Securitization
Securitization
Securitization
Page
Particulars
No.
1. Introduction 2
STRUCTURE 4
FEATURES OF SECURITIZATION 8
ADVANTAGES TO ISSUER 14
2. DISADVANTAGES TO ISSUER 17
3. RISKS TO INVESTOR 20
4. ROLE OF REGULATORS 22
5. ROLE OF ADMINISTRTOR 26
6. CASE STUDY 28
7. CONCLUSION 36
8. BILOGRAPGHY 37
Securitization
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Securitization is the financial practice of pooling various types of contractual
debt such as residential mortgages, commercial mortgages, auto loans or credit
card debt obligations (or other non-debt assets which generate receivables) and
selling their related cash flows to third party investors as securities, which may be
described as bonds, pass-through securities, or collateralized debt obligations
(CDOs). Investors are repaid from the principal and interest cash flows collected
from the underlying debt and redistributed through the capital structure of the new
financing. Securities backed by mortgage receivables are called mortgage-backed
securities (MBS), while those backed by other types of receivables are asset-
backed securities (ABS).
Critics have suggested that the complexity inherent in securitization can limit
investors' ability to monitor risk, and that competitive securitization markets with
multiple securitizers may be particularly prone to sharp declines in underwriting
standards. Private, competitive mortgage securitization played an important role in
the U.S. subprime mortgage crisis.[1]
The granularity of pools of securitized assets can mitigate the credit risk of
individual borrowers. Unlike general corporate debt, the credit quality of
securitized debt is non-stationary due to changes in volatility that are time- and
structure-dependent. If the transaction is properly structured and the pool performs
as expected, the credit risk of all tranches of structured debt improves; if
improperly structured, the affected tranches may experience dramatic credit
deterioration and loss.
Securitization has evolved from its beginnings in the late 18th century to an
estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in
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Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455
trillion in the US and $652 billion in Europe.WBS (Whole Business Securitization)
arrangements first appeared in the United Kingdom in the 1990s, and became
common in various Commonwealth legal systems where senior creditors of an
insolvent business effectively gain the right to control the company. There are main
players in securitization, they include investors, securiters and corporates.
For example: If I want to own a car to run it for hire, I could take a loan with which
I could buy the car. The loan is my obligation and the car is my asset, and both are
affected by my other assets and other obligations. This is the case of simple
financing.
On the other hand, if I were to analytically envisage the car, my asset, as having the
ability to generate a series of hire rentals over a period of time, I might sell a part
of the cash flow by way of hire rentals for a stipulated time and thus raise enough
money to buy the car. The investor is happier now, because he has a claim for a
cash flow, which is not affected by my other obligations; I am happier because I
have the cake and eat it too, and the obligation to repay the financier is taken care
of by the cash flows from the car itself.
Structure
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Pooling and transfer
The originator initially owns the assets engaged in the deal. This is typically a
company looking to either raise capital, restructure debt or otherwise adjust its
finances (but also includes businesses established specifically to generate
marketable debt (consumer or otherwise) for the purpose of subsequent
securitization). Under traditional corporate finance concepts, such a company
would have three options to raise new capital: a loan, bond issue, or issuance of
stock. However, stock offerings dilute the ownership and control of the company,
while loan or bond financing is often prohibitively expensive due to the credit
rating of the company and the associated rise in interest rates.
The consistently revenue-generating part of the company may have a much higher
credit rating than the company as a whole. For instance, a leasing company may
have provided $10m nominal value of leases, and it will receive a cash flow over
the next five years from these. It cannot demand early repayment on the leases and
so cannot get its money back early if required. If it could sell the rights to the cash
flows from the leases to someone else, it could transform that income stream into a
lump sum today (in effect, receiving today the present value of a future cash flow).
Where the originator is a bank or other organization that must meet capital
adequacy requirements, the structure is usually more complex because a separate
company is set up to buy the assets.
