Autor: Francisco Jareño – Profesor Titular de Universidad – Dpto. de Análisis Económico y Finanzas
This report focuses on the securitization process and its consequences and implications on the global economy. Also, this article is related with a previous report: “The Financial crisis (I): the origin”.
As far as securitization process is concerned, GSEs developed the mortgage market, trading with Mortgage Backed Securities (MBS). GSEs sold MBSs and obtained funds to finance new mortgages. Thus, they created a secondary mortgage market, that is, the segment of the mortgage market where mortgages were resold, not where mortgages were originated. Mortgages in this secondary market were often grouped together and sold as collateralized debt obligations (CDOs), collateralized mortgage obligations, mortgage-backed securities (MBSs), or other types of securities.
Thus, the securitization process was defined as a financial transaction in which assets such as mortgage loans are pooled, and securities representing interests in the pool are issued. Making home loans sales more efficient and profitable was the main objective of this process.
In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. Then, the securitizer forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds were called Mortgage Backed Securities (MBS) and were typically sold in a public offering to investors. Investors typically made a payment up front, and then hold onto the MBS securities which repaid the principal plus interest over time.
Collateralized debt obligations (CDOs) were another type of structured finance product whose securities received credit ratings and were sold to investors. CDOs were a more complex financial product that involved the re-securitization of existing income-producing assets (e.g. MBS securities from multiple mortgage pools). These CDOs were often called “cash CDOs,” because they received cash revenues from the underlying MBS bonds and other assets. The CDO arranger calculated the revenue stream coming into the pool of assets, designed a waterfall to divide those incoming revenues among a hierarchy of tranches, and used each tranche to issue securities that could then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets had BBB ratings.
Credit Default Swap (CDS) was an insurance contract. The buyer of the swap made periodic payments to the seller of the swap in return for protection against a possible “credit event” affecting the value of a specified asset. The seller agreed to buy the specified asset from the buyer at par in the event of a credit default. Thus, the asset was typically some type of security, such as a corporate bond, CDO, or MBS. Neither the buyer nor the seller typically owned the security and, finally, CDSs were derivatives.
Various “credit events” might trigger the buyer’s protection: missed payments to owners of the security, a downgrading of the security’s credit rating, a downgrading of the seller’s own credit rating. When the protection was triggered, the seller compensated the buyer. To compensate for a decline in the security’s market value, the seller may deliver collateral to the buyer in the amount of the decline. Then, the seller may also close out the swap by paying full par value to buy the reduced-value security from the buyer. Parties and counterparties could disagree as to the amount of the decline in the value of the security and the compensation that was due.
Nevertheless, this securitization process had disastrous implications and consequences. As a result of innovations in securitization, risks related to the inability of homeowners to meet mortgage payments had been distributed broadly, with a series of consequential impacts (Credit risk, Asset price risk, Liquidity risk, Counterparty risk, and Systemic risk).
The general public was not given adequate warning of the emerging dangers in the mortgage market. We could not expect policymakers to second guess markets or to know when assets were overvalued, but we could and should expect policymakers to warn of the growing riskiness of certain assets that might generate large rewards but that could also lead to large losses. Thus, households should have been warned that continuing large increases in house prices were not a sure thing.
On the other hand, Credit Rating Agencies failed to accurately assess the risk of the securitized assets they graded, so they faced a conflict of interest in their fee structure. A big part of the credit ratings problem was that the system got so opaque that rating agencies became the de facto “arbiters of risk,” as everyone — even regulators — came to utterly rely on their opinion of risk assessment. Thus, there should be reforms in the credit ratings structure and perhaps less reliance on agency ratings.
Besides, Federal and state regulators believed that less regulation was better and that the market would take care of any problems. The push to deregulate of the past thirty years had led to a lack of discrimination in policy. Thus, Economies needed to eliminate bad regulation that suppresses competition and inhibits innovation, but these Economies needed to improve regulation where it could make markets work better and avoid crises.
The infrastructure of the financial system needed to be revised. While complex derivatives like CDS had grown exponentially, no one knew how exposed any institution was to these products because each CDS transaction was done Over the Counter (OTC) rather than on an exchange. This lack of transparency further exacerbated the problem of asymmetric information and magnified the potential for systemic risk.
To sum up, the origin of the financial crisis was in the US mortgage market and characterized by special features of the US mortgage market (creation of subprime market), lack of supervision to mortgage brokers, expansive monetary policy and the bubble in the house-price, particular characteristics of subprime mortgages (mainly ARM) and, finally, the complexity of the securitization process (securities difficult to value).
- Bernanke, B.S.(2008): Financial Markets, the Economic Outlook and Monetary Policy. Conference at the Women in Housing and Finance and Excheque Club Joint Luncheon, Washington D.C. Board of Governors of the Federal Reserve System. January 10.
- Firla-Cuchra, M. & Jenkinson, T (2005): Why Are Securitisation Issues Tranched?. Oxford University Press Working Paper March 2005
- Gramlich, E.M. (2007): Subprime Mortgages. America’s Latest Boom and Bust. The Urban Institute Press. Washington D.C.
- Mason, J.R & Rossner (2007): How Resilient Are Mortgage Backed Securities to collateralized Debt Obligation Market Disruptions. Paper presented to the Hudson Institute, Washington D.C. February 15.
- Navarro, E. (2008): Reflections about the crisis in the subprime market (in Spanish). Working paper.
- TeiteBaum, Henry (2008): Europe Subprime Survivor. Institutional Investor, February 2008
- United States. Financial Crisis Inquiry Commission (2011): The financial crisis inquiry report: final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Editorial: New York, NY : Public Affairs.