securitization and subprime crisis by falloul moulay el mehdi

8/9/2019 Securitization and Subprime Crisis by Falloul Moulay El Mehdi

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COMMUNICATION SCIENTIFIQUE SECURITIZATION AND SUBPRIME CRISIS

Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca) 1

Colloque International sur le Management et le Développement

(Ecole Nationale de Commerce et de Gestion de Casablanca)

SECURITIZATION AND SUBPRIME CRISIS

Ahmed HEFNAOUI

Enseignant chercheur,Chef de département des sciences économiques,

Université Hassan II Mohammedia,[email protected]

Moulay El Mehdi FALLOULDoctorant en économie et finance appliquée,

Laboratoire de performances économiques et logistique,Université Hassan II Mohammedia,

[email protected],

Abstract

Securitization had in the beginning a main objective which is facilitating the development ofthe credit activity particularly through Credit markets. This innovation has transformed thenature of the capital and consequently transformed the notion of ownership. Securitizationwas created for the purpose of risk management and mitigation, nevertheless it turns out that

this kind of innovation is very dangerous for the entire financial system because it contributesin the formation of speculative bubbles, the increase of the information asymmetry and thecreation and the spread of highly financial toxic assets. The subprime crisis is clearly the mainillustration of the danger of these practices. Indeed at the heart of the subprime crisis we findthe development of financial engineering and derivative products particularly securitizationwhich had increased significantly during the last decade, contributing in the development ofthe financial disintermediation and the transfer of the credit risk.

Keywords: Securitization, subprime crisis, information asymmetry, leverage effects, financialengineering.


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INTRODUCTION

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 and

selling said debt as bonds, pass-through securities, or Collateralized mortgage

obligation (CMOs), to various investors. The principal and interest on the debt, underlying the

security, is paid back to the various investors regularly. Securities backed by mortgage

receivables are called mortgage-backed securities, while those backed by other types of

receivables are asset-backed securities.

The recent international financial crisis has highlighted excesses in the use of financialinnovations and specifically the securitization of subprime mortgages. Indeed, this financial

innovation was at the heart of the recent financial global financial meltdown.

The crisis has spread by the widespread securitization of subprime mortgages; this type of

loans had been considered as a safe investment before the financial debacle. Securitization has

proved as a vector of complexity and risk propagation in the financial system. It

generates conflicts of interest between stakeholders and creates asymmetric information and

liquidity problems that are very dangerous to the international financial system.

In this article we will first analyze securitization as a sophisticated financial engineering

product by focusing on the different stakeholders, and the benefits that could be generated by

this process, then we will first present a chronology of events of the financial crisis and we

will try to locate the securitization in the context of this crisis while focusing on the

shortcomings that had produced this technique in the global financial system.


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1. The mechanism of Securitization

1.1 Overview of securitization

1.1.1 Securitization process and participants

A securitization operation involves a series of actors, which explains that at first glance, it

appears complicated and that it leads to a relatively high cost. Indeed the increase in the "cost

of entry" is justified by the fact that the operation is complex and requires precision.

1.1.2 The actors in a securitization process

Servicer

A servicer collects payments and monitors the assets that are the crux of the structured

financial deal. The servicer can often be the originator, because the servicer needs very

similar expertise to the originator and would want to ensure that loan repayments are paid to

the Special Purpose Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the

collection policy, which influences the proceeds collected, the charge-offs and the recoveries

on the loans. Any income remaining after payments and expenses is usually accumulated to

some extent in a reserve or spread account, and any further excess is returned to the seller.

Bond rating agencies publish ratings of asset-backed securities based on the performance of

the collateral pool, the credit enhancements and the probability of default.

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-

keeper of the assets that are being held in the issuer. Even though the trustee is part of the

SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to

protect the assets and those who own the assets, typically the investors.