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Accounting standards govern when such a transfer is a true sale, a financing, a
partial sale, or a part-sale and part-financing.[17] In a true sale, the originator is
allowed to remove the transferred assets from its balance sheet: in a financing, the
assets are considered to remain the property of the originator.[18] Under US
accounting standards, the originator achieves a sale by being at arm's length from
the issuer, in which case the issuer is classified as a "qualifying special purpose
entity" or "qSPE". Because of these structural issues, the originator typically
needs the help of an investment bank (the arranger) in setting up the structure of
the transaction.
Issuance
To be able to buy the assets from the originator, the issuer SPV issues tradable
securities to fund the purchase. Investors purchase the securities, either through a
private offering (targeting institutional investors) or on the open market. The
performance of the securities is then directly linked to the performance of the
assets. Credit rating agencies rate the securities which are issued to provide an
external perspective on the liabilities being created and help the investor make a
more informed decision.
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Credit enhancement and tranching
Unlike conventional corporate bonds which are unsecured, securities created in a
securitization are "credit enhanced", meaning their credit quality is increased above
that of the originator's unsecured debt or underlying asset pool. This increases the
likelihood that the investors will receive the cash flows to which they are entitled,
and thus enables the securities to have a higher credit rating than the originator.
Some securitizations use external credit enhancement provided by third parties,
such as surety bonds and parental guarantees (although this may introduce a
conflict of interest).
The issued securities are often split into tranches, or categorized into varying
degrees of subordination. Each tranche has a different level of credit protection or
risk exposure: there is generally a senior ("A") class of securities and one or more
junior subordinated ("B", "C", etc.) classes that function as protective layers for the
"A" class. The senior classes have first claim on the cash that the SPV receives,
and the more junior classes only start receiving repayment after the more senior
classes have been repaid. Because of the cascading effect between classes, this
arrangement is often referred to as a cash flow waterfall.[20] If the underlying asset
pool becomes insufficient to make payments on the securities (e.g. when loans
default within a portfolio of loan claims), the loss is absorbed first by the
subordinated tranches, and the upper-level tranches remain unaffected until the
losses exceed the entire amount of the subordinated tranches. The senior securities
might be AAA or AA rated, signifying a lower risk, while the lower-credit quality
subordinated classes receive a lower credit rating, signifying a higher risk.[19]
The most junior class (often called the equity class) is the most exposed to
payment risk. In some cases, this is a special type of instrument which is retained
by the originator as a potential profit flow. In some cases the equity class receives
no coupon (either fixed or floating), but only the residual cash flow (if any) after
all the other classes have been paid.
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There may also be a special class which absorbs early repayments in the
underlying assets. This is often the case where the underlying assets are mortgages
which, in essence, are repaid whenever the properties are sold. Since any early
repayments are passed on to this class, it means the other investors have a more
predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two separate
"waterfalls" because the principal and interest receipts can be easily allocated and
matched. But if the assets are income-based transactions such as rental deals one
cannot categorise the revenue so easily between income and principal repayment.
In this case all the revenue is used to pay the cash flows due on the bonds as those
cash flows become due.
Credit enhancements affect credit risk by providing more or less protection for
promised cash flows for a security. Additional protection can help a security
achieve a higher rating, lower protection can help create new securities with
differently desired risks, and these differential protections can make the securities
more attractive.
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A third-party letter of credit or corporate guarantee.
Features of Securitization
A securitised instrument, as compared to a direct claim on the issuer, will generally
have the following features:
1. Marketability:
In most jurisdictions of the world, well-coded laws exist to enable and regulate the
issuance of traditional forms of securitised claims, such as shares, bonds,
debentures (negotiable instruments). Most countries do not have legal systems
pertaining to securitised products, of recent or exotic origin, like securitization of
receivables. It is imperative on part of the regulator to view any securitised
instrument with the same concern as in case of traditional instruments, for investor
protection. However, where a law does not exist to regulate such issuance, it is
nave to believe that it is not permitted.
