Jake's View

Beijing ABS on beaten path to nowhere

PUBLISHED : Thursday, 26 September, 2013, 12:00am
UPDATED : Thursday, 26 September, 2013, 3:18am

Beijing is expected to allow mainland banks to sell billions of yuan in asset-backed securities (ABS) soon, adding to concerns about increased leverage in the economy.

SCMP, September 9

You know that something has a bad name when they change that name. How would it be if we were to give the name collateralised debt obligation (CDO) to these new instruments instead of calling them asset-backed securities?

How it would be is that the prospective customer would immediately say: "CDOs? Them things are poison. Don't you remember what a disaster they created in the American financial market in 2008? Get them out of here. We're not having any of that CDO rubbish."

All it took was gullible investors who regarded rating agency ratings as rulings from God

And that would be the end of the ABS idea, as an ABS is, of course, exactly one and the same thing as a CDO. It is a debt instrument that relies for its value on the pledge of underlying saleable assets should interest or principal not be paid.

Let's continue to go with the name ABS, however, as it would be a pity if this idea were killed for all time because ignorance and credulity brought it low in the United States.

The underlying idea is a superb one.

Why did it go wrong?

Hundreds of books have now been written on the question, and one more column won't make the surfeit worse. I pin the blame directly on the notion that the risk of a financial instrument can reliably be assessed by credit analysts working for an independent agency paid through fees.

The rating agencies made a mess of it. They first took packages of substandard mortgages that had only been issued because federal government agencies thought it their duty to help poor credit risks buy homes.

They then gave these debt packages much higher credit ratings than they deserved. The alternative was to lose fee business to other, more accommodating, rating agencies. The analysts, well down the hierarchy, were under pressure from their bosses to get the business in and also pressure from too little time to do their jobs adequately. There was little, if any, kicking of the tyres.

All it then took was gullible institutional investors who regarded rating agency ratings as rulings from God, and hundreds of billions of dollars' worth of these CDOs were flogged on to the public.

The antidote to this poison had also been devised, however. It was the credit default swap (CDS), a form of reverse insurance on CDOs. If you held a CDS insurance policy on a CDO, you owed your counterparty regular premium payments as long as interest payments were kept up on that CDO. If the interest payments failed, however, your counterparty would owe you the difference between the face value and the market value of the CDO.

Sorry, I can't make it any less complicated than this. It is derivative finance. The point, however, is that these CDS instruments were an effective check on CDO excess and would have been even more so if the US government had allowed the big holders of CDOs to go bust instead of rescuing them.

CDS pricing of any CDO would then have been a very effective market-based risk assessment tool. That price at any time would have had to take full account of the risk that a collapse of the underlying CDO might render the CDS counterparty unable to pay up. It would have provided a fine-tuned early warning system of debt default.

CDS pricing could thus have supplanted agency ratings as the way of assessing the quality of marketable debt, and it would have done the job superbly. But it was never allowed to do so. It was wrecked by unnecessary US government intervention.

The big CDS holders, who should have got nothing, because they called too late on bust counterparties, were instead indirectly paid out in full by Uncle Sam.

What a shame. If the new game had been played the way things were shaping up, these new mainland ABS instruments might have been matched with effective CDS checks, too, and a real market in yuan debt emerge.

Instead they will be rated by tired old rating agencies that will probably get it wrong again, and the whole thing will go nowhere.