One of the main problems that our banking sector is currently facing is the incredibly excessive amount of non-performing loans (NPLs) on our banking institution’s balance sheets; these have reached almost 50% of their total loan portfolios, amounting to some €28 billion. A number of recommendations have been made regarding how to deal with this significant issue and a lot of pressure has been exerted on the banks’ management to restructure these problematic loans. Unfortunately, until the Fall of 2014, restructuring was only at a rate of about 12% of total NPLs. Just recently, the Governor of the Central Bank of Cyprus (CBC) stressed that reducing the level of NPLs in the banking sector is the institution’s number one priority.
One thing is certain: there are no magic solutions to the NPL problem. One suggestion, that was actually part of the latest MoU but received a lot of criticism by the political parties and is now under review, has to do with securitization and sale of loans to third parties.
Securitization Mechanism
Securitization is a framework in which some illiquid assets (loans/mortgages in our case) of a corporation/bank are transformed into a package of securities backed by these assets. The process starts with the pooling of loans (in our case, NPLs and non-NPLs) to create a large loan portfolio that would be of interest to large institutional investors. The loans are standardized to make it easier to predict the cash flows from the pool (same maturity, interest rate, amount of loan, etc.) and are also guaranteed, for a fee, by governmental or private entities against default and for the timely payment of the cash flows. Special purpose vehicles (SPVs) are then formed to construct the pool of assets and issue the mortgage (or asset)-backed securities. The reason for these vehicles is to place some separation between the originators and the pool of assets. Thus, if the originator – the bank – defaults, it will not affect the pool of loans held by the SPV. The parties who are investing in these securities are essentially buying "bonds" that entitle them to a share of the cash paid by the borrowers on their mortgages.
Securitization is not new; it emerged in the U.S. in the 1970s during which mortgage originators (banks) sold loans to agencies which pooled them and created marketable mortgage-backed securities (MBS). Prior to the global financial crisis, there was an unprecedented expansion in the mortgage market, especially the subprime, due to securitization that offered many benefits to society. However, the crisis of 2007-2009 and the bust in the U.S. housing market highlighted the dangers associated with such mechanism. In the case of Europe, securitization is actually something not as widely accepted, perhaps because of a lack of relevant knowledge and experience. However in many countries with problematic banks and a need for deleveraging, we see now an expanded usage of securitization which I believe will grow further with time.
Benefits & Risks
Securitization has the effect of improving liquidity in the mortgage market, spreading the level of risk, increasing the amount of credit available in the economy, and making it easier or more affordable to own a house. This was certainly the impact that was noted in the U.S., prior to the financial crisis. Furthermore, the banking sector will benefit by having the capability to deleverage and offload problematic loans from the banks’ balance sheets, ultimately leading to a healthier banking sector as a whole. However, there are risks involved that certainly should be taken into serious account by the lawmakers and regulating bodies. One risk is that the added complication of securitization will make it more difficult to apply the necessary flexibility and creativity to assist borrowers facing difficulty. Furthermore, the interests of borrowers might not align with the interests of the other participants such as investors or servicers. Even if it is to the benefit of the borrower to have a modification of the loan agreement at times of difficulty, the terms of the securitization agreement or the interests of the other participants might prohibit them in pursuing such an approach.
My final thoughts on this is that we should not prohibit securitization and I believe, if used properly, can have multiple benefits to our society, can bring much needed liquidity and credit to the economy and help resolve the issues with our banking sector. However, prior to utilizing such a mechanism the right legal framework should be put in place and the regulating bodies such as the CBC should provide an efficient supervision.