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The second issue is of having a market for the instrument. Securitization is a
fallacy unless the securitised product is marketable. The purpose will be defeated if
the instrument is loaded on to a few professional investors without any possibility
of having a liquid market therein. Liquidity is afforded either by introducing it into
an organised market (securities exchanges) or by one or more agencies acting as
market makers, i.e., agreeing to buy and sell the instrument at pre-determined or
market-determined prices.
2. Merchantable Quality:
The integration of several assets into one lump, and then their differentiation into
uniform marketable lots often invites the next feature: an intermediary for this
process.
If one imagines a financial world without securities, all financial transactions will
be carried only as one-to-one relations. If a company needs a loan, it will have to
seek such loan from the lenders, who will have to establish a one-to-one relation
with the company. Each lender has to understand the borrowing company, and look
after his loan. This is often difficult, and hence, a financial intermediary, such as a
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bank, pools funds from many such investors, and uses these pooled funds to lend to
the company. If the company securitises the loan, and issues debentures to the
investors, will this eliminate the need for the intermediary bank, since the investors
may now lend to the company directly in small amounts each, in form of a security
which is easy to appraise, and which is liquid?
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Utilities Added By Financial Intermediaries
A financial intermediary initially came into the picture to avoid the difficulties in a
direct lender-borrower relation between the company and the investors. The
difficulties could have been one or more of the following:
3. Perceived risk: The risk that investors perceive in investing in a bank may be
much lesser than that of investing directly in the company, though in reality, the
financial risk of the company is transposed on the bank. However, as the bank is
a pool of several such individual risks, the investors' preference of a bank to the
company is reasonable.
Securitization of the loan into bonds or debentures solves all the three difficulties
in direct exchange, and hence, avoids the need for a direct intermediary. It avoids
the transactional difficulty by breaking the lumpy loan into marketable lots. It
avoids informational difficulty because the securitised product is offered generally
by way of a public offer, and its essential features are well disclosed. It avoids the
perceived risk difficulty, as the instrument is usually well secured and rated for
investor satisfaction.
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However, it does not eliminate the need for the intermediary: it merely redefines
the intermediary's role. E.g.: if a company is issuing debentures to the public to
replace a bank loan, it may be avoiding the bank as an intermediary, but would still
need the services of an investment banker to successfully conclude the issue of
debentures.
In case of a direct loan, the lending bank was performing several intermediation
functions noted above: it was a distributor as it raised its own finances from a large
number of small investors; it was appraising and assessing the credit risks in
extending the corporate loan, and having extended it, it was managing the same.
Securitization splits each of these intermediary functions, each to be performed by
separate specialised agencies. Distribution will be performed by the investment
bank, appraisal by a credit-rating agency, and management possibly by a mutual
fund that manages the portfolio of security investments of investors. Hence,
securitization replaces fund-based services by several fee-based services.
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Issuance trust
In 2000, Citibank introduced a new structure for credit card-backed securities,
called an issuance trust, which does not have limitations that master trusts
sometimes do, that requires each issued series of securities to have both a senior
and subordinate tranche. There are other benefits to an issuance trust: they provide
more flexibility in issuing senior/subordinate securities, can increase demand
because pension funds are eligible to invest in investment-grade securities issued
by them, and they can significantly reduce the cost of issuing securities. Because of
these issues, issuance trusts are now the dominant structure used by major issuers
of credit card-backed securities.
Grantor trust
Grantor trusts are typically used in automobile-backed securities and REMICs
(Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to
pass-through trusts used in the earlier days of securitization. An originator pools
together loans and sells them to a grantor trust, which issues classes of securities
backed by these loans. Principal and interest received on the loans, after expenses
are taken into account, are passed through to the holders of the securities on a pro-
rata basis.
Owner trust
In an owner trust, there is more flexibility in allocating principal and interest
received to different classes of issued securities. In an owner trust, both interest
and principal due to subordinate securities can be used to pay senior securities.
