global securitization outlook

7/21/2019 Global Securitization Outlook

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CONTENTS

1. Introduction To Securitization ...................................................................................... 3

A. Various Terms Used In Securitization Process: ................................................... 3

B. Asset Securitization: ................................................................................................. 5

C. Need For Securitization ........................................................................................... 6

D. The Broader Meaning: ............................................................................................. 8

E. Reasons For Growth of Securitization: ................................................................. 9

2. Capital Markets Role In Securitization ....................................................................... 10

3. Economic Impact of Securitization ............................................................................ 12

4. Social Benefits of Securitization .................................................................................. 14

5. Securitizations Role In The Financial Crisis............................................................. 16

6. What Went Wrong, And What Needs To Be Fixed? ............................................... 17

A. Problematic Asset Type ......................................................................................... 17

B. Moral Hazard .......................................................................................................... 18

C. Servicing Conflicts .................................................................................................. 20

D. Overreliance on Mathematical Models ................................................................ 21

7. The Future Of Securitization ....................................................................................... 22

A. Introduction ............................................................................................................ 22

B. General Observations ............................................................................................ 24

C. Alternatives to Securitization ................................................................................ 27

8. Conclusion ...................................................................................................................... 29

REFERENCES .................................................................................................................... 31


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1. INTRODUCTION TO SECURITIZATION

Securitization is the process of pooling and repackaging of homogenous illiquid

loans, receivables and other financial assets into marketable securities that can be sold

to investors. It broadly implies every such process which converts a financial relation

into a transaction. These securities, some of which are referred to as asset-backed

securities, are issued and sold to investors, principally institutions in the public and

private markets by or on behalf of issuers. The issuers use securitization to finance

their business activities. The financial assets that support payments on asset-backed

securities include residential and commercial mortgage loans, as well as a wide variety

of non mortgage assets such as trade receivables, credit card balances, consumerloans, lease receivables, automobile loans, and other consumer and business

receivables. Although these asset types are used in some of the more prevalent forms

of asset based securities, the basic concept of securitization may be applied to any asset

that has a reasonably ascertainable value, or that generates a reasonably predictable future stream of

revenue.Consequently, securitization has been extended to a diverse array of less well

known assets, such as insurance receivables, obligations of shippers to railways,

commercial bank loans, health care receivables, obligations of purchasers to natural

gas producers, and future rights to entertainment royalty payments, among many

others. Other instances of securitization of relationships are commercial paper, which

securitizes a trade debt.

A.Various Terms Used In Securitization Process:

The entity that securitizes its assets is called the originator. The name signifies the fact

that the entity was responsible for originating the claims that are to be ultimately

securitized. There is no distinctive name for the investors who invest their money in

the instrument. Therefore, they are generally called as investors. The claims that the

originator securitizes could either be existing claims, or existing assets (in form of


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claims), or expected claims over time. In other words, the securitized assets could be

either existing receivables, or receivables to arise in future. The latter, for the sake of

distinction, is called future flow securitization, in which case the former is a case of

asset-backed securitization.

Another distinction is between mortgage-backed securities and asset-backed securities.

This only is to indicate the distinct application: the former relates to the market for

securities based on mortgage receivables.

Since it is important for the entire exercise to be a case of transfer of receivables by

the originator, not a borrowing on the security of the receivables, there is a legal

transfer of the receivables to a separate entity. Transfer of receivables is calledassignment of receivables. It is also necessary to ensure that the transfer of receivables

is respected by the legal system as a genuine transfer, and not as a mere paper

transaction where in reality it is a mode of borrowing. In other words, the transfer of

receivables has to be a true sale of the receivables, and not merely a financing against

the security of the receivables.

Since securitization involves a transfer of receivables from the originator, it would beinconvenient, to the extent of being impossible, to transfer such receivables to the

investors directly, since the receivables are as diverse as the investors themselves.

Besides, the base of investors could keep changing, as the resulting security is a

marketable security. Therefore, there is a need for intermediary. This intermediary will

hold the receivables on behalf of the end investors. This entity is created solely for the

purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or a

special purpose entity (SPE) or, if such entity is a company, special purpose company

(SPC). The function of the SPV in a securitization transaction could stretch from

being a pure conduit or intermediary vehicle, to a more active role in reinvesting or

reshaping the cash flows arising from the assets transferred to it, which is something

that would depend on the end objectives of the securitization exercise. Therefore, the


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originator transfers the assets to the SPV, which holds the assets on behalf of the

investors, and issues to the investors its own securities. Therefore, the special purpose

vehicle is also called the issuer.

There is no uniform name for the securities issued by the SPV as such securities take

different forms. These securities could either represent a direct claim of the investors

on all that the SPV collects from the receivables transferred to it. In this case, the

securities are known as beneficial interest certificates as they imply certificates of

proportional beneficial interest in the assets held by the SPV. The SPV might be re-

configuring the cash flows by reinvesting it, so as to pay to the investors on fixed

dates, not matching with the dates on which the transferred receivables are collectedby the SPV. In this case, the securities held by the investors are called pay through

certificates. The securities issued by the SPV could also be named based on their risk

or other features, such as senior notes or junior notes, floating rate notes, etc.