Underwriter

Underwriters-usually investment banks- serve as intermediaries between the issuer (the

SPV or the trust) and investors. Typically, the underwriter will consult on how to structure the

ABS and MBS based on the perception of investor demand. The underwriter may, for

example, advise the SPV to issue different tranches each with specific characteristics


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attractive to different segments of the market. Underwriters also help determine whether to

use their sales network to offer the securities to the public or to place them privately.

Perhaps most importantly, underwriters assume the risk associated with buying an issue of

bonds in its entirety and reselling it to investors.

Special Purpose Vehicle and the Trust

The SPV can either be a trust, corporation or form of partnership set up specifically to

purchase the originator's assets and act as a conduit for the payment flows. Payments

advanced by the originators are forwarded to investors according to the terms of the specific

securities. In some securitizations, the SPV serves only to collect the assets which are then

transferred to another entity—usually a trust—and repackaged into securities. Individuals are

appointed to oversee the issuing SPV or trust and protect the investors' interests. The

originator, however, is still considered the sponsor of the pool.

Dealers

Just as in other bond markets, dealers play an important role once an issue is initially

distributed. For most bond investors, liquidity—the ability to easily buy or sell a security—isan important characteristic. By offering prices at which they will buy or sell bonds to the

investment community, dealers provide this service. Bonds typically trade more actively

closer to their date of issue. Because bond investors—usually institutional investors such as

pension funds and insurance companies—hold most bonds to maturity, trading in bonds

declines as they draw nearer to their stated maturity date. The issuance volume of a certain

bond, a bond's credit rating and whether it was issued publicly or privately can also affect

liquidity. All ABS and MBS are traded on the dealer-based, over-the-counter markets so

liquidity depends in part on the ability and willingness of dealers to maintain an inventory, or

make a market, in a certain bond.


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Figure 1: Basic Securitization process

Tasca & Zambelli: 2005:1


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1.2 Benefits of Securitization

The evolution of securitization is not surprising given the benefits that it offers to each of

the major parties in the transaction.

1.2.1 Benefits for Investors

Securitized assets offer a combination of attractive yields (compared with other instruments

of similar quality), increasing secondary market liquidity, and generally more protection by

way of collateral overages and/or guarantees by entities with high and stable credit ratings.

They also offer a measure of flexibility because their payment streams can be structured to

meet investors’ particular requirements. Most important, structural credit enhancements and

diversified asset pools free investors of the need to obtain a detailed understanding of the

underlying loans. This has been the single largest factor in the growth of the structured

finance market.

1.2.2 Benefits For Originators

Securitization improves returns on capital by converting an on-balance-sheet lending

business into an off-balance-sheet fee income stream that is less capital intensive. Depending

on the type of structure used, securitization may also lower borrowing costs, release additional

capital for expansion or reinvestment purposes, and improves asset/liability and credit risk

management.

1.2.3 Benefits For Borrowers

Borrowers benefit from the increasing availability of credit on terms that lenders may not

have provided had they kept the loans on their balance sheets. For example, because a market

exists for mortgage-backed securities, lenders can now extend fixed rate debt, which many

consumers prefer over variable rate debt, without overexposing themselves to interest rate

risk. Credit card lenders can originate very large loan pools for a diverse customer base at


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lower rates than if they had to fund the loans on their balance sheet. Nationwide competition

among credit originators, coupled with strong investor appetite for the securities, has

significantly expanded both the availability of credit and the pool of cardholders over the past

decade.

1.2.4 Benefits for the transferor

A new source of financing

Securitization enables to change the illiquid portfolio into liquid stocks, which enables to «

sell » the portfolio, not to an investor anymore, but to many investors, meaning to funds

markets, and a market with an important number of investors, present throughout the world.

Transfer of risks

The risk of loss on the portfolio went on the investors, which means that if the portfolio

appears to be of bad quality and if the flows generated are insufficient, it is the investor that

will undergo, if necessary, a financial loss. However, it is rare for the whole risk to be

transmitted to the investors. In general, some mechanisms are set so that the assignor keeps

what we call the «first risk» on the portfolio. For banks submitted to a control of risks by their

controller, securitization, used as a risk transfer tool, is therefore particularly important.