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Due to this, owner trusts can tailor maturity, risk and return profiles of issued
securities to investor needs. Usually, any income remaining after expenses is kept
in a reserve account up to a specified level and then after that, all income is
returned to the seller. Owner trusts allow credit risk to be mitigated by over-
collateralization by using excess reserves and excess finance income to prepay
securities before principal, which leaves more collateral for the other classes.
Advantages to Issuer
Reduces funding costs:
Through securitization, a company rated BB but with AAA worthy cash flow
would be able to borrow at possibly AAA rates. This is the number one reason to
securitize a cash flow and can have tremendous impacts on borrowing costs. The
difference between BB debt and AAA debt can be multiple hundreds of basis
points
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as a sale for accounting purposes, these firms will be able to remove assets from
their balance sheets while maintaining the "earning power" of the assets.[22]
Locking in profits:
For a given block of business, the total profits have not yet emerged and thus
remain uncertain. Once the block has been securitized, the level of profits has now
been locked in for that company, thus the risk of profit not emerging, or the benefit
of super-profits, has now been passed on.
Securitization makes it possible to transfer risks from an entity that does not want
to bear it, to one that does. Two good examples of this are catastrophe bonds and
Entertainment Securitizations. Similarly, by securitizing a block of business
(thereby locking in a degree of profits), the company has effectively freed up its
balance to go out and write more profitable business.
Earnings:
Securitization makes it possible to record an earnings bounce without any real
addition to the firm. When a securitization takes place, there often is a "true sale"
that takes place between the Originator (the parent company) and the SPE. This
sale has to be for the market value of the underlying assets for the "true sale" to
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stick and thus this sale is reflected on the parent company's balance sheet, which
will boost earnings for that quarter by the amount of the sale. While not illegal in
any respect, this does distort the true earnings of the parent company.
Admissibility:
Future cashflows may not get full credit in a company's accounts (life insurance
companies, for example, may not always get full credit for future surpluses in their
regulatory balance sheet), and a securitization effectively turns an admissible
future surplus flow into an admissible immediate cash asset.
Liquidity:
Future cashflows may simply be balance sheet items which currently are not
available for spending, whereas once the book has been securitized, the cash would
be available for immediate spending or investment. This also creates a
reinvestment book which may well be at better rates.
Benefits of Securitization
There are several key benefits that securitization provides to market participants
and the broader economy:
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Disadvantages to Issuer
May reduce portfolio quality:
If the AAA risks, for example, are being securitized out, this would leave a
materially worse quality of residual risk.
Costs:
Securitizations are expensive due to management and system costs, legal fees,
underwriting fees, rating fees and ongoing administration. An allowance for
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unforeseen costs is usually essential in securitizations, especially if it is an atypical
securitization.
Size limitations:
Securitizations often require large scale structuring, and thus may not be cost-
efficient for small and medium transactions.
Risks:
Since securitization is a structured transaction, it may include par structures as well
as credit enhancements that are subject to risks of impairment, such as prepayment,
as well as credit loss, especially for structures where there are some retained strips.
Advantages To Investors
Opportunity to potentially earn a higher rate of return
(on a risk-adjusted basis)
Opportunity to invest in a specific pool of high quality assets:
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Due to the stringent requirements for corporations (for example) to attain high
ratings, there is a dearth of highly rated entities that exist. Securitizations, however,
allow for the creation of large quantities of AAA, AA or A rated bonds, and risk
averse institutional investors, or investors that are required to invest in only highly
rated assets, have access to a larger pool of investment options.
Portfolio diversification:
Depending on the securitization, hedge funds as well as other institutional
investors tend to like investing in bonds created through securitizations because
they may be uncorrelated to their other bonds and securities.
Investment Characteristics of
Securitized Products
High Yield
Many securitized products offer relatively attractive yields. These high returns
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don't come for free though; compared to many other types of bonds, the timing of
the cash flows from securitized products is relatively uncertain. This uncertainty is
why investors demand higher returns.
Diversification
As one of the largest fixed-income security types, securitized products present
fixed-income investors with an alternative to government, corporate or municipal
bonds.
