Wainwright, Thomas

English

Kingston University Research Repository

Not so elite anymore?: The uneasy boundaries between financial governance and financial engineeringThomas WainwrightAims1. To provide a brief overview of securitisation and the crunch2. To explain how subprime defaults and credit risk should have been contained3. To explore the uneasy boundaries between the elites of governance and financial engineering –regulator or collaborator?MethodologySemi-structured interviews (n=40)Conducted in 2006-2007Included senior directors and junior executives in the UK Organisations included: mortgages lenders (building societies, centralised lenders, banks), investment  banks, asset managers, trade bodies, credit referencing agencies, corporate service providers, law firms and bond-rating agenciesRespondents sourced from searches of the financial media from leading firms identified in the financial pressSecuritisation at the heart of the crisisRMBS Residential Mortgage Backed SecuritiesProcess used to sell bonds as debt£100k bonds backed by mortgagesSale of assetsABS: Asset Backed SecuritiesCredit cards, consumer loans, commercial propertyCapital adequacy ratiosBasel 8 per cent reserves£1 billion in mortgage assets = £80 millionDiversify their funding away from other sources, such as depositsWhy securitize?To gain finance to lend and expand market shareBorrow money to issue mortgages via a „warehouse line‟ - a huge overdraftEnabled the repackaging of higher risk subprime loans, and into lower risk securities Then refinance this overdraft with securitisationNorthern Rock/HBOS did this to become a hybridWhy securitize?The „waterfall structure‟AAABBBCCCReserveAAA Investor profitBBB Investor profitBB Investor profitBBeserveBBRBBB£/€/$ReturnInvestorsRetail banks (originator)Investment banksSPVConsumersBond-rating agenciesLaw firmsCredit-referencing agenciesFinancial elitesFinancial products are produced at the boundaries of firms (Thrift, 1994)Until recently, there has been a lack of attention on elites (Savage & Williams, 2008; Hall, 2009)Financialised elites (Hall, 2009)Capital market intermediaries (Folkman, et al. 2007)‘Proactive initiators’ investment bankers, corporate lawyers‘Responsive functionaries‟  bond-rating agencies in governanceHas the role of bond-rating agencies become more blurred?Have they moved beyond a role of supervision and are they interacting more proactively with other elites?The role of bond-rating elites in  the development and operation of securitisationThe role of bond-rating agencies in financeSince the 1980s, financial organisations moved from intermediation to disintermediation - where borrowers accessed credit directly from investors by issuing bonds, instead of through bank deposits (French & Leyshon 2008)This created the emergence of a new private mode of financial surveillance, creating a regime of governance, not government  (Sinclair, 1994)Bond-rating agencies provide a key role in providing independent metrics, and ratings of the quality of bonds to investors (Sinclair, 1994)These agencies provide „judgements‟ on bond quality that have  assisted the financialisation of Anglo-American economies through their judgements (Erturk, et al (2004)The aim of these metrics has been to calculate estimates that bond issuers will default, or not, to overcome information asymmetries (Sinclair, 2005)This has created a global elite of private governance with private analysts that control the metrics provided to bond issuersBond-rating agencies emerged in the US and have moved into Europe, Asia and Latin AmericaThere are three main agencies that rate the credit quality of bonds globally, including corporate bonds, sovereign bonds and securitisation notesLowRiskHighRiskStandard &Poor’s AAA AA A BBB BBFitch Ratings AAA AA A BBB BBMoody’s Aaa Aa A Baa BaThe agencies use the following rating measures for RMBS bonds:Usually, 90pc of a securitisation is of low risk AAATheoretically the same risk as holding a sovereign bond, but with a higher yieldDifferent investors sought bonds of varying risk to meet their investment mandates3 agencies wield considerable power over financial marketsSmall global teams with considerable power, especially in LondonBefore bonds are issued, bond-rating agencies run stress tests including the quality of the issuer, liquidity risk, credit risk, repayment of the notesHowever, the quality of a bond issue is monitored over its lifetime -increasing and decreasing the ratingBond-rating agencies have a powerful location within financial networks – ratings limit access to investorsExpanding British RMBS markets: The role of bond agenciesBond-rating agencies and their metrics have provided greater transparency for investorsEnabling them to compare