Balance-sheet management

Securitization enables to manage the balance-sheet by controlling its inflation if it is

considered as being excessive. Indeed, by refunding the credit portfolio, an assignor liberates

funds and can increase his activity or generate new assets while keeping his balance-sheet at a

controlled level, for the assets went out of his balance-sheet.


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2. Securitization and the financial crisis

The recent international financial crisis has highlighted excesses in the use of financial

innovations and specifically the securitization of subprime mortgages. Indeed, this financial

innovation was at the heart of the recent financial global financial meltdown.

This financial engineering technique had acted as a propagator of the financial crisis by its

uncontrolled use: massive refinancing of the American mortgage by securitization of

subprime mortgage loans (ABS), resecuritization of the ABS in complex products (CDOs),

dissemination of these products throughout the international financial system. As the

downturn in the US housing market began, the credit risk of subprimes unraveled: defaults

accumulated, leading to suspicion on securitized products (ABS, CDOs), these complex

products had begun to collapse with the rise of the Banking panics which had dried up a

source of funding at the heart of the global financial system.

It has also created holes in the balance sheets of financial institutions holding these toxic

products whose market value had sunk dramatically, securitized products had became dirty

financial products and no one wanted to buy them. We devote the next section to discussing

and analyzing the role that had played credit derivatives and securitization in the international

financial crisis. But we should first give a brief chronology of major events in the subprimecrisis, and then we will discuss the crisis transmission channels at the center of the recent

financial crisis, and finally we will analyze three major elements in the originate to distribute

model which, asymmetric information, liquidity problems and leverage effect.

2.1 A brief chronological review of the crisis

The trigger of the global financial crisis is undoubtedly the subprime mortgage market

collapse whose symptoms appeared in the summer of 2006. Before explaining the chaining of

the crisis (see annex II), it is worth mentioning the different types of mortgages In the US

Mortgage market.

Indeed, the U.S. residential real estate market is dominated by two types of credits: the first

type called (conforming loans) granted to less risky borrowers ( prime borrowers) this credit

mortgage loan is conform to the standards of warrants issued by governmental agencies


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(Government sponsored agencies GSE ), and the second type of loans called (non-conforming

loans) which are not consistent with the standards of the GSE's) that include the Jumbo, alt-A

and subprime.

The Jumbos includes loans to prime borrowers with an original principal balance larger than

the conforming limits imposed on the agencies by Congress (this limit is currently USD

417.000);

The alt-A asset class involves loans to borrowers with good credit but include more

aggressive underwriting than the conforming or Jumbo classes (i.e. no documentation of

income, high leverage);

Subprime mortgage asset class involves loans to borrowers with poor credit history.

Subprime mortgage is at the heart of the international financial crisis called Subprime crisis,

specifically the sub-prime are real loans granted by (not subject to bank regulation) brokers

to us household low-income considered insufficient to ensure repayments. These lending

institutions based on anticipation of increase in the value of these properties that could then be

a sufficient guarantee or to get out of debt by reselling the property. In other words, taking

advantage of the rise of the real estate market, these companies have, through techniques of

aggressive selling, encouraged households to engage in real-estate speculation.

These credits were accompanied by a significant margin precisely because borrowers were

below market standards (subprime).

However, the US housing market has been reversed in the third and fourth quarters of 2005.

This downward trend of home prices had accompanied a decline of credits to households as

shown in the following graph.


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Figure 2: The evolution households’ credits and home prices in the USA in %

The borrowers’ defaults appeared in the first quarter of 2006 and delays for deadlines

increase in mortgage loans other than sub-prime mortgage credits, home prices had plunged.

Throughout 2007, the defaults had been growing. The increase in number of default of

borrowers had led naturally to an increase in home foreclosures as shown in figure 33.


