest in the loans, also play a key role in financing mortgage lending (see box).

Covered Bonds

A covered bond is a secured debt obligation collateralized by a dedicated portfolio of assets (the cover pool) that is kept by the issuer on its balance sheet. Because issuers of covered bonds are fully liable up to their registered capital, there is a double layer of protection for investors-the assets and the issuer. Most covered bonds are issued under special laws that set prudential standards for product structures and the credit quality of the cover pool, to limit incentives for excessive risk-taking and slippage in underwriting and monitoring standards. In Europe, covered bonds have long been the preferred method of capital market-based mortgage funding. But covered bonds do have a downside: They do not provide the balance sheet leverage and regulatory capital relief commonly associated with securitization in which the pool of assets backing a bond is moved off the issuer's balance...