Opening Address by Mr Ong Chong TeeDeputy Managing Director, Monetary Authority of SingaporeSingapore Structured Credit Conference 2008
1 Good morning, distinguished guests, ladies and gentlemen. To our overseas guests, may I extend a very warm welcome back to Singapore since I believe most, if not all of you do come to Singapore often. The Singapore Structured Credit Conference provides a good occasion to bring together a wide group of participants – originators, intermediaries and investors – to discuss trends in the industry, share useful lessons and explore opportunities.
2 This is the second conference. Many of you were here last year. The credit market then was exuberant and on hindsight, perhaps irrationally so. Since then, of course, the credit bubble has burst - and this year, we are holding the conference under very different conditions. We are in the midst of arguably one of the most challenging crises since the crash of 1929. Despite this, I am very heartened to see such a large turnout today. I believe this reflects two things: one, an assessment that this crisis does not spell the end of the structured credit or securitization markets; and two, a collective desire to learn and to exchange views, so as to better strategize and prepare for that next step in market development.
3 So what’s next for the structured credit market? Allow me to share some personal thoughts from two perspectives: firstly, some comments on the near term state of the markets, and following that, a longer term reflection of some of the structural issues the securitization industry will need to address.
4 First, on the more immediate state of markets. What started off as a problem in the US sub-prime sector, which was a relatively small percentage of the US mortgage market, has turned into a massive problem affecting banks, fund managers, insurance companies and investors. A near paralysis of the financial systems in the US and Europe was seen. Credit spreads ballooned and equities and other risky assets plunged. The fact that there is a re-pricing of risk following the bursting of a bubble is not unexpected. What is perhaps surprising is that as asset prices fell, what used to be fairly deep markets suddenly seized up and became dysfunctional.
5 As many of you would know, secondary market liquidity evaporated in many credit markets – from ABSs to corporate bonds, to emerging markets. In the primary market, debt underwriting activity during the second half of 2007 totaled US$2.3 trillion, a 47% drop from the first half of the year. The same picture can be observed in the equity market. Although equity issuance enjoyed an overall good year in 2007, the increased volatility in global stock markets had led many issuers and underwriters to withdraw or postpone planned IPOs. Global equity and equity related underwriting volumes in the first quarter of 2008 fell to US$100.6 billion, the lowest level since the first quarter of 2003. Even the core of financial markets, the LIBOR market, became dysfunctional.
6 A confidence crisis that affected an entangled system of complex and inter-dependent relationships feeds on itself. Banks withhold lending to one another and small net positions with a counterparty in perceived trouble or potential trouble is no comfort. Many suffer mark-to-market losses on their asset holdings. According to a Bloomberg report, major banks and securities firms have reported over US$230 billion in asset write-downs and credit losses since the beginning of 2007 and the IMF has predicted that losses can reach close to US$1 trillion.
7 Asia, so far, has been largely spared the worst ravages of this credit storm. But the region cannot be insulated either. Capital market liquidity has tightened in some market segments, and spreads have widened. But Asian money markets have generally weathered this storm relatively well. Perhaps, the fact that Asia is still largely centred around traditional bank intermediation and that Asia is a relatively late entrant in the securitization market, are a blessing in disguise. It also helped that Asian economies are expected to continue to grow strongly despite the credit market crunch, with ADB projecting Asia’s growth to come in at 7.6% this year. This outlook may of course be adjusted down if the US slowdown turns out to be deeper and more prolonged.
8 Many reasons have been offered to explain the pervasiveness of the crisis and how this permeated from a sub-prime concern to affect a much broader set of financial institutions, investors and market sectors. I do not intend to add to the discussion here on the “whys” and the “hows” of the credit crisis.
9 But an equally pertinent question is how long we believe this crisis will last? Are we approaching the beginning of the end, or are we simply at the end of the beginning – with yet more problems to surface?
10 Some of you may have read Charles Kindleberger’s classic text titled “Manias, Panics, and Crashes”. He noted two ways in which financial crises had historically ended. One, when all the ills and excesses have been purged (he called it the burned out way) or two, when a lender of last resort steps in. It may be said that we are seeing signs of both. Financial institutions have announced large write-downs in asset values – more than US$200 billion since the start of the crisis. Indeed, there is an increasing recognition that it may be better to announce all the bad news at once, rather than have the bad news come out piecemeal. Some banks have folded; others have recapitalized and deleveraged.
11 At the same time, central banks in US, Europe, Canada and Australia have taken assertive steps to broaden their liquidity facilities substantially – across many dimensions – the types of collateral, the tenure of the loans, the classes of participants – in essence fulfilling the lender of last resort role envisaged by Kindleberger. Just this past Monday, the Bank of England announced a facility to provide Gilts in exchange for more illiquid securities, including those that are not denominated in sterling. These measures by central banks are not insignificant. So perhaps, there may be some reasons to be cautiously optimistic. But as all market participants here will know well, there is little room for complacency. A financial system has to be underpinned by a certain level of confidence and trust, and sentiment remains fragile, not least because of concerns over the impact on real activities amidst rising commodity prices.
