Reputation, pricing and performance in the European securitisation market

Deku, Solomon Yayra

Business
October 2017

Thesis or dissertation


Rights
© 2017 Solomon Yayra Deku. All rights reserved. No part of this publication may be reproduced without the written permission of the copyright holder.
Abstract

This study investigates the impact of reputation on the pricing and performance of securitised bonds. On the one hand, we ascertain whether investors incorporate the reputation and experience of issuers and trustees into pricing mortgage-backed securities (MBS). On the other hand, we examine the link between the disciplining mechanisms of price and issuer reputation on the performance of mortgage-backed securities proxied by delinquency rates and rating changes. We address these objectives using pricing and performance data on the MBS issued from 1999-2007 in 14 European countries’ securitisation markets.

In perfect capital markets, asset backed securitisation should be irrelevant. However in an environment with asymmetric information, banks prefer to securitise assets rather than fund assets with deposits. The literature concurs that European banks mainly engage in securitisation to augment their liquidity positions and diversify their funding alternatives. Other incentives include risk diversification and regulatory capital arbitrage, however, this was a more common motive in the US, prior to the financial crisis. During that period, the growth of securitisation was fuelled by increased credit supply which in turn was nurtured by relaxed lending standards and a low interest rate environment. Furthermore, banks retained riskier loans and junior tranches to signal the quality of securitised bonds to investors. Hence securitisation, originally designed to transfer credit risk, ultimately involved very limited risk transfer. This trend resulted in the accumulation of risks on banks’ balance sheet which in tend increased the likelihood of a systemic crisis. Contemporary evidence from the equity markets also indicates securitisation announcements typically had negative wealth effects on the market value of issuing banks. As MBS issuance levels increased in the years preceding the financial crisis, investors in securitisation transactions also began to incorporate varying credit factors in excess of credit ratings into the launch spreads of securitised bonds. More importantly, spreads were informative enough to predict bond performance in terms of cumulative losses and rating downgrades.

We examine pricing from two dimensions. In the first empirical chapter, we assess the certification value of issuer reputation in securitisation by examining initial yield spreads of MBS. We find that issuer reputation has a certification value for riskier, difficult to evaluate MBS, especially when information asymmetries in credit markets intensify. Furthermore, we show that MBS originated by subsidiaries of foreign banks are perceived to be riskier, regardless of the repuation of the issuer. We also find that investors require higher yields if there is a higher probability of rating shopping and when issuers expand rapidly.

In the second empirical chapter, we consider the role of trustees –who are nominated to protect the interests of investors– in securitisation pricing and whether investors rely on them to mitigate risks. We assess the effect of trustee reputation on initial yield spreads and we find that engaging reputable trustees led to lower spreads during the credit boom period prior to the 2007-2009 financial crisis. Our findings suggest that trustees’ reputation was considered by investors to be more important when risk assessment became more challenging. Thus, investors began to associate trustee reputation with effective debt monitoring as the concern for defaults grew in the boom period. In hindsight, it is evident that investors took steps to protect their investments, however inadequate, by adjusting the valuations of the structured notes they purchased.

Concerning performance, in the third empirical chapter, we find that reputable issuers sold bonds collateralized by low-quality assets during the boom period. However, these bonds were less likely to be downgraded by rating agencies, probably due to the compensating effects of structuring techniques. We attribute this decline in quality to reduced monitoring efforts. We also find that foreign reputable issuers tend to sell lower quality bonds, which are more likely to be downgraded. Furthermore, we confirm that initial yield spreads are informative enough to predict performance. More specifically, this finding is solely driven by non-AAA rated bond yields. Our key finding, however, is that initial yields were generally not informative in the years preceding the boom period (2004-2007). Therefore, at the turn of the millennium, most investors exclusively relied on credit ratings. However, during the growth period, sophisticated investors began to price the increased uncertainty and complexity associated with MBSs.

Overall, the analysis provides some insights on the role of reputation in the securitisation markets. Investors demanded lower spreads on securities with reputable sponsors and trustees especially during the growth period preceding the 2007-09 financial crisis. Although the quality of the assets underlying these securities deteriorated rather rapidly, the securitised bonds were less likely to be downgraded, most likely due to countervailing structural features. Furthermore, the findings of this study show that investors, mainly sophisticated investors, grew increasingly sceptical in the years preceding the financial crisis. This is evident in the relative predictive potency of initial yield spreads on non-prime bonds issued during this period.

Publisher
Business School, The University of Hull
Supervisor
Kara, Alper; Rhodes, Mark J.
Sponsor (Organisation)
University of Hull
Qualification level
Doctoral
Qualification name
PhD
Language
English
Extent
3 MB
Identifier
hull:16532
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