Safety
There are several methods that financial intermediaries use in order to issue bonds
that are safer than the assets that back them. Most securitized products have
investment-grade ratings.
Internal credit enhancement refers to safeguards that are built into the structure of
the securitized product itself. Common forms of internal credit enhancement
include subordination (where highly rated tranches receive cash flow priority over
lower-rated tranches) and overcollateralization (where the amount of bonds issued
by the SPV is less than the value of the assets backing the deal). The intended
effect of any type of internal credit enhancement is that cash flow shortfalls due to
losses in the value of the underlying assets do not affect the value of the safest
tranches of bonds. This works well given relatively low levels of losses, but the
value of the protection is less certain if losses on the underlying assets are
substantial.
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Risks To Investors
Liquidity risk
Credit/default:
Default risk is generally accepted as a borrowers inability to meet interest
payment obligations on time. For ABS, default may occur when maintenance
obligations on the underlying collateral are not sufficiently met as detailed in its
prospectus. A key indicator of a particular securitys default risk is its credit rating.
Different tranches within the ABS are rated differently, with senior classes of most
issues receiving the highest rating, and subordinated classes receiving
correspondingly lower credit ratings.[19] Almost all mortgages, including reverse
mortgages, and student loans, are now insured by the government, meaning that
taxpayers are on the hook for any of these loans that go bad even if the asset is
massively over-inflated. In other words, there are no limits or curbs on over-
spending, or the liabilities to taxpayers.
However, the credit crisis of 20072008 has exposed a potential flaw in the
securitization process loan originators retain no residual risk for the loans they
make, but collect substantial fees on loan issuance and securitization, which doesn't
encourage improvement of underwriting standards.
Event risk
Prepayment/reinvestment/early amortization:
The majority of revolving ABS are subject to some degree of early amortization
risk. The risk stems from specific early amortization events or payout events that
cause the security to be paid off prematurely. Typically, payout events include
insufficient payments from the underlying borrowers, insufficient excess spread, a
rise in the default rate on the underlying loans above a specified level, a decrease
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in credit enhancements below a specific level, and bankruptcy on the part of the
sponsor or servicer.
Like all fixed income securities, the prices of fixed rate ABS move in response to
changes in interest rates. Fluctuations in interest rates affect floating rate ABS
prices less than fixed rate securities, as the index against which the ABS rate
adjusts will reflect interest rate changes in the economy. Furthermore, interest rate
changes may affect the prepayment rates on underlying loans that back some types
of ABS, which can affect yields. Home equity loans tend to be the most sensitive to
changes in interest rates, while auto loans, student loans, and credit cards are
generally less sensitive to interest rates.
Contractual agreements
Moral hazard:
Investors usually rely on the deal manager to price the securitizations underlying
assets. If the manager earns fees based on performance, there may be a temptation
to mark up the prices of the portfolio assets. Conflicts of interest can also arise
with senior note holders when the manager has a claim on the deal's excess spread.
Servicer risk:
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1 Role of Regulators and Other Agencies
1.1 Role of Regulators
Securitization essentially involves moving the assets from the balance sheet of the
Originator to an SPV. The SPV then proceeds to issue securities in which various
entities invest their funds. At each stage regulators have a crucial role to play, to
ensure that the objectives of securitization are achieved with the larger interests of
the financial system always held uppermost. The role of the regulators emerges,
vis--vis their regulatory interest in the various facets of the transaction. Since
securitization lends itself primarily to financial assets, more often than not, the
Originator would be a FI in which case, the Central Bank of the country would
have valid concerns relating to the transaction. These may be related to
determination of whether the assets have actually moved off the balance sheet or
calculation of any residual risks that may remain with the Originator. An additional
aspect may be regarding the health of the Originator's balance sheet subsequent to
the cherry picking that normally goes along with securitization. The regulators
would also be concerned with treatment to be accorded to any credit enhancement
or other ancillary facilities provided by the FIs to securitization transactions either
of their own assets or to outside transactions This is more so because despite the
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fact that clear benefits accrue to the organisations that engage in securitization,
these activities have the potential to increase the overall risk profile if they are not
carried out prudently. For the most part, the types of risks that financial
institutions encounter in the securitization process are identical to those that they
face in traditional lending transactions including credit risk, concentration risk,
interest rate risk, operational risk, liquidity risk, rural recourse risk and funding
risk. However, since the securitization process separates the traditional lending
function into several limited roles such as originator, servicer, credit enhancer,
trustee, investor, the type of risks that our institutions will encounter will differ
depending on the roles they assume. Thus, Institute of Chartered Accountants of
India as well as the tax authorities would have to put into place a system of clear
and unambiguous rules, which would serve as guidance for various situations.
