Sunday, January 09, 2011
Dr. Dennis Vink, Associate Professor of Finance and Director of the Nyenrode Center of Finance, contends that plans which are currently being made to contain the influence of credit rating agencies will ultimately have very little effect. In his view, the influence that these types of organizations have is currently overestimated and that investors investing in structured debt actually pursue a more independent course than is often believed. Vink believes that the market will regulate itself. “Start supplying investors with much more information. This will make them less 'clueless’ when it comes to their investments”.
Banks as intermediaries
Vink starts by describing how banks currently act as a type of intermediary in extracting money from the market. “Consumers entrust their savings to banks. The banks in turn can use this money to extend mortgages to others. As a result, the banks acquire a claim on the person who has taken out a mortgage with them. A financial institution can only apply the money received from savers for extending mortgages once, so in order to be able to still continue to engage in new activities, the financial institution will have to free up funds. To do this, they resell the loans they have extended to people with a mortgage to interested investors.”
Vink starts by describing how banks currently act as a type of intermediary in extracting money from the market. “Consumers entrust their savings to banks. The banks in turn can use this money to extend mortgages to others. As a result, the banks acquire a claim on the person who has taken out a mortgage with them. A financial institution can only apply the money received from savers for extending mortgages once, so in order to be able to still continue to engage in new activities, the financial institution will have to free up funds. To do this, they resell the loans they have extended to people with a mortgage to interested investors.”
SecuritizationThis reselling of debts to free up funds for new activities is referred to as “securitization”. “The concept of securitization is still a relatively new one,” Vink says. “In particular, we have seen a considerably high number of mortgage debts being resold to investors since the start of this millennium. These debts are then combined to create packages containing a lot of mortgages. Investors buy these packages to earn returns on them themselves and for a long time, this went well.”
Subprime crisis
“Financial institutions currently have very few alternatives available to them for acquiring capital,” Vink continues. “Normally, they issue stocks or bonds. However, no one wants to buy these equities anymore since there is so much uncertainty in the market. On the other hand, securitization has a really negative image at the moment. The subprime crisis in the United States developed because something went wrong with the resale of the debts to investors by financial institutions.”
Why did it go wrong? According to Vink, investors are generally incapable of accurately estimating the quality of a structured debt. “This is a very complex task and this is also why, before they buy a debt from a bank, investors first consult credit rating agencies such as Moody's, Standard & Poor’s or Fitch Ratings. These credit rating institutions evaluate a mortgage holders’ ability to satisfy their mortgage loan payment obligations, and thus the quality of the portfolio being offered. Since these packages were made up of a great variety of types of debtors, as well as enormous quantities of debts, often tens of thousands per portfolio, at a certain point, a problem arose. The institutions regularly issued incorrect credit ratings which were often overly positive. This was, in a nutshell, the cause of the subprime crisis.”
Measures
Following this, many lawsuits were initiated in the United States in which credit rating agencies had to defend the way in which they did their work, and what went wrong. According to Vink, this has occurred to a lesser degree in Europe, where the debts are also estimated more accurately. “However, the current sentiment is to take a hard line with credit rating agencies everywhere. Various governments and institutions working with capital now want to make sure that this can never happen again. One of the measures they want to take is to impose restraints on the credit rating agencies. This idea is based on the fact that people assume that the problem was caused by investors relying too heavily on the opinion of the credit rating agencies, and that they hardly performed any credit analyses of their own.”
However, Vink believes that investors actually did assess these structured debts based on their own analyses. This places the idea of imposing measures to control the influence of the credit rating agencies in an entirely new light. Vink: “The measures that have now been proposed lean towards imposing restraints on the credit rating agencies which imply that the investors will have to perform more analyses themselves. However, the investors were doing this all along, even though it now appears that they are actually incapable of doing this
properly."
Following this, many lawsuits were initiated in the United States in which credit rating agencies had to defend the way in which they did their work, and what went wrong. According to Vink, this has occurred to a lesser degree in Europe, where the debts are also estimated more accurately. “However, the current sentiment is to take a hard line with credit rating agencies everywhere. Various governments and institutions working with capital now want to make sure that this can never happen again. One of the measures they want to take is to impose restraints on the credit rating agencies. This idea is based on the fact that people assume that the problem was caused by investors relying too heavily on the opinion of the credit rating agencies, and that they hardly performed any credit analyses of their own.”
However, Vink believes that investors actually did assess these structured debts based on their own analyses. This places the idea of imposing measures to control the influence of the credit rating agencies in an entirely new light. Vink: “The measures that have now been proposed lean towards imposing restraints on the credit rating agencies which imply that the investors will have to perform more analyses themselves. However, the investors were doing this all along, even though it now appears that they are actually incapable of doing this
properly."
Confidence in the market
Vink has more confidence in the market’s own workings. “The market will regulate itself. Financial institutions will now start ensuring that the structures become less complex. They will also, for example, start supplying investors with a lot more information. This will make them less 'clueless’ when it comes to their investments, and this is something which is definitely necessary. One thing that is clear is that the three large credit rating agencies, Moody's, Standard & Poor’s and Fitch Ratings, together have control over the vast majority of the market. Perhaps their power would decrease if there were more major players.” Vink says that 70% of the Dutch mortgage market is securitized. “The securitization market is slowly starting back up again in the Netherlands as well. Little by little, SNS and Rabobank are becoming active again in this area and the structures here are also becoming increasingly less complex.”
Vink has more confidence in the market’s own workings. “The market will regulate itself. Financial institutions will now start ensuring that the structures become less complex. They will also, for example, start supplying investors with a lot more information. This will make them less 'clueless’ when it comes to their investments, and this is something which is definitely necessary. One thing that is clear is that the three large credit rating agencies, Moody's, Standard & Poor’s and Fitch Ratings, together have control over the vast majority of the market. Perhaps their power would decrease if there were more major players.” Vink says that 70% of the Dutch mortgage market is securitized. “The securitization market is slowly starting back up again in the Netherlands as well. Little by little, SNS and Rabobank are becoming active again in this area and the structures here are also becoming increasingly less complex.”
Subprime crisis in the Netherlands?
In spite of this, a crisis resulting from the securitization system is not unthinkable in the Netherlands, Vink warns. If people with a mortgage are able to deduct the interest from their taxes, as is the case in the Netherlands, their credit rating goes up because of the tax refund they receive. In a situation in which the mortgage interest deduction were to suddenly be eliminated entirely, and people with a mortgage no longer receive extra compensation, their credit rating will decrease. But their debt at the bank would still remain the same.”
Vink believes that there is a hgh chance that the housing prices will drop in such a situation. “At that point, the credit rating of home owners in the Netherlands will be devalued by the credit rating agencies. This means that the debts investors have purchased will also be devalued.”
Vink: “This would effectively mean a subprime crisis in the Netherlands. This is in essence what happened in the United States, even though it happened in an entirely different way there. Consumer credit ratings also decreased there, and the real estate prices dropped.”
He continues: “No one hears the banks in the Netherlands talking about this scenario, even though it is a very real one. They think that talking about it would not serve their best interests. After all, even just talking about a possible decrease in credit ratings will increase the likelihood that they will have a harder time borrowing money.” The question however is whether this practice of burying their heads in the sand will backfire on them sooner or later.
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