Another word commonly used in securitization exercises is bankruptcy remote

transfer. What it means is that the transfer of the assets by the originator to the SPV is

such that even if the originator were to go bankrupt, or get into other financial

difficulties, the rights of the investors on the assets held by the SPV is not affected. In

other words, the investors would continue to have a paramount interest in the assets

irrespective of the difficulties, distress or bankruptcy of the originator.

B.Asset Securitization:

Asset securitization is a device of structured financing where an entity seeks to pool

together its interest in identifiable cash flows over time. After identification it

transfers the same to investors either with or without the support of further

collaterals, and achieves the purpose of financing. The end-result of securitization is

financing. However, it is not financing per se, since the entity securitizing its assets.


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It is not borrowing money, but selling a stream of cash flows that will otherwise

accrue to it.

Let us consider an example. A person wants to own a car to rent it to a business

organization. He has to either use his own funds or obtain a loan. He is likely to get

rent from the organization for utilization of his car. If he obtains a loan for the

purchase of the car, the loan is obligation, the car is asset, and other assets and other

obligations of the person affect both obligations and assets. If he fails to repay money

he other assets may be attached or if he does not pay for other loans his car may be

attached. This is the case of financing and obligations under various legal provisions.

For the purpose of discussion, we will call this person as an issuer (an appropriateword for him is originator but for simplicity we use the term issuer. Various terms

used in securitization will be discussed later.

In the example studied, it is a claim to value over a period i.e. ability to generate a

series of hire rentals over a period. The issuer may sell a part of the cash flow by way

of hire rentals for a stipulated time to an investor and thereby raise money to buy the

car. The investor is better off, because he has a claim for a cash flow, which is not

affected by other obligations of the issuer. The issuer is better off because the

obligation to repay the financier is taken care of by the cash flows from the car itself.

With this example, we can know that power of securitization.

C.Need For Securitization

The generic need for securitization is similar to that of organized financial markets.

From the distinction between a financial relation and a financial transaction earlier, we

understand that a relation invariably needs the coming together and remaining

together of two entities. Not that the two entities would necessarily come together of

their own, or directly. They might involve a number of financial intermediaries in the


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process, but a relation involves fixity over a certain time. Financial relations are

created to back another financial relation, such as a loan being taken to acquire an

asset, and in that case, the needed fixed period of the relation hinges on the other that

it seeks to back-up.

Financial markets developed in response to the need to involve a large number of

investors. As the number of investors keeps on increasing, the average size per

investors keeps on coming down, because growing number means involvement of a

wider base of investors. The small investor is not a professional investor. He needs an

instrument, which is easier to understand, and provides liquidity and legal sanction.

These needs set the stage for evolution of financial instruments which would convertfinancial claims into liquid, easy to understand and homogenous products. They

would be available in small denominations to suit even a small investor. Therefore,

securitization in a generic sense is basic to the world of finance, and it is right for us

to say that securitization envelopes the entire range of financial instruments, and the

range of financial markets.

Securitization is one way in which a company might go about financing its assets.

There are generally seven reasons why companies consider securitization:

1. to improve their return on capital, since securitization normally requires less capital

to support it than traditional on-balance sheet funding;

2. to raise finance when other forms of finance are unavailable (in a recession banks

are often unwilling to lend - and during a boom, banks often cannot keep up with

the demand for funds);

3. to improve return on assets - securitization can be a cheap source of funds, but the

attractiveness of securitization for this reason depends primarily on the costs

associated with alternative funding sources;


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4. to diversify the sources of funding which can be accessed, so that dependence

upon banking or retail sources of funds is reduced;

5. to reduce credit exposure to particular assets (for instance, if a particular class of

lending becomes large in relation to the balance sheet as a whole, then

securitization can remove some of the assets from the balance sheet);

6. to match-fund certain classes of asset - mortgage assets are technically 25 year

assets, a proportion of which should be funded with long term finance;

securitization normally offers the ability to raise finance with a longer maturity

than is available in other funding markets;

7.

to achieve a regulatory advantage, since securitization normally removes certain

risks which can cause regulators some concern, there can be a beneficial result in

terms of the availability of certain forms of finance (for example, in the UK

building societies consider securitization as a means of managing the restriction on

their wholesale funding abilities).

Establishing the primary rationale for the securitization activity, is a vital part of the

preparation for a securitization transaction, since it influences the sorts of

administrative tasks which need to be developed as well as the transaction structures

themselves.

D.The Broader Meaning:

Let us broaden our thinking of securitization. The present-day meaning of

securitization is a blend of two forces that are critical in today's world of finance:structured finance and capital markets. Securitization leads to structured finance, as

the resulting security is not a genericrisk in entity that securitizes its assets, but in

specific assets or cash flows of such entity. We have seen in the case of simple

financing the risk is with the issuer (the person who purchased the car by a loan), now


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it is shifted to the asset or cash flows of such entity. Two, the idea of securitization is

to create a capital market product that is, it results into creation of a securitywhich

is a marketable product.

1) Securitization is the process of commoditization. The basic idea is to take the

outcome of this process into the market, the capital market. Thus, the result of every

securitization process, whatever might be the area to which it is applied, is to create

certain instruments, which can be placed in the market.