different bonds and asset classes - especially for RMBSThe early UK RMBS market was mainly inhabited by UK investors, including banks, insurance companies and pension fundsReputation was important for investors, as was local knowledgeMost investors undertake due-diligence into RMBS, scrutinising the mortgage portfolio, lender and transaction detailsRating agencies assisted the expansion of the UK market by enticing international investorsExpanding British RMBS markets: The role of bond agenciesInternational US investors were unsure of the market, but they were familiar with US bond-rating agency metrics This provided reassurance for investors who began to buy UK assets. widening the market to other international investorsThis also sped up the market as investors would happily purchase AAA bonds, with reduced due-diligenceThe introduction of bonds explains why, at the peak of the market, 70 per cent of investors in UK RMBS were from overseas (CML 2010)Bond-rating agencies had facilitated this with the power of their metricsThis enabled the housing market to grow, subprime issuance to increase, profitability, for lenders to increaseCritiquing bond-rating elitesIf elites conducting surveillance suppose that a bond is weakening, they will downgrade the bond. This increases the risk, and often increases the interest rate that the issuer must pay to investorsBodenman (1996) has argued that these metrics, especially downgrades, on US municipal bonds have increased the debt of poorer cities, increasing the proportion of tax revenues being spent on bond repayments, not city servicesFerri et al (1999) have argued that agencies exacerbated the Asian Crisis in the 1990s, by downgrading debt on bonds, and increasing bond repayments, placing companies under stress, and exacerbating the problem into a self-fulfilling prophecyThe reliance on external capital also increased the UK‟s dependence on these funds, exacerbating the fallout after the crisisMore recently German ChancellorAngela Merkel criticised bond-ratingagencies for not classifying USsubprime bonds as high riskinvestmentsThis, she has argued, misled investorsadding to the intensity of the creditcrunchUnderstood by many as a conflict of interest between issuers of bonds and bond-rating agencies, where the agency fees are paid by issuers,  which may have coerced them into providing favourable ratingsPortes (2008) argues that Moody‟s generated 44 % of its revenues from rating activitiesQuestionable that they would rate high-risk assets with low-risk metricsas it could damage their reputation - problematizes their role as privategovernors of global capital marketsInvestigating the roles of these elites suggest how agencies wereimplicated in the crisis, but did not seek to give over-optimistic ratingsMaking finance: Securitisation and the confused roles of elites? Structuring RMBS bondsThe development of RMBS transactions relies on a select group of epistemic elitesThese include structurers in investment banks that  create the waterfall structure and transaction model to develop the note tranchingThis model is then stress tested to analyse the effects of different financial scenarios, that could be expected, to see how the transaction responds– this can include increasing interest rates and unemploymentThese elites develop the models, and originally the bond rating agencies would then certify their quality and risk, with different ratingsThese evaluations of the stability provided independent metrics of private governance, but the agencies have become more involved in this processIn practice, this supervisory role becomes more complexInvestment bank structurers „create‟ the securitisation structuresBut, if the structure fails to meet the guidelines of the bond-rating agencies, the analysts give advice and hints as to how the deal should be amendedSuggests a complex relationship as they move from governor to a role in shaping transactionsThen structurers started using the methodologies from bond-rating agencies as „cook books‟, or model answers to build their transactionsThe RMBS structures became  programmed around the bond-rating assumptions“Yeah, some of them [bond rating analysts] say what you giveus [transaction] we will rate, and then you ask for feedback, soif in this scenario, where, what can we do to make thisscenario better, it depends on the analyst you‟re working with,some are more helpful than others, it depends how busy theyare, it‟s a bit of give and take on both sides, and experience,some banks will know just as well as the agencies, it‟sexperience, that will help, they will say try that around, or thisdoesn‟t look right, check your model is working, but there isgive and take on each deal,” (Investment Bank, Structurer2007)During