Europe’s securitization markets¹ may still be ten times smaller than their US counterparts, but they are growing much faster. Since 1998, the value of new issues of fixed-income securitized assets has grown at a compound annual rate of about 55 percent in Europe, to reach $160 billion in 2001, compared, over the same period, with 11 percent in the United States, where their value reached $2 trillion. Europe’s bankers might have hoped to earn higher fees and profits from securitization than they do in their traditional fixed-income business, in which profits are thin, but recent McKinsey research shows that only a few have generated profits in these securitization markets.² Most players will have to rethink their approach.

The product itself is sound: securitization and the resulting assets have been phenomenally popular with both issuers and investors. Issuers like the idea that selling asset-backed securities helps them reduce the cost and diversify their sources of funding, thereby making them less reliant on bank borrowing, for example. Meanwhile, investors such as insurance and pension companies, mutual funds, and conduits, drawn by the high credit rating of the top tranches and the better yields of securitized assets as compared with corporate and government bonds, have been eager buyers of asset-backed securities.

Moreover, the sizable and growing revenue pool created by securitization has been particularly useful for investment banks, which usually help issuers of these securities, in a depressed investment-banking market. For the $160 billion of asset- and mortgage-backed securities issued in 2001, European banks recorded underwriting and trading revenues of about $700 million and total securitization-related revenues³ of $1.3 billion. The prospects for 2002 look even better, and the medium-term outlook for growth remains positive, thanks to strong demand from investors and the increasing popularity of securitization among potential issuers, such as corporations, asset managers, and public institutions.

So why has this deep revenue pool thus far yielded such small profits? The reason, in our opinion, is that almost all banks are trying to provide securitization services across every asset class in every major European country (Exhibit 1)—a tremendously expensive strategy. The variety of asset classes and issuers, the differences among regulatory and tax regimes across Europe, and the slow, complex origination and structuring process for each issue mean that banks wishing to participate on this scale must employ teams of up to 60 professionals. The costs are so high, and so many banks have invested in securitization resources in the past three years, that most players are competing away their fees.

Of the 25 to 30 banks with a substantial presence in the market, our research revealed that only 3 companies pursuing this strategy generated substantial profits from securitization in 2001 (Exhibit 2). The profitable players had the imagination to structure securities from new types of assets and the market knowledge to target ideas to the issuers and investors most likely to find them attractive and therefore wasted less effort on transactions that never came to market. It is critically important that these banks were also more willing than the others to commit the large amounts of capital needed for warehousing and bridging, so they could respond to the issuers’ rising demand for this kind of "bundled" lending and underwriting and thereby secure additional revenues.

Given the high cost of this comprehensive strategy and the skills and capabilities required to make it work, perhaps only three to five banks could ever execute it profitably. Several commercial banks have sufficient capital but lack the essential distribution and structuring capability and credibility in the market, while the opposite is true of many traditional investment banks, so most players need to change tack. Since securitization markets are still in the early stages, few banks will want to exit now, but those wishing to stay should probably choose between two other potentially profitable strategies.

A bank that chooses to be a niche-product specialist will cover a subset of asset classes, providing underwriting as a standard service and lending when required. Specialization will allow such a bank to build a reputation in its chosen area while keeping costs under control. One potential niche is to focus on structuring, underwriting, and selling nonflow offerings, including collateralized-debt-obligation (CDO) and collateralized-loan-obligation (CLO) products,⁴ for issuing banks that lack the scale, desire, or skills to do so themselves.

The other strategy is to act as an internal originator, focusing on the securitization of internally generated assets, such as residential mortgages or commercial loans. While this strategy is a way of avoiding costs rather than generating revenue, it can be attractive for banks that have a large flow of internal assets but lack the skills needed to capture many similar transactions from third parties.

Which strategy proves most attractive to a particular bank will depend on its aspirations, its willingness to commit capital, and its skills across the range of securitization activities: origination, bridging and warehousing, structuring, underwriting, and distribution. One thing is sure, however: only a few banks can succeed as comprehensive providers.