2) Securitization is the process of integration and differentiation: The entity that

securitizes its assets first pools them together into a common hotchpotch (assuming it

is not one asset but several assets, as is normally the case). This process of integration.Then, the pool itself is broken into instruments of fixed denomination. This is the

process of differentiation.

3) Securitization is the process of de-construction of an entity. If we think of an

entity's assets as being composed of claims to various cash flows, the process of

securitization would split apart these cash flows into different units .We classify these

units, and sell these classified units to different investors as per their needs. Therefore,securitization breaks the entity into various sub-sets.

We will discuss further the present-day meaning of securitization after some more

understanding of generic meaning of the term. The process of converting an asset or a

relationship into a security or a commodity.

E.Reasons For Growth of Securitization:

1. Financial claims often involve large sums of money, which is outside the reach of

the small investor who lacks expertise. In order to cater to this need development of

financial intermediation is important. In a simple case an intermediary such as a bank


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obtains resources of the small investors and uses the same for the larger investment

need of the user.

2. Small investors are typically not in the business of investments, and hence, liquidity

of investments is most critical for them. Underlying financial transactions need fixity

of investments over a fixed time, ranging from a few months to may be a number of

years. This problem could not even be sorted out by financial intermediation, since,

the intermediary provided a fixed investment option to the seeker, and itself requires

funds with an option for liquidity. Or else, it would be into serious problems of a

mismatch. Hence, the answer is a marketable instrument.

3. Generally, instruments are easier understood than financial transactions. Aninstrument is homogenous, usually made in a standard form, and generally containing

standard issuer obligations. Hence, it can be understood generically. Besides, an

important part of investor information is the quality and price of the instrument, and

both are difficult to be ascertained.

The need for securitization was almost inescapable, and present day's financial

markets would not have been what they are, unless some standard thing that marketplayers could buy and sell, that is, financial securities, were available. Therefore, there

is large scope for development in this area. Capital markets are today a place where we

can trade, claims over entities, claims over assets, risks, and rewards. Let us consider

certain types of securitization.

2. CAPITAL MARKETS ROLE IN SECURITIZATION

The capital markets have provided the needed impetus to disintermediation market.

Professional and publicly available rating of borrowers has eliminated the

informational advantage of financial intermediaries. Let us imagine a market without

rating agencies: any investor has to take an exposure security has to appraise the


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entity. Therefore, only those who are able to employ analytical skills will be able to

survive. However, the availability of professionally conducted ratings has enabled

small investors to rely on the rating company's professional judgment and invest

directly in the security instruments rather than to go through intermediaries. But thisshould not be construed as no role for banker.

The development of capital markets has re-defined the role of bank regulators. A

bank supervisory body is concerned about the risk concentrations taken by a bank.

More the risk undertaken, more is the requirement of regulatory capital. On the other

hand, if the same assets were to be distributed through the capital market to investors,

the risk is divided, and the only task of the regulator is that the risk inherent in theproduct is properly disclosed. The market sets its own price for risks - higher the risk,

higher the return required. Capital markets tend to align risks to risk takers. Free of

constraints imposed by regulators and risk-averse depositors and bank shareholders,

capital markets efficiently align risk preferences and tolerances with issuers

(borrowers) by giving providers of funds (capital market investors) only the necessary

and preferred information. Other features of the capital markets frequently offset any

remaining informational advantage of banks: variety of offering methods, flexibility of

timing and other structural options. For borrowers able to access capital markets

directly, the cost of capital will be reduced according to the confidence that the

investor has in the relevance and accuracy of the provided information. As capital

markets become more complete, financial intermediaries become less important as

touch points between borrowers and savers. They become more important as

specialists that

(1)complete markets by providing new products and services,

(2) transfer and distribute various risks via structured deals, and


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(3) Use their reputational capital as delegated monitors to distinguish between high-

and low-quality borrowers by providing third-party certifications of

creditworthiness. These changes represent a shift away from the administrative

structures of traditional lending to market-oriented structures for allocating moneyand capital.

In this sense, securitization is not really-speaking synonymous to disintermediation,

but distribution of intermediary functions amongst specialist agencies.

3. ECONOMIC IMPACT OF SECURITIZATION

Securitization is necessary to the economy similar to organized markets.

A.Creates of Markets In Financial Claims:

By creating tradable securities out of financial claims, securitization helps to create

markets in claims, which would, in its absence, have remained bilateral deals. In

the process, securitization makes financial markets more efficient, by reducing

transaction costs.

B.

Spread of Holding of Financial Assets:The basic intent of securitization is to spread financial assets amidst as many savers

as possible. With this end in view, the security is designed in minimum size

marketable lots as necessary. Hence, it results into dispersion of financial assets.

One should not underrate the significance of this factor just because institutional

investors have lapped up most of the recently developed securitizations. Lay

investors need a certain cooling-off period before they understand a financial

innovation. Recent securitization applications, viz., mortgages, receivables, etc. are,

therefore, yet to become acceptable to small investors.

C.

Promotion of Savings:


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The availability of financial claims in a marketable form, with proper assurance as

to quality in form of credit ratings etc., securitization makes it possible for the

simple investors to invest in direct financial claims at attractive rates. If the bank

rate are lower than the rates offered by securities, investors will go for theseinstruments.