the 1990s, methodologies used by rating elites were made available to structurers to assist the structurers in developing their waterfall and securitisation structuresCreated a significant shift in the role of these elites from private governors to co-producers„Independent production‟  of  RMBS began to converge and conform on particular  models and assumptions of bond-rating agenciesGovernance and SurveillanceFinancial ActivityGovernance and SurveillanceFinancial Activity“…bankers used to model the transactionand we used to validate the model, andnow we model our own transaction so it’s alot more independent and easier tounderstand what’s going on with thetransaction, I think that’s the main change,so we can reconcile our model with thebanker’s model and we know the bank isn’thiding anything,” (Bond-rating Analyst,2007)“then you get rating agency templates,which, three different rating agencies havedifferent things they try to populate... youget the rating agency reports and then it‟srun through cash flow models, so it‟s a bigmodelling process to come out with, onceyou run through all the models, do all thedifferent stresses each agency hasdifferent stresses, so there‟s, it‟s just CPRall prepayments from 40% to half apercent, stress arrears going up to, erm,it‟s different for different rating categories,err, if you look at the rating methodology ofthe agencies, so it‟s running the cash flowmodels, coming out with your loss severitywhich would give you a triple A and howmuch you would get”, (Investment Bank,Structurer, 2007)Summary: The conflicting roles of elites in governanceBond rating agencies should be providing governance of RMBS transactions, but their role has become progressively interrelated with productionThe 3 main bond rating agencies use elite analysts to produce key texts thatwere used to develop securitisation structuresWhilst critics have argued that bond-rating agencies provided metrics thatwere too low-risk for some transactions, these elites and theirmethodologies caused a convergence of the transactions, partiallycontributing to their constructionThe assumptions and structures of the bond-rating agencies can be viewed as a contributor to the crisis, as they guided the engineering that underpinned RMBS transactions, especially subprime deals in the USThe European Securitisation Forum (ESF) and the Securities Industry and Financial Markets Association (SIFMA)  are arguing for greater transparency within the „future‟ securitisation market, and are calling for renewed trust in rating agenciesFindings of the research suggest that the relationship between private governance and finance is more complex than originally thoughtTo provide added protection against future financial crisis, this complicated relationship needs to be understood in greater detail.Perhaps the agencies and their models should be scrutinised, but who should fulfil that task?Would  reducing the power of agencies be useful, by forcing more due diligence by investorsNew directions: new hybrids of financial, cultural and religious elitesNew directions?: Regulatory elites and religious financeA new generation of financial products have co-evolved with securitisation using similar featuresShariah finance, known as sukuk bondsInvolved in the Dubai‟s financial downturn, but potentially seen as a new method of accessing Islamic finance marketsSubject to bond-rating agency metrics, but also due to Islamic LawSukuk are subject to religious oversight – cultural contrast to capitalismShariah Law – Principles of Banking and Finance1. The prohibition of Riba2. The prohibition of Gahar, including risk-taking3. The avoidance of socially responsible  investments, including gambling and alcohol4. Risk sharing between entrepreneurs and financiers5. Investments into material and tangible goods and assets6. Social justice – where neither party of a transaction are exploitedGait and Worthington (2008:785)New directions?: Regulatory elites and religious financeSukuk are rated for credit quality by bond-rating agencies Sukuk bonds are governed by Shariah scholars for Shariah complianceThe views and opinions of individual scholars and their social position as elites provides them with the power to determine the Islamic quality of bondsSukuk bonds are only rated, as with bond-rating metrics, once these powerful elites are satisfied with the quality of bondsThis quality is compliance with Islamic Law, and not just bond rating metricsNew directions?: Regulatory elites and religious financeShariah ScholarSukuk BondInvestor DemandIssuer/StructurerBond-rating agencies

Not so elite anymore? The uneasy boundaries between financial governance and financial engineering

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