Regulation thus would be impacting specified activities as well as the entities that
perform these specific activities.
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Although credit enhancements internal to the transaction structure play an
important role, their impact could be limited. (Internal credit enhancements
frequently resorted to are cherry-picking of the asset pool to be securitised, over-
collateralization, provision of cash collateral by the Originator, etc).
When the intrinsic credit quality of the Originator is not very high, it becomes
essential to obtain some sort of external credit enhancement in the form of a
guarantee / insurance from a third party. External credit enhancements can usually
take form of:
Letter of Credit / Guarantee
Monoline Insurance
Multiline Insurance
Each technique can provide full or partial support depending upon the credit
quality of the portfolio. In general, the quantum of credit enhancement would vary
inversely with the inherent credit quality of the portfolio.
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Multiline Insurance Companies are general insurance companies who are in
the larger business of insurance and provide risk cover to specific aspects of
securitization transactions also. Those normally provide risk cover up to a
percentage of portfolio value.
CASE STUDY
I. The mortgage lending process in the US
In the residential mortgage business in the US, a homeowner, with the help of a
real
estate broker, selects a mortgage lender who gives the loan after checking the
borrowers
creditworthiness and the property that serves as collateral for the loan. After the
loan is
disbursed, most mortgage lenders resell these loans to investors or Wall Street
firms,
often through multiple intermediaries. Wall Street firms in turn bundle thousands
of
mortgage loans from different lenders into mortgage-backed securities
(MBS).These
institutions then slice these mortgages into residential mortgages backed
securities(RMBS) or in other words, securities that are backed by collateral; the
collateral
here being the mortgages held by sub-prime borrowers. These mortgage-backed
securities are, in turn, often sliced and diced into different structures, for example,
a
Collateralized Debt Obligation (CDO). Thus CDOs are pools of bond securities
that are
grouped together to help diversify risk The different tranches of these structures are
assigned a risk rating by the rating agencies such as Moodys, Standard & Poors,
and
Fitch based on various parameters. They are subsequently sold by Wall Street firms
to
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institutional investors worldwide mutual funds, banks, hedge funds, central banks
and
pension funds.
The above discussion helps us to list the agents involved the US housing mortgage
market. This will help to identify those hit by the crisis.
Homeowners.
Real estate agents.
Mortgage lenders.
Wall Street firms
Rating agencies
Investors
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III. Housing bubble and sub-prime crisis.
A housing bubble is characterized by rapid increases in the valuations of real
property
such as housing until unsustainable levels are reached relative to incomes, price-to-
rent
ratios, and other economic indicators of affordability. The housing bubble (See
Figure 1)
was largely fed by the lowering of interest rates to record low levels to diminish
the blow
of the massive collapse of the bubble. Encouraged by the low interest regime and
high
liquidity, thanks to inflows from Asia and other economies, US banks started
lending
liberally for housing. Their credit to sub prime mortgages bloomed because of the
low
interest regime and hefty promotional campaigns. The sub prime crisis is the result
of
excessive amounts of loans made to people who could not afford them and
excessive
amounts of money thrown into the mortgage arena by investors who were very
eager for
high-yielding investments. It fed the real estate mania, the real estate bubble in
many
parts of the country. The bubble prices in the US housing market were caused by:
Lax lending standards.
