Article Preview – Motor Securitisation and Credit Rating Agencies: A Focus on Roles

In the final article preview this week, this short post will discuss a topic that has been discussed before here in Financial Regulation Matters, and that is the issue of the ever-increasing ‘bubble’ that is motor finance. In previewing the article ‘The Warning-Light of Automobile Securitisation: Credit Rating Agencies and Their Role in a post-2016 World’, to be published in the Business Law Review (but is available here in its pre-published format), this short post will discuss the issues raised in the article, and will conclude by assessing the dangers that are becoming increasingly apparent in this specific sector.

The article begins by contextualising the issue at hand – namely, the elements of the securitisation process that sees the rating agencies play a fundamental part. To begin with, the major difference between the securitisation process that we saw with the Residential Mortgage-Backed Securities (RMBS) that was central to the Financial Crisis and the current ‘bubble’ forming within the field of motor finance – the size – is put forward as something that must be considered when analysing this current bubble. Apart from the size of the market for these securities in terms of dollar value (a house is obviously more expensive than a car), the ‘maturity’ of motor finance deals are equally as obviously shorter, meaning that the refinancing or transference of debt options are much more extensive than was available during the rise of the RMBS bubble. The article also makes clear the point that the process of securitisation, in itself, is not necessarily a negative construct – it is the abuse of the process that threatens society continually. However, it is important to understand the role credit rating agencies play in the securitisation process, simply so we know what they are supposed to do which synergistically informs us of any transgressions.

Simply put, the securitisation process funnels the payments of many finance deals (cars, homes, commercial rent etc.) and pools them. Then, that pool is divided into tranches (French for ‘slices’) and the rating agencies assign a rating to each tranche – the most investable tranche, i.e. the one that the agencies are most confident will see the investment returned (albeit at a lower rate) is called the senior tranche, whilst the least investable trance (which offers the highest returns but also the highest risk of default) is called the equity tranche. This is a very simplistic understanding of the process (a better understanding can be gained from this resource), but it suffices for our usage because those who invest in these two extremes signify for us the role of the agencies. A number of large financial institutions, like pension funds for example, are constrained either by regulations or their own internal control mechanisms, to only invest in tranches rated ‘AAA’ by the rating agencies, and the agencies only rate senior tranches at this level. Conversely, financial institutions like Hedge-Funds, who seek the highest of returns for the clients, are free to invest in what they like, and the highest returns can be found in the equity tranches. This is, essentially, the role of the agencies – to signal the strength of any given pool, via its tranches, to the marketplace. However, without going into the details of the Financial Crisis, we know the agencies have a poor record in fulfilling this role to any meaningful standard. This is why the suggested issues within the motor finance securitisation process are causing alarm.

It is being suggested that because the leading car manufacturers outsource the investigative stage of underwriting proceedings, the fact these institutions responsible for doing so then own no equity shares in the origination process makes it that much more likely that they will focus on volume rather than quality control. This, when combined with the relative explosion in this sector as we have discussed before, hints at the presence of the necessary ingredients for the bursting of a financial bubble. When we factor in the historical enthusiasm of the rating agencies to assign ratings to securities that they know are inaccurate but for which they have been paid handsomely for, the list of ingredients missing for the swelling and subsequent bursting of a bubble grows ever larger. The article concludes by discussing the effect that the current environment may have upon this ever-growing bubble, ultimately declaring that there is a distinct possibility (or even perhaps inevitability) that the isolationist agenda being advanced on both sides of the Atlantic will feed this bubble by relaxing the vigilance needed to stop entities like the rating agencies from transgressing like they have proven they will do if given the slightest opportunity.

What is important to state is that all is not lost. It may appear to be utopian in nature, but this short-sighted, unduly economically-driven society does not have to be our reality. Rather than getting clouded by the parameters that are advanced by political parties on both ‘sides’, there is the potential to limit the actions of financial actors so that we, as a society, are fundamentally protected from the iniquities of the sector. That potential can only be realised if we reject the polarising rhetoric that is advanced by most (if not all) media outlets, if we take democratic action based upon this ideal, and commit, in everything that we do, in advancing a sustainable economic mentality that will, due to the dynamics of modern society, filter into almost every area of society. Yes, it is idealistic, but to accept that we must lurch from crisis to crisis, downplay the dramatic and heart-rending effects that predatory finance has upon everyday life, and entertain ourselves with distractions that only serve to continue the torment that predatory economic mentality inflicts upon almost all of us, is quite simply unacceptable.