D.Reduces Costs:

Securitization tends to eliminate fund-based intermediaries, and it leads to

specialization in intermediation functions. This saves the End-user Company from

intermediation costs, since the specialized-intermediary costs are service-related,

and comparatively lower.

E.Risk Diversification :

Financial intermediation is a case of diffusion of risk because of accumulation by

the intermediary of a portfolio of financial risks. Securitization spreads diversified

risk to a wide base of investors, with the result that the risk inherent in financial

transactions is diffused.

F. Focuses on Use of Resources, And Not Their Ownership:

Once an entity securitizes its financial claims, it ceases to be the owner of such

resources and becomes merely a trustee or custodian for the several investors who

thereafter acquire such claim. Imagine the idea of securitization being carried

further, and not only financial claims but claims in physical assets being

securitized, in which case the entity needing the use of physical assets acquires

such use without owning the property. The property is diffused over investors. In

this sense, securitization process assumes the role of a trustee of resources and not

the owner.


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4. SOCIAL BENEFITS OF SECURITIZATION

Securitization does is to break a company, a set of various assets, into various subsets

of classified assets, and offer them to investors. Imagine a world without

securitization: each investor would be taking a risk in the unclassified, composite

company. How can we call this as serving economic benefit if the company is made

into different parts and sold to different investors?

To appreciate the underlying economics driving a securitization, consider an

imaginary holding company ABC Ltd. It has on its balance sheet three wholly-owned

subsidiaries, A, B, and C. The process of securitization can be thought of as treating

distinguishable pools of assets as if they were wholly-owned subsidiaries A, B & C.

Let us make the following assumptions about the subsidiaries A, B and C.A is 100%

debt financed (5-year debentures issued at 9%) with its only asset a single 5-year loan

to an AAA-rated borrower paying 10%. B is a software company with no earnings or

performance history, but with projections for attractive, volatile, future earnings. C is

a well-known manufacturing company with predictable earnings.

If ABC goes to the debt markets seeking additional unsecured funding, potential

investors would face the difficult task of evaluating its assets and assessing its debt

repaying abilities. The assessed cost of marginal ABC borrowing might consist of an

averageof the calculated returns on the assets of the segments that comprise ABC.

This average would necessarily reflect known and unknown synergies, and costs and

associative risks arising from the collective ownership parts (i.e., the group's imputed

contribution for credit support, insolvency risk and liability recourse) and would likely

include an uncertaintydiscount.

Now consider the probable outcomes if ABC is to legally sell the ownership of one or

more of its parts. In exchange for the exclusive rights to the cash flows from A,

investors would return to ABC maximum equivalent value in the form of cash. Such


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an offering appeals to a wide range of investors. This includes investors with a

preference for, and having superior information regarding the risk represented by A's

obligors.

Those new investors who have had an aversion for the risk presented by the

associated costs and risks represented by B and C. This new arrangement returns to

ABC is the full value the market attaches to the certainty of the information

concerning A, without uncertainty of the information regarding Band C. The value of

the resulting ABC shares depends in part on the disposition of the cash received from

the spin-off. If ABC retains the cash, there may be a discount or revaluation resulting

from the market's assessment of ABC's ability to achieve a return equal or better thanit would have earned from keeping the asset. There is always one clear collateral

benefit to the resulting ABC that derives from any divestment. The perceived value of

the remaining components is relieved of any previously imposed discount for the

disposed component's credit support and insolvency risk. Holding aside separate

considerations of corporate strategy and internal synergies, to the extent that the

consideration received from the divestment improves (in the perception of the

market) the capital structure of the resulting ABC and/or reduces the marginal

funding cost for the resulting organization ABC. The decision to divest or securities is

simplified. If the information held by ABC concerning any of its segments is not or

cannot be fully disclosed, or when disclosed will not be fully or accurately valued, the

correct decision is to retain the asset. Without securitization, ABC's bank faces

significant and largely irreducible costs of evaluating the marginal impact on ABC's

borrowing cost from ABC's pledging of assets (receivables) and of evaluating similarinformation for each other borrower that the lender or finances. If the imposed cost

of borrowing is to be judged solely on the assets as we have seen, the most efficient

way to assess the true cost of asset based borrowing). Evaluating each pool of assets


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and assessing the likelihood that the cash flows from them will be uninterrupted must

be repeated for each borrowing.

By developing a market for asset-specific expertise (not the least of which is

represented by the expertise of the rating agencies), and by relying on the capital

markets to determine the best price for the rated asset-backed securities (such rating

representing the expression of the information provided by the developed expertise),

the cost of borrowings for issuers using properly organized securitization structures

has steadily decreased and is well below the cost of borrowing from a lending

institution.

5.

SECURITIZATIONS ROLE INTHE FINANCIAL CRISIS

The securitization of subprime mortgage loans is widely viewed as a root cause of the

financial crisis. In the United States, there was significant government pressure on

banks and other lenders to make home-mortgage loans to expand home ownership,

even for risky borrowers. These subprime loans were often made, for example, to

borrowers with little de facto income, anticipating that home-value appreciation

would enable the borrowers to refinance to lower-rate mortgages. Historically, home

prices had generally been increasing in the United States since the Great Depression.

