Trustee reputation in securitization: When does it matter?

• Published date: 01 May 2019
• Author: Solomon Y. Deku,Alper Kara,David Marques‐Ibanez
• Date: 01 May 2019
• DOI: http://doi.org/10.1111/fmii.12106

DOI: 10.1111/fmii.12106

ORIGINAL ARTICLE

Trustee reputation in securitization: When does it

matter?

Solomon Y. Deku1AlperKara2David Marques-Ibanez3

1Nottingham TrentUniversity, Nottingham

Business School, Nottingham, UK

2University of Huddersfield, Huddersfield

Business School, Huddersfield, UK

3European CentralBank, Financial Research

Division, Frankfurt,Germany

Correspondence

SolomonY. Deku, Nottingham TrentUniversity,

NottinghamBusiness School, Nottingham, UK.

Email:solomon.deku@ntu.ac.uk

Abstract

We consider the role of trustees–who are nominated to protect

the interests of investors–in securitization pricing and whether

investors rely on them to mitigate risks. In particular, we examine

the effect of trustee reputation on initial yield spreads of European

mortgage-backed security (MBS) issuances between 1999 and the

first half of 2007. We find that engaging reputable trustees led to

lower spreads during the credit boom period prior to the 2007–2009

financial crisis. Our findings suggest that trustees’ reputation was

considered by investors to be more important when risk assessment

became more challenging.

KEYWORDS

2007–2009 financial crisis, MBS, securitization, trustee reputation

JEL CLASSIFICATION

G21, G28

1INTRODUCTION

Investors in mortgage-backed securities (MBSs) suffered tremendous losses during the 2007–2009 financial crisis.

Stakeholders–issuers, rating agencies, trustees, and investors–across the securitization chain were blamed for failing

to meet expected standards. Issuers relaxed lending criteria for mortgages that underlay the MBSs (Jiang, Nelson, &

Vytlacil, 2014; Kara, Marques-Ibanez, & Ongena, 2016; Keys, Mukherjee, Seru, & Vig, 2009; Keys,Seru, & Vig, 2012),

rating agencies underestimated the risk embedded in these securities (Brennan, Hein, & Poon, 2009; Coval, Jurek, &

Stafford, 2009; Richardson & White, 2009), trustees failed to enforce repurchase clauses (Dolmetsch, 2014; Stempel,

2016; Yoon, 2014) and investorswere criticised for being overly reliant on credit ratings (Mählmann, 2012). Modern

securitization has grown significantly since the 1980s. Although the use of securitization techniques was initially a

United States (US) phenomenon, the swift growth of European securitization in the late 1990s has been attributed to

the introduction of the Euro and increased financial marketintegration. Outstanding volumes climbed by about 1400%

from $139 billion in 1999 to $2 trillion in 2007. These volumes were largely driven by the securitization of mortgages,

which accounted for 62% of European securitization outstanding by mid-2007.

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Financial Markets,Inst. & Inst. 2019;28:61–84. wileyonlinelibrary.com/journal/fmii 61

62 DEKU ET AL.

In this paper, we consider the role of trustees in securitization pricing and whether investors relied on trustees

to mitigate MBS risks. Trustees playan important role on securitization transactions. They are nominated to protect

the interests of investors by managing the special purpose vehicle (SPV) on their behalf.As agents, trustees protect

investors’ interests by ensuring compliance of issuers and servicers with the agreements governingthe securitization

deal (Gorton & Metrick, 2012a). They are also responsible for channelling payments to investors and notifying them

of representation and warranty violations. This data intensive role also involvesvalidating the performance of the col-

lateral underlying the MBS on behalf of investors (Cetorelli & Peristiani, 2012). Investorsrely on trustees to enforce

repurchase obligations as provisions in the indenture do not allow direct repurchase requests from investors.

We examine whether investors price the efficacy of the trustee mechanism into initial MBS prices. In particular,

given the certification value of reputation in the financial services industry (Booth & Smith, 1986; Fang, 2005; Titman

& Trueman,1986), we hypothesise that investors may have attempted to mitigate risks by considering trustee reputa-

tion when pricing MBS. We test our arguments by examining the initial yields of MBS issuances. A number of studies

show that investors incorporate the potential costs of misaligned interests in the primary yields of MBSs by account-

ing for issuer size, rating bias, collateral, and tranchestructure (Fabozzi & Vink, 2012a, 2015; J. J. He, Qian, & Strahan,

2012). Wecontend that larger and more active trustees may be perceived as more efficient in identifying discrepancies

and notifying investors of breaches accordingly. Theymay create value for investors, especially during credit events.

Consequently,MBSs with reputable trustees should have lower risk and lower spreads.

We contribute to the literature byfactoring trustee reputation into the determination of primary spreads to exam-

ine whether investors incorporate potential trustee indiscipline in initial valuations of MBSs. This is a dimension of

securitization pricing that has not been investigated. Forexample, Andres, Betzer, and Limbach (2012) study the influ-

ence of trustees in pricing but only for high yield US corporate bonds. It is conceivable that investorsrelied on trustees

to detect fraud for a multiple reasons (Colloff,2005). First, except for the servicer, the trustee remains the main party

with direct administrativeresponsibilities from deal closure to the maturity of the MBSs. Second, the trustee performs

a fiduciary role in an event of default. Third, trustees tend be expertsin regulatory and compliance issues. In addition,

they tend to have marked international presence to tackle collateralliquidation and litigation in various jurisdictions.

Finally,trustees typically offer enhanced services in excess of conventional trustee services for additional fees.

We build a unique dataset comprising 4,201 tranches from 730 transactions originated in Europe between 1999

and the first half of 2007. Our focus is on the European market whose growth was mainly due to private marketforces

rather than government-sponsored enterprises (GSEs)in the US market. The US securitization markets expanded pri-

marily due to the influence of the GSEs. However,EU law (Articles 87 and 88 of the EC treaty) prohibits state aid in the

form of guarantees as this may distort competition in the mortgage markets (Coles& Hardt, 2000). Furthermore, the

growth of European securitization was largely inhibited by regulatory constraints (Stone & Zissu, 2000).1

The outstanding growth of the European mortgage securitization markets has been attributed to increased insti-

tutional demand, technological and financial innovation, and the introduction of the Euro (Altunbas, Gambacorta, &

Marques-Ibanez, 2009). The adoption of the Euro resulted in the elimination of exchange rate risk in the Euro area,

lowered transaction costs, and increased liquidity.However, the growth of the securitization marketshas been hetero-

geneous across the Euromarket.2This growth was attained with certain associated costs: agency problems that mis-

aligned incentives, increased complexity and opaqueness of securitized bonds that rendered efficient pricing difficult

(Segoviano, Jones, Lindner,& Blankenheim, 2015). Given this backdrop, investors in Europe may have relied on other

avenues such as credit ratings and trustees for mitigating MBS risks. Therefore, we aim to assess whether investors

may haveincorporated the experience and reputation of trustees in the pricing of MBSs.

We find that engaging reputable trustees led to lower MBS spreads during the credit boom period (between 2005

and the first half of 2007) prior to the 2007–2009 financial crisis. Furthermore, the importance of reputable trustees

for risk mitigation increased gradually each year between 2005 and 2007 as the crisis loomed. Our findings suggest

that the reputation of trustees was deemed to be a critical yardstick as risk assessment became more difficult.

The paper is structured as follows. Section 2 provides a background to the securitization trustee's role and reviews

the extant literature.Section 3 describes the data and methodology used. Section 4 presents the results and Section 5

puts forward the conclusions.