Asset-Backed securitisation and financial stability: the downgrading delay effect

Asset- backed securitization (ABS) may contribute to generating instability in financial markets both through an ‘inside effect’ in the banking system – facilitating progressive deterioration of bank assets’ quality – and through an ‘outside effect’ – favouring credit risk transfer from balance sheets of banks acting as originators to investors in asset- backed securities (ABS). The rating assigned to ABS has the function of indicating to the market the credit risk borne by investors. This depends on the quality of assets and of guarantees lent by originators and by any third- party guarantor, as well as on the trend of macroeconomic determinants which may compromise the capacity of principal debtors to honour their debts. The underlying hypothesis on which this work is based is that rating models do not correctly embody the impact of macroeconomic variables on debtors’ solvency, determining a lag in downgrading. In particular, it is considered that any variations in interest rates and GDP have an impact on ABS performances, but that such an impact is not picked up in a timely fashion by rating models. Essentially, in pre- crisis periods, when interest rate increases as well as decreases are recorded in growth rates f GDP, rating assessments fail to register risk increases in ABS securities, only proceeding to downgrade later, when variations in macroeconomic variables have generated negative effects on the flow of ABS funds. We verify this hypothesis specifically with reference to ABS ransactions active during the recent financial and economic crisis. We then proceed to test information on ABS rating, assessing it in relation to the timing of downgrading on a sample of transactions which took place between 2000 and 2009. The conclusions reached confirm the theoretical hypothesis, demonstrating that, in the pre- crisis period, when macroeconomic variables suggested the need for a downgrading judgement, agencies delayed downmarking, making the announcement only at a later stage, after the crisis had taken place and the transaction criticalities were already displayed. The chapter is related to the literature analysing relations between the financial crisis and asset- backed securitization, bringing an innovative contribution to empirical and theoretical studies, aimed at defining an interpretational model for relations between ABS and financial crises.