But this model failed when, in 2007 and 2008, home prices fell significantly. In one

sense, the precipitous drop in home prices was unexpectedlike Montys Pythons

skit, Nobody expects the Spanish Inquisition. In another sense, though, the fall

arguably should have been anticipated based on the earlier liquidity glut and its

artificially low interest rates, driving up housing prices artificially.

As a result of the fall in home prices, borrowers who were relying on refinancing for

loan repayment could not refinance. Furthermore, many subprime mortgage loans

had adjustable rates which increased after an initial teaser period. Borrowers who


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could not afford the rate increases had expected to refinance at lower interest rates.

That likewise was stymied by collapsing home prices. For these reasons, many risky

borrowers began defaulting.

6.WHATWENTWRONG,ANDWHAT NEEDSTO BE FIXED?

A.Problematic Asset Type

The failure of subprime mortgage securitization was caused by its almost absolute

dependence on home appreciation. Some believe this type of particular sensitivity to

declines in house prices was unique. From that perspective, parties structuringsecuritization transactions can minimize

future problems by excluding, or at least limiting and better managing, subprime

mortgage loans as an eligible type of underlying financial asset, and also by

conservatively assessing the payment prognosis for other types of financial assets

underlying securitizations. This is important not only to protect the integrity of

securitization transactions but also to avoid the unintended consequence that

securitization of a problematic asset type can motivate greater origination of that asset

type. This is not to say these procedures will be failsafe. Parties to (and investors in)

securitization transactions must always be diligent to recognize and try to protect

against the possibility that the underlying financial assets might, as in the case of

subprime mortgage loans, fail in unexpected ways. What would happen to automobile

loan securitization, for example, if a technological innovation makes cars obsolete,

depriving even financially healthy borrowers of the incentive to repay their loans? The

invention of a new form of personal transportation is at least as plausible as the idea

that home priceswhich generally had only risen since the 1930swould suddenly

collapse in value at a rate higher than that seen during the Great Depression (as

happened in the recent financial crisis).


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The financial crisis also teaches us the danger of mixing politics and finance. Before

that crisis, there was political pressure to securitize risky subprime mortgage loans to

facilitate financing for the poor. We are likely to see the same type of political pressure

to securitize risky microfinance loans to facilitate financing for the poor anddisadvantaged, which I later discuss.

B.Moral Hazard

Some argue that securitization facilitated an undisciplined mortgage lending industry.

By enabling mortgage lenders to sell off loans as they were made (a concept called

originate-to-distribute), securitization is said to have created moral hazard sincethese lenders did not have to live with the credit consequences of their loans.

Mortgage underwriting standards therefore fell, exacerbated by the fact that mortgage

lenders could make money on the volume of loans originated.

I find the moral hazard argument weak. Mortgage underwriting standards may have

fallen, but there are other explanations of why. For example, lower standards may well

reflect distortions caused by the liquidity glut of that time, in which lenders competed

aggressively for business, allowed otherwise defaulting home borrowers to refinance,

and (in the corporate lending context) even made so-called covenant-lite loans. The

fall in standards may also reflect conflicts of interest between lending-firms and their

employees in charge of setting those standards, such as where employees were paid

for booking loans regardless of the loans long-term performance.

Blaming the originate-to-distribute model for lower mortgage underwriting standards

also does not explain why standards were not similarly lowered for originating non-

mortgage financial assets used in other types of securitization transactions. Nor does it

explain why the ultimate beneficial owners of the mortgage loansthe investors in

the mortgage backed securitiesdid not govern their investments by the same strict


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lending standards that they would observe but for the separation of origination and

ownership (although I observed in yesterdays lecture that this failure may at least

partly be explained by (i) the inherent inadequacy of disclosure for the most complex

(ABS CDO) mortgage-backed securities; (ii) the possibly excessive diversification ofrisk created by these securities, undermining any given investors incentive tomonitor;

and (iii) the tendency of investors to engage in herd behavior). Although I dont

believe the originate-to-distribute model was a significant cause of the financial crisis,

the model may need fixing to avoid its perception as the cause. There is little question,

though, that the model should remain basically intact; it is critical to the underlying

funding liquidity of banks and corporations, and empirical evidence tentatively

indicates that it creates net value. The goal therefore should be to minimize any

potential moral hazard resulting from the originate-to-distribute model without

undermining the models basic utility.

There are various ways this might be done. Potential moral hazard problems could be

managed, for example, by requiring mortgage lenders and other originators to retain

some realistic risk of loss. This is the central approach of the Dodd-Frank Act in the

U.S., although we have already discussed in these lectures how this can lead to a

mutual misinformation problem.

Moral hazard problems also could be managed by regulating loan underwriting

standards. The United States took this type of approach, for example, in response to

the margin-loan underwriting failures that helped trigger the Great Depression. When

stock values began depreciating in 1929, margin loans (that is, loans to purchase

publicly-listed stock) became undercollateralized, resulting in a high loan default rate

which, in turn, caused bank lenders to fail. To protect against a recurrence of this

problem, the Federal Reserve promulgated margin regulations G, U, T, and X,

requiring margin lenders to maintain minimum two-to-one collateral coverage.


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A similar type of approach applied to home-mortgage loans would certainly protect

against a repeat of the recent crisis. That protection would come at a high price,

though, potentially impeding and increasing the cost of home ownership and

imposing an administrative burden on lenders and government monitors.

