Never blame securitization

Securitization offers many advantages to all participants in the marketplace. Derivatives decrease barriers of entry to a host of markets, increase potential diversification and customization, and enhance liquidity and hedging activities.

Securitization has represented a series of innovations that have brought about greater efficiency but the problem with innovation, almost by definition, is that they outpace the ability of the infrastructure, on both the private and public side, to sustain the innovation.

Now, the system is trying to catch up but we risk an overreaction that may limit the potential of securitization. Hopefully, an understanding that a return to securitization is crucial to economic recovery (by allowing banks to lend more through risk transference) will lead policymakers to resist any misguided populist sentiment.

The new products present challenges for risk managers and regulators alike. It also burdens operations, technology, and settlement systems in the process. In reality, every level of the financial system will need to continually adapt to changing risk and complexity.

Unfortunately, policymakers, almost by default, will always be behind the curve. Because an attractive fee is extracted at every stage of securitization, the agents, or intermediaries, will will always be prone to excesses. Innovation will always outpace the ability of the infrastructure to sustain it and securitization crises will be a recurring phenomenon in the new age global finance, you bet. But try doing away with it, you're only deepening the liquidity crisis.

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Welcome to mezzanine... but will it work...?

Hard times call for novel solutions. Real estate sector took it in the chin and is deep in trouble. Bankers don’t lend, properties don’t sell, investors shun the asset class and even Private Equity that once was its messiah wouldn’t take to it kindly.

In comes Mezzanine financing. It is a debt-like instrument consisting of cash income and an equity-linked component, sandwiched between debt and equity on a company’s balance sheet. Here usually a strategic investor (say a PE firm) funds a company through debt and equity. The net cost of investments is 20-25%. Of this, 15-20% is paid as interest on debt and the remaining 5-10% is offered to the private equity investor as warrants at zero cost.

Now my question. The real estate sector lost its sheen when land prices rose to obscene levels and construction inputs like steel, cement, equipment and consumables became unremunerative. The final product, a house or commercial unit could not be sold at a reasonable cost. When liquidity dried up, the highly capital intensive real estate sector lost its only lifeline for working capital – Bank / PE funding. That was the death knell.

So how is mezzanine structure going to solve the problem of absent cash flows? When you expect the payback in the form of part interest and part stake, cash flows matter all the more. How will the borrower meet the interest obligations? Equity may come cheap, but if the sector takes longer to recover and people continue to give priority to survival than property acquisition, how do they expect valuations to improve? Even if valuations improve, with equity markets in a downward trend, how long will they stay put with value erosion and no interest income?

Clearly more than a missing link here. May be the structure envisages high margin collateral to cushion the downside. But most real estate companies are already highly leveraged, no cushion will offer complete comfort ;-)

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