Sunday, March 27, 2016

The lousier the sand turned into "gold", the more profitable is securitization… for the securitizers.

What can you earn by packaging a lot of AA rated instruments (like good 30 years fixed rate mortgages) into a security rated AAA? Very little, basically it is not even worth the effort.

But if you package something rated BB- or below into a security that gets an AAA rating, then there is a fortune to be shared, by all except, those who signed the original BB- obligations.

Securitization has been defended on the ground that it provides more financing to those who otherwise cannot afford it. That is 99% a lie. It provides much financing to those who cannot afford it, in order to benefit the originators, the packagers and the intermediaries.

Here’s the real deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket an immediate tidy profit of $210.000

But if you think that’s all with securitization looking to turn sand into gold, just you wait.

If an AA rated instrument is packaged into a security that gets an AAA rating it means nothing in terms of risk-weighted capital requirements for banks but, if a BB+ rated or an unrated instrument is packaged into a security that gets an AA rating, then the risk weight diminishes from 100 percent to 20 percent. And that, in terms of Basel II, meant that banks instead of having to hold 8 percent in capital against that instrument, were then only required to hold a meager 1.6 percent in capital. Meaning that instead of leveraging their equity 12.5 times to 1 they could leverage it a mind-blowing 62.5 times to 1.