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Figure 3: Number of home foreclosures in the United States, in thousands

In June 2007 the Investment Bank Bear Stearns announced the collapse of two of its hedge

funds who have invested in subprimes. While the wave home foreclosures of subprime

borrowers (high risk borrowers) kept going, markets discovered that low quality securities

that will now take the nickname of "toxic» have been invested in the markets to boost their

performance by forgetting to inform that they are backed by insolvent households.

A few weeks later, we learn that the German bank IKB is in difficulty, indeed it has placed

through the Rhineland investment fund, more than 17 billion in toxic financial products. In

France: Oddo (subsidiary of French bank BNP Paribas) Corporation announces that it freezesthe subscriptions and redemptions on funds exposed to the subprime mortgage.

Following these accidents, market players are beginning to realize that the phenomenon of

toxic products scattered among investors is not that of saving corporations in The USA, but

no doubt of many others around the world.

These elements have sown a motion of no confidence to market players, as they begin to

realize the extent of the risks associated with these products and the difficulty locate and

evaluate them. This general risk aversion behavior was at the base of first true stock slip of


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the financial values in global financial markets while, throughout the first half of 2007, the

courses of these values remained in line with the General indices.

This movement now does not cease to grow. Indeed, in September 2007 in Britain, queues

of customers formed at the gate of the fifth-largest bank of the country, Northern Rock, tocarry out withdrawals of their deposits. The Bank of England granted Northern Rock an

emergency loan to avoid bankruptcy. At the same time, the European Central Bank (ECB)

and the Federal Reserve System (FED) begin granting cash in exchange for financial toxic

products. Before the end of 2007, large international banks such as Citigroup and UBS and

other US banks or European announce provisions on their sub-prime portfolios.

The year 2008 is as a black year for the financial world, indeed it begins with a big bad

news from the American Bank Meryl Lynch which States have lost on the fourth quarter

nearly 10 billion dollars on derivatives financial products. Another bad news is the

announcement of nationalization of Northern Rock, the virtual bankruptcy of Bear Stearns

bought by JP Morgan with the help of the US Treasury. Meanwhile, the FED lowered interest

rates, to help refinancing investment banks. The IMF evaluates the financial system's losses to

nearly $ 1 trillion (or $ 1 trillion).

End of June a shocking information coming from the United States ;AIG, the largest

insurance company in the world, was also hit by the spectrum of the crisis, mired in the CDS

market and toxic securities and must be rescued and government sponsored enterprises

,Freddie Mac and Fannie Mae, which are in early September, under the authority of the

Treasury.

On Global stock markets, the panic began cracking down. Accelerate the sales of

securities, restructured portfolios and speculative short sells. July 15, 2008, the French indices

and New York indices compared to early January, respectively-28% and -18%. Against its

nature, the price of a barrel of oil turned and began to move down. All cash and derivatives

markets and all financial markets, including financial markets of the emerging countries, are

of extreme volatility.

September 15th, 2008 was the beginning of the banking crisis following the decision by the

US authorities of not to rescue the 4th largest Bank in United States Lehman Brothers. Indeed

this substantial signal has shown to the market that any bank could disappear without the

intervention of the central bank to recue it, an event which gave rise to a movement of general

distrust of banks to all their banking correspondents. The lack of transparency increases the

aversion to risk in times of stress, promoting a complete drying of the liquidity.


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The domino effect could be put in place because no one knew exactly where Lehman

Brothers was ‘counterparty risk and the value of this risk what. Lehman reported having at

least 85 billion of toxic assets, which are on the market of the CDOs and CDS, which makes

their valuation a disastrous situation for all counterparty institutions.Banks, in front of the opacity of the situation, stopped feeding lines of credit. The money

market is frozen. The first victim is AIG it was about to go bankrupt (its stock price crashed

losing about95% of its value). The only alternative is the nationalization! Lehman Brothers

having sunk, Bear Stearns, having been taken over by JP Morgan for a trivial value, Merrill

Lynch was acquired by Bank of America. A few days later, the last two banks of investment,

Morgan Stanley and JP Morgan, took the status of universal banks. All the giants of the

American Bank are now regulated.