C.Servicing Conflicts

Mortgage securitization made it difficult to work out problems with the underlying

mortgage loans because the beneficial owners of the loans are no longer the mortgage

lenders but a broad universe of investors in the mortgage-backed securities. Servicers

theoretically bridge the gap between investors (as beneficial owners of the loans) andthe mortgage lenders, retaining the power to restructure the underlying loans in the

best interests of those investors; but the reality is problematic. is uncertainty whether

their costs will be reimbursed; whereas foreclosure costs are relatively minimal.

Servicers may also prefer foreclosure over restructuring because foreclosure is more

ministerial and thus has lower litigation risk. Restructuring can involve difficult

decisions.

For example, in a mortgage securitization transaction in which cash flows deriving

from principal and interest are separately allocated to different investor classes, or

tranches, a restructuring that reduces the interest rate would adversely affect

investors in the interest-only tranche (and likewise, a restructuring that reduces

principal would adversely affect investors in the principal-only tranche). This leads to

what some have called tranche warfarea bad pun on Armistice Day!

These problems can, and in the future should, be fixed. Parties should write

underlying deal documentation that sets clearer and more flexible guidelines and more

certain reimbursement procedures for loan restructuring, especially when restructuring

appears to be superior to foreclosure. Parties also should try to minimize allocating


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cash flows to investors in ways that create conflicts. Furthermore, I have argued that

nonconflicted servicers that engage in restructuring in good faith should be protected,

perhaps akin to the type of protection afforded corporate directors under a business

judgment rule.

D.Overreliance on Mathematical Models

To some extent the financial crisis resulted from an abandonment of common sense

and an overreliance on complex mathematical models. Models are essential to

securitization because of the need to statistically predict what future cash flows will

become available from the underlying financial assets to pay the mortgage-backedsecurities.

Models can bring insight and clarity. If the model is realistic and the inputted data are

reliable, models can yield accurate predictions of real events. However, if the model is

unrealistic or the inputted data are unreliable, models can be misleadingcreating the

danger of garbage in, garbage out.

Subprime mortgage securitization models relied on assumptions and historical datawhich, in retrospect, turned out to be incorrect and therefore made the valuations

incorrect. We discussed yesterday the limitations of the value-at-risk (VaR) model.

The securitization models also incorrectly assumed that housing would not depreciate

in value to the levels later seen.

Valuation errors were compounded to the extent mortgage loans increasingly were

made with innovative terms, such as adjustable rates, low-to-zero down payment

requirements, interest-only payment options, and negative amortization. These terms

were so complex that some borrowers did not fully understand the risks they were

incurring. As a result, they defaulted at a much higher rate than would be predicted by

the historical mortgage-loan default rates relied on by loan originators in extending


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credit. Securitization models also have been used, sometimes erroneously, to

substitute for real market information. For example, some highly-leveraged ABS

CDO securities did not have an active trading market, so investors instead relied on

mark-to-model valuation of these securities. When assumptions underlying themodels turned out to be wrong, investors panicked because they did not know what

the securities were worth.

In theory, this overreliance on mathematical models is self-correcting because the

recent crisis, by its very existence, has shaken faith in the markets ability to analyze

and measure risk through models. Securitization products are likely to be confined, at

least in the near future, to those that can be robustly modeled. The only question willbe the longevity of the lesson that future risks cannot always be predicted through

mathematical models.

7.THE FUTURE OF SECURITIZATION

A.

Introduction

Taking a birds eyeview of todays financial market turmoil, one is inevitably

reminded of an old economic tale, the tragedy of the commons. Originally coined by

Gerrit Hardin in his seminal paper in Science in 1968, the author recounts the age-old

story of the demise of community graze land, open to all dwellers belonging to a

township. The upshot is, of course, that individuals pursuing their self-interest may

exert external effects in the form of overgrazing, ultimately destroying the common

resource. The crisis we now witness has some similar characteristics. Financial stability

is a commons that is being undermined by overleveraging standard banking activities,

by erosion of real estate loan quality, and by designing complex financial instruments,

like CDOs, that eventually lost investor confidence. Market liquidity eroded to the

point of complete market disruption, and prices fell to levels unimaginable at the time

of issue.


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Still, eyed from the helicopter, we now realize that misaligned incentives on the micro

level, i.e. the pursuit of individual happiness on the firm level, can lead to complete

opacity on the macro level, eliminating vital market functionalities, namely pricing

efficiency, market depth and liquidity.As usual, deficiencies on the micro-level are not universal. A large number of financial

intermediaries retained a prudent policy over the last years. But others, including some

large players, did not. This set off the infection which first hit these players, but then

undermined the confidence in the financial system on a large scale with far-reaching

contagion effects.

As we tried to show in the earlier sections of this paper, this crisis is a rational crisis,

it is not the result of irrational exuberance of any sort, nor is it the consequence of

euphoria and fear, as some observers have argued. We have identified weaknesses and

violations of rules of prudent financial engineering that may be called the root cause

of the immense degradation of asset value over the past 18 months. These violations

have also contributed to the strong drying up of market liquidity in several of the

most popular financial instruments of the last decade, like CDOs, CPs, and ABS in

general.