12 Let me now offer some longer term perspectives. What will the structured credit markets look like when the dust finally settles? A number of commentators have proclaimed that CDOs will be relegated to the history book of financial products; others have derided the ‘evils’ of financial innovation with calls for a return to basics.
13 This crisis has certainly delivered some hard lessons and probably timely ones too. But as the publication Economist had aptly described, “just like junk bonds, another once-misused financial instrument, many of the new derivatives will be back, for no better reason than that they are useful”. I think it is necessary to distinguish the ‘tool’ from the ‘greed and deed’ of market excesses. In its simplest, the theory of securitization supplements traditional bank lending, by helping to package smaller, more standardized loans into larger parcels and distributing them to capital market investors. In short, this enhances the efficiency of risk intermediation, spread risks and promote economic efficiency by providing cheap capital. Capital market intermediation has the ability to transcend geographical boundaries in ways that traditional banking is unable to.
14 However, practice is seldom a perfect replication of theory. Indeed, this crisis has surfaced some fundamental deficiencies at the heart of the securitization market. The three tenets by which investors traditionally value and assess securitized products: origination standards, credit ratings and statistical pricing models – are all increasingly questioned. Let me elaborate.
15 First, origination standards. Stemming from the sub-prime experience, many investors are now left pondering whether origination standards were undermined because of a basic misalignment of interest between originators and investors. The business model of originators is typically based on “warehousing” loans for a short time and quickly securitizing them into the capital markets and earning a fee. Their revenue, and hence bonuses, are tied to the volume of loans they securitized, not the repayment of these loans. Thus, there may not be the incentive to implement and monitor tight underwriting standards. After all, it is the short-term gains that matter since one’s compensation formula is geared towards that. With massive competitive pressures, each originator raced to lend against ever looser underwriting standards, culminating in the now-infamous “nina” loans, ie to customers with ‘no income, no assets. The retention of some of the first-loss piece by originators will go some way towards aligning the interests of originators and investors, but perhaps more can be done. There is also the issue of whether retention of risks goes against the entire idea of risk-transfer that securitization seeks to achieve in the first place. The industry should confront this issue.
16 Second, credit rating agencies, the whipping boy of this crisis. Some investors have similarly noted that there are risks of conflict of interests in credit rating agencies who receive fees from originators. While some of these concerns are not unfounded, I believe investors are also not without fault. Many may have chosen to over-rely on, or some may say, misuse credit ratings to justify their investment decisions. Credit ratings are measures of default risk. But investors have extended them to be indicators of market or even liquidity risk. Higher rated securities are assumed to be more stable and liquid. As seen in the last few months, in extreme situations, AAA securities may also exhibit the illiquidity and price volatility of lower rated securities.
17 Third, the assumption that market prices provide a good gauge of an asset’s value is now in the spotlight as well. Market pricings can be severely distorted – both on the way up and on the way down. This is especially the case for very complicated structures such as CDO-squares and structured finance CDOs. As such, there is a necessary simplification of products going forward notwithstanding that the innovation game will carry on. Furthermore, investors have come to realise that market pricing can be driven by a myriad of factors that are not linked to the intrinsic quality of the security. For example, the seizure of the ABCP market essentially compelled many investors to dump their securities, pushing down prices below what may have been otherwise reasonable fair values.
18 As all these three areas: origination standards, credit ratings and market pricing are fundamental pillars of securitization, these issues will need to be addressed for investors’ faith and the market’s long-term viability to be fully restored. How will all these affect the future of securitization in Asia?
19 Certainly, this crisis which has unfolded largely in the developed markets provides useful and necessary lessons for all of us in this part of the world. The development of legal frameworks, increased investor sophistication, the need of financial and corporate institutions to diversify funding sources will all, in my view, mean that securitization activities will grow over the medium to long term even if there is a pause or slowdown in current times. An increasing proportion of these deals will probably be seen in local currencies, partly because of the turmoil in the G3 markets and partly because Asian local currency products are rapidly gaining favour. In the past few months, several deals have been concluded in various markets throughout Asia, including the securitization of receivables by a telco in Malaysia as well as issuance by repeat issuers in Korea. The Chinese market has also seen continued activities, including its first auto loan backed securitization.
20 The opportunities in Asia remain exciting, which also explains why you are all here in this hall today. I noted in the beginning that the first structured credit conference was held in a time of euphoria. The second is now held in a time of crisis. Next year, I hope to see all of you again. Perhaps then, it will be a period of a crisis aftermath with all the war stories and lessons to be told.
21 For now, I am sure this conference will see an exciting exchange of views and best practices as well. As an economist once said, “knowledge is the only instrument of production that is not subject to diminishing returns”. I certainly hope to hear from some of you on how you see further developments in the securitized industry and its growth prospects.
22 On this note, I wish all of you a fruitful and interesting conference.