Bank of Canada Gov. Says Securitization Originators Must Maintain Standards

The banks and non-bank financial institutions that originate loans and then securitize them must be incentivized to maintain credit standards, advised Bank of Canada Governor David Dodge. In remarks to the Vancouver Board of Trade, he also noted that a reduction in securitization now seems likely, as well as a degree of re-intermediation by financial institutions. More broadly, he wondered if regulators fully appreciated just how much the increase in securitization represented an easing of credit conditions. Loans were being shifted off balance sheets, allowing more loans to be made.

The governor also rejected calls for tighter regulation of credit-rating agencies, reasoning instead that those credit-rating agencies that do not work harder to ensure that users understand the nature of their ratings will soon have fewer clients. But he did urge credit-rating agencies to more clearly explain the rationale for, and limitations of, their ratings for highly structured securities products. They should make it clear that their ratings should not be used with the same degree of certainty as ratings for conventional, single-name issuers, and that the securities involved do not trade with the same degree of market liquidity. At the same time, he urged investors to do their own homework instead of simply relying on the word of credit-rating agencies.

The originators of mortgage and other loans are immune from default risk once the loans are securitized and sold, he noted, and thus currently lack the proper incentives to adequately assess the creditworthiness of the borrower. While market forces may rebalance incentives, there may also be an active role for policy-makers in this regard. Another issue related to securitization concerns the capitalization of banks. The governor wonders that, if banks are moving securitized loans off their balance sheets but still providing liquidity guarantees for these securities, how much capital should they be required to set aside. He raised the specter of the Basel Committee revisiting this issue in light of recent experiences.

While the process of securitization is not new, he observed, increasingly complex securities have been developed in response to the demand for higher returns. And as these securities have become more complex and opaque, it has become harder to determine the quality of the assets at the root of the security and to assess the counterparty risk. Securitizing means bundling the loans together into securities backed by the cash flows generated by the loan repayments. These securities are then often sold in tranches offering varying degrees of protection from the default risk involved. In turn, these structures allow higher risk assets to take on the qualities of lower-risk assets.

Because of the complexity and opacity of these securities, it is extremely difficult for investors to confidently determine both the creditworthiness of the assets backing a particular security and the market value of the security itself. In these circumstances, uncertainty can lead to contagion and dislocated money markets. According to Gov. Dodge, investors should demand greater transparency, which in turn should force vendors of financial instruments to structure them so that market players can clearly see what they are buying..