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We have thus delivered a structural explanation of why the crisis was predictable,

given the incentives of market participants, and given a set of inadequate rules of the

game currently inplace.

B.General Observations

Because securitization,properly utilized, is an efficient financial tool, its future should be

assured no matter how investors or politicians might temporarily overreact.

Nonetheless, in the near future at least, it is likely that securitization transactions will

need to refocus on basic structures and asset types in order to attract investors. To

this end, there likely will be an emphasis on cash-flow securitizations in which thereare the traditional two-ways out. An example of this would be the securitization of

prime mortgages, in which payment can come from the borrower or the collateral.

Furthermore, we are not likely to see many highly complex securitization products,

like ABS CDO transactions, which magnify leverage.

But there are exciting potential new applications of securitization, such as to

microfinance. Microfinance refers to providing small loans and other proportionallysized financial services to low-income individuals and the poor, in order to enable

them to start or expand small businesses.

Microfinance loans are now being made domestically and around the world, with

estimates of between $20 and $60 billion outstanding. As a result of microfinances

success, the need for microfinance lending vastly exceeds the amount of funds that

can be raised from charitable donors. It has been estimated, for example, that of the

one-and-a-half billion people potentially eligible for microfinance loans, only a

hundred million peopleless than seven percentreceive them.


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To satisfy this demand, commercial banks have become vital funding sources for

microfinance loans in many countries. But many of these banks are charging

exorbitant rates of interest, with some charging interest rates of 100 percent or more.

It is argued that securitization can, and indeed should, be applied to microfinance to

disintermediate the need for commercial banks. Even profit motivated investors

should want to invest in microfinance lending as a means of diversifying their

portfolios, thereby protecting themselves from market risk. The challenge, though, is

to ensure that microfinance securitization transactions are structured with the lessons


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of the failure of subprime mortgage securitization in mind, and to resist political

pressures to cut corners.

In the medium term, securitizations future will be at least marginally influenced by

the extent to which the intrinsic values of mortgage-backed securities turn out to be

worth more than their market values. It is argued that, as a result of irrational panic,

the market prices of mortgage-backed securities originally collapsed substantially

below the intrinsic value of the mortgage loans underlying those securities. A large

differential would indicate that the problem was more investor panic than intrinsic

lack of worth; although the subsequent collapse of the real economy to some extent

has made the price collapse a self-fulfilling prophecy by causing even prime borrowersto lose their jobs and default.

Whether securitization will remain vibrant and inventive in the long term, however,

will turn on our ability to better understand the problems of complexity, which was atthe root of many of the failures that gave rise to the financial crisis.


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C.Alternatives to Securitization

Covered bonds, which have a long history in European securities markets, are being

widely touted as an alternative to securitization. By the end of 2008, the amount of

covered bonds outstanding in Europe alone was approximately 2.38 trillion Euros, up

from 1.5 trillion Euros in 2003.

There is no formal international convention or treaty defining covered bonds. They

are instead defined, de facto, by their characteristics. Essentially they are long-term

debt securities that are secured by specific assets of the issuer of the bonds. The assets

so constituting collateral are called cover-pool assets. To the extent the cover-pool

assets are insufficient to repay principal and interest on the covered bonds, investorsin the bonds have an unsecured claim against the issuer for the insufficiency (dual

recourse).

As with any granting of collateral, the cover-pool assets are deemed to remain on the

issuers balance sheet (i.e., they remain owned by the issuer) for accounting purposes.

Unlike normal collateral, however, these assets are ring-fencedeffectively

segregated from the issuers estateto give covered bondholders greater protection inthe event of the issuers bankruptcy. Additionally, weak cover-pool assets are required

to be replaced by good-quality assets throughout the life of the covered bonds,

thereby maintaining a requisite level of overcollateralizationa surplus of collateral

value over indebtedness.

To ensure this is all enforceable by covered bondholders against other creditors of the

issuer, some countries have promulgated specific covered bond legislation (a

legislative covered bond regime). Absent such legislation, covered bondholders

must rely on contractual protections and related commercial law (a structured

covered bond regime).


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Covered bond and securitization transactions have significant similarities. The most

important is that both strive for bankruptcy remotenessthe goal of protecting

covered bond investors in the event of the issuers bankruptcy. Covered bond

transactions strive to achieve bankruptcy remoteness through ring-fencing or bylegislative fiat.

Securitization transactions achieve bankruptcy remoteness by having the company

originating the receivables (the originator) transfer those receivables, in a true sale

under bankruptcy law, to a bankruptcy-remote SPVsteps that can parallel ring-

fencing.

Another important similarity is that after covered bondholders are paid in full, andalso after securitization investors are paid in full, any residual value from the

transferred assets is returned for the benefit of other creditors.

There are, however, several differences between covered bonds and securitization. A

primary distinction is that covered bonds have dual recourse, whereas securitization

constitutes non-recourse financing. Another distinction is that, in covered bond

transactions, the cover-pool assets typically remain on the issuers balance sheet foraccounting purposes whereas, in securitization transactions, it has been more typical

for the transfer of assets from the originator to the SPV to be accounted for as a sale.

This accounting distinction is somewhat artificial, however. Securitization transactions

can beand increasingly arestructured as on balance-sheet transactions. The

absence of an accounting benefit does not undermine securitizations key fundraising

and risk-transfer functions. The dual recourse distinction, however, is more critical.