Low treasury rates on adjustable rate mortgages.
Speculative behavior by consumers.
Because of higher interest rates, people became more cautious in
borrowing to buy houses and there occurred a general slowdown in demand in the
housing market. This led to banks holding assets that people were not just willing
to buy.
Rise in supply of mortgaged houses couple with no demand for them led to
plummeting s apprehensions about CDOs because it's not entirely clear how much
is in
bonds backed by risky subprime mortgages versus bonds backed by safer corporate
debt.
But the prospectus notes holdings of bonds backed by subprime debt as a "risk
factor"
that would need to be weighed by investors.
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V. Costs of securitization became apparent.
It is argued that the transaction costs of CDOs are high and the benefits are
questionable.
CDOs are being used to transform existing debt instruments that are accurately
priced
into new ones that are overvalued. The more eclectic CDOs bind together the fate
of
assets which have few real economic links. For example, a lowly rated energy
bond and
top notch bank paper may be in the same structure. Separately, they would not
move in
tandem. If they are put in CDO, they fall together in a credit squeeze, by virtue of
being
in the same structure, as investors rush to exit or seek to hedge their risk.
Investors seeking to redress have encountered unforeseen problem. Securitizations
are
generally structured as true sales: the seller wipes its hands off the risk. In practice
buyers
have some protection. Many contracts allow them to hand back loan pools that
sour
surprisingly quickly. Some have done just this with the most rancid sup prime
mortgages,
requesting an injection of better-quality loans into the pool. But there were so
many bad
loans that originators could not oblige. The effective secondary market punishment
mechanism turned out to be faulty when the problems grow beyond a certain size.
VI. Who were responsible for the crisis?
The crisis is the result of excessive amounts of loans made to people who could not
afford them and excessive amounts of money thrown into the mortgage arena by
investors who were very eager for high-yielding investments. However, apart from
mere
borrowers, lenders and investors, a number of agents have played their role in
generating
the crisis.
Government policy: Some observers claim that government policy actually
encouraged
the development of the subprime debacle through legislation like the Community
Reinvestment Act.
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Feds policy of reducing the rate of interest: This was done to contain the adverse
impact
of dot com boom.
VII. Passing the buck
For all its flaws, the old bank model resolved the incentive in a simple way. Loans
were
kept in-house, banks had to underwrite cautiously and also to keep a tab on the
borrower
after the money is disbursed to the borrower. Lax rating by the rating agencies
made it
easier for the banks securitizing and further repackaging debt to create the greatest
number of securities with lowest regulatory cost (that is highest rating).
Securitization has
allowed banks which are regulated holders of credit risk to unregulated traders of
credit
risk with smaller balance sheet. As a result, although the risk of bank runs as faced
by the
holder of such securities was shifted to the banking system at large because other
banks
have bought the security. It could also have been bought by other hedge funds. So a
bank
can push risk out of the front door, only to find it sneaking through the back.
While financial innovations spread risk form lenders to the investor and the
markets, it
distanced the borrower from the ultimate provider of funds-the Wall Street firms
and the
hedge funds. Hence, while the ultimate holder of the risk, the investor, has more
reason to
be careful but owns a complex product too far down the chain for monitoring to
work.
The risk was great but so was the return.
The expansion of US housing loans would not have been so disastrous if it were
not fed
mostly investors from Wall Street firms buying securitization bonds-made up of
sub
prime loan assets. Attracted by the higher returns on sub-prime loans, they relied in
the
rating of these by rating agencies. Given the rating agencies laxity and investors
complacency, Wall Street kept pushing the envelope while structuring the
mortgagebacked
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derivatives.
VIII. Devastating impact of the crisis
Since 2000, the market for MBS has overtaken even those for US treasury notes
and
bonds. This led to a broad-based and devastating impact of the crisis. It is hard to
overstate the extent of this reversal in fortunes, if only because it is hard to
overstate the
effect that securitization has on financial markets.
Homeowners: A vicious circle was created when subprime loan payers defaulted
on their
obligation, leaving foreclosure of their mortgages as the only perceived recourse
for
investors in the loan. When other homeowners with mortgages also attempt to meet
their
financial obligations, some of them put their homes up for sale, which drags down
the
price of other houses in their neighborhood, not merely those houses with subprime
mortgages. Thus the entire real sector was involved. Sales of previously owned
homes
fell in September to annual rate of 5.04 million, the lowest since the records began
in
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atmosphere of acute uncertainty, where no one knows which firms have exposure
to subprime
or the amounts involved, banks decided to stop lending -- not just housing debt but
other forms of debt as well. This led to the liquidity crunch in August, 2007 which
in turn
hit the markets worldwide.
Solvency crisis: Thus the gravest and most immediate threat to the banking system
arose.
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may fluctuate5. The sub prime crisis demonstrated that relying on the asset market
for realization of dues was counter productive, even when the asset was as solid as
a real estate. If the price of the collateral prevailing in the market happens to be
low when the asset is sold, then the seller will not be able to recover his dues
through selling. However, a very peculiar scenario was observed during the sub
prime crisis where the same factor which leads to defaults is also forcing the prices
of real estate to drop. This variable is rate ofinterest fixed by Fed, which is a policy
variable. Such a variable is found to influence
both aspects: demand and supply of real estate. Let us go through the chain of
events. A rise in the interest rate caused defaults in sub-prime category. Faced with
this, the investors who bought the securitized instruments attempted to sell them in
the market. However, every rise in the rate of interest is also simultaneously
leading to drying of demand through a rise in mortgage payments. Thus rise in the
rate of interest led leading to widening of the gap between supply and demand and
pushed below the price of collateral creating a vicious cycle from which no escape
is apparently in sight. This has demolished the myth that real estate is considered a
solid security. A bitter lesson emerging out of the crisis is that market of asset does
not provide any respite in case of failed lending.
2) New model of bank with modern principles of finance is not sustainable:
Unwillingness of the mortgage banks to asses the risk profiles of the borrowers and
lend
on the basis of risk in a regime of low interest rate made financial system very
fragile.
Many lenders had to relax their credit norms due to competition. In addition, given
that
most mortgage lenders in the US sell their loans within a month or two, their
primary
motivation was to generate as many loans as they could and then sell them quick.
This
was yet another reason they lacked strong incentives for credit checks. It vindicates
the
old model of banks which provides loan and keeps it on its books till it matures.
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CONCLUSION
It is the failure of the response of the financial sector in the form of financial
innovation in the garb of derivatives, which failed to contain risks of lending. Fed
had been attempting to counteract the recessionary tendency through a rate
cut. However, in a situation in which one does not know, who is affected and by
how much, the efficacy of the monetary policy pursued by Fed becom
questionable. Securitization was a revolution that brought huge gains. The
transformation of sticky debt into something more tradable, for all its
imperfections, has forged hugely beneficial links between individual borrowers and
vast capital markets that were previously out of reach. However, the costs of
securitizations became apparent later. As it comes under scrutiny, the debate should
be about how this system can be improved, not dismantled. The
challenge before the Fed and other central bankers is to control and regulate
securitization without hurting the beneficial outcomes of increased flexibility,
which securitization reportedly provides. Lastly, a debate is on whether central
bankers may have themselves been responsible for the problems that led to sub-
prime mess in the first instance and whether their subsequent actions are over
compensating. The debacle has been a testing ground for central bankers of the
world and will have a profound impact on the conduct of macroeconomic policy.
This created an unprecedented situation characterized by credit crunch, insolvency,
crash in stock price and fall in price of dollar. While some observers are comparing
it with Great Depression in its impact, it is clear that the fundamental nature of the
crisis is different because the recession in the real sector has been created by
instability in financial sector.
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BILOGRAPGHY
BIBLIOGRAPHY
http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3483513/
www.wikipedia.com
www.google.com
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