Securitization, much like a new-money loan, would not harm unsecured creditors of a

company to the extent it entails the exchange of one type of asset (e.g. mortgage

loans, automotive loans, or other financial assets) for another asset, cash. But

unsecured creditors can fare differently when a company issues covered bonds.


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Covered bonds are roughly equivalent to a securitization in their neutral immediate

impactunsecured creditors would only be harmed to the extent a covered bond

issue increases the issuers chance of bankruptcy or there is overinvestment of the

proceeds of the bond issue. Covered bonds, however, go beyond securitization in two ways thatcan harm unsecured creditors.

In a securitization, if the overcollateralization is insufficient to repay investors, the

investors suffer a loss because they only have recourse to assets that the SPV has

already purchased. The pool of assets available for repayment is, in other words,

effectively fixed or static. In contrast, in covered bond transactions, the cover pools

are usually dynamic, requiring the covered bond issuer to continually segregate newassets as needed to maintain overcollateralizationthereby enabling the covered

bonds to continue to be paid in priority to unsecured claims.

Covered bonds also go beyond securitization in their recourse. Whereas securitization

transactions are non-recourse, covered bonds have dual recourse. If, therefore, the

cover-pool assets are insufficient, covered bondholders have a recourse claim against

the issuer. That claim, being pari passu with unsecured creditor claims, would further

dilute unsecured creditor recovery.

As a result of the dynamic cover pool and dual recourse, covered bond transactions

thus shift virtually all risk to unsecured creditors. The extent to which risk should be

allocated so asymmetrically is an important policy question that should be addressed

by any governments and market participants exploring covered bonds as an

alternative to securitization.

8. CONCLUSION

The US sub-prime securitization market played an important role in contributing to

the global financial crisis. Significant regulatory reform efforts have since been


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undertaken to improve the disclosure and transparency for this asset class in general,

the eventual and cumulative effects of which are yet to be fully assessed. Once pre-

conditions for a recovery are in place, investor condense is expected to return,

allowing securitization to once again become an important channel for both debtmarkets and the general economy over the medium term.

During this transition period, it is important for market participants and regulators to

weigh the costs associated with regulatory changes versus the benefits that

securitization can offer though the redistribution of credit risk. The risk remains that

should a recovery in securitization fail to materialize, banks will be forced to raise

capital from other sources in order to meet heavy securitization redemption schedulesover the coming years. The financial sector depends upon a well functioning

securitization market, one that is built on simple structures and a high level of

transparency and disclosure. Creating the appropriate regulatory framework at the

current point in time will help ensure sustainability of the securitization market over

the longer term.

A sustained recovery in private-label securitization is unlikely to occur until policy

makers have enough confidence in their economies to allow securitization markets to

be weaned off government support. In this context, important steps are being put in

place that should allow the banking sector in developed countries to return to a

modicum of good health. Improvement in housing market conditions is also

important to re-establish confidence among consumers, investors and financial sector

participants. In the medium term, the US Administration is planning an eventual exit

from the securitization market by its government-sponsored agencies, in favour of a

return by private interests in the housing-related securitization markets. This process

is likely to take a number of years.


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REFERENCES

Adam J. Levitin, Andrey D. Pavlov, & Susan M. Wachter, Securitization: Cause

or Remedy of The Financial Crisis?, Institute for Law & Economics, University

of Pennsylvania Law School.Adrian, T. and H. S. Shin (2007), Liquidity and Leverage. Discussion paper,

Princeton.

Allen, F. and D. Gale (2007). Understanding financial crises, Oxford University

Press.

Allen, F. and E. Carletti (2008). The role of liquidity in financial crises, 2008

Jackson Hole Symposium.

Andrews, E. L. (2007). Fed shrugged as subprime crisis spread, New York

Times, December 18, 2007. also available at

http://www.nytimes.com/2007/12/18/business/18subprime.html.

Ashcraft, A. B. and T. Schuermann (2007). Understanding the securitization of

subprime mortgage credit, Federal Reserve Bank of New York.

Bank for International Settlements (2008). Credit risk transfer - developments

from 2005 to 2007.

Bernanke, B. S. (2007). The Subprime Mortgage Market, speech delivered at the

Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure

and Competition, Chicago, May 17,

Greenspan, A. (2008). We will never have a perfect model of risk, Financial

Times, 16 March, also available at http://www.ft.com/cms/s/0/edbdbcf6-

f360-11dc-b6bc-0000779fd2ac.html?nclickcheck=1.Haensel, D. and Krahnen, J. P. (2007). Does credit securitization reduce bank

risk? Evidence from the European CDO market, Working Paper, Goethe-

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Hodder, J. and Jackwerth, J. (2007), Incentive Contracts and Hedge Fund

Management, Journal of Financial and Quantitative Analysis 42, 811-826.

Nicolle,Tim, Introduction to Securitization http://www.riskltd.demon.co.uk/

Purnanandam, A. Originate-to-distribute model and the sub-prime mortgage

crisis, University of Michigan, (2008).

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Different? An International Historical Perspective, American Economic

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Shiller, Robert (2008), The Subprime Solution: How Todays Global Financial

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global securitization outlook

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