Now, the financial world plunged into a crisis without precedent. On the stock market,

financial values show historical decreases, followed by the rest of the values. The major

indices lose between 2 September and late October, 31% for the Standard and Poors 500, 25%

for the CAC 40. Now, the world of finance immersed in a severe crisis of confidence, this

catastrophic situation, States took urgent measures to save their banking system. Indeed,

central banks granted banks daily liquidity, moreover these institutions coordinate a historical

global cut in interest rates. The States have developed rescue plans of bankrupt institutions. In

this context, stimulus plans have been proposed, these roadmaps objectives guarantee the

banks on their loans and deposits and recapitalize those who are most in difficulty. First the

Paulson plan with a $ 700 billion to the United States, and the European plan of 1 700 billion

Euros (which is an attempt to develop a general plan that aggregates the European national

plans under the impetus of the French Presidency of the European Union). In each of the

countries, States bring cash or equity or quasi permanent financing specific to institutions in

difficulty. According to the IMF the loss of banks, was amounted at end January 2009 to 2

200 billion, a figure which maybe 16 times undervalued in the eyes of some other

stakeholders. It is in this context and at the request of Europe that brings to Washington a G20

(see annex III) which had set a number of recommendations that have never seen the day.

The question that arises here is;

How a crisis on a segment of the real estate market in the States is transformed into a global

economic crisis?


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2.2 Channels of crisis transmission

The following figure shows the transition from a markets crisis to a global economic crisis,

and the channels of the crisis transmission.

Figure 4: a crisis in three time: markets, banks, real economy

The sub-prime crisis has spread to a certain structured products because these sub-prime

credits entered in the composition of these complex financial products, and then to all

structured products because there was doubt the composition of this securitized products. At

the same time, these products have experienced a wide dispersion in the whole financial

system throughout securitization.

Structured products are difficult to understand because of the complexity of this kind of

products. So to facilitate the sale, these products were rated by rating agencies. The sub-prime

crisis has naturally resulted in a degradation of the rating of structured products and therefore

a distrust of investors.


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This element explains well the transition from a phenomenon of market to the banking

crisis. Indeed the degradation the rating of structured products has generated difficulties for

vehicles "SIV" because they hold them in their assets, and because these vehicles couldn’t

anymore fund them by issuing commercial paper "ABCP" (see annex IV). To ease thissituation, the vehicles used liquidity lines which had been granted by the banks.

Two specific propagation channels explain the transition from a market crisis (sub-prime) to

a financial crisis (commercial paper ABCP market) and then to a banking crisis, liquidity and

valuation.

2.2.1 The liquidity

The drawing of the lines of bank liquidity granted by banks to their vehicles is

accompanied in many cases with a phenomenon of re-intermediation by the banks. This

phenomenon has had an impact on the balance sheet channel. Indeed many financial

institutions have reinstated operations, either because of financial ties (liquidity lines), and

either for reasons of notoriety (avoiding the materialization of a risk of reputation). This

channel of balance occurs in two ways:

-The reintegration of the stock of liquidity of "SIV" vehicles.

-The inability to securitize new assets.

2.2.2 Valuation

The fact that these financial products have been registered in accounting at their market

value caused a problem in their funding. Indeed the degradation of the rating of these

financial products led to a reduction of their value. In fact; investors removed from the market

and have no more wanted to buy this type of product, this had of course led to a draining of

liquidity which has in turn maintained a reduction in their value and the engagement of a

vicious circle. This phenomenon has had a significant impact on financial institutions through

the profit and loss account, which generated a crisis of the real economy via the restriction of

credit.

Next, we will analyze the role that had the securitization in global financial crisis.


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2.3 Securitization, transfer of risk and information asymmetry

In the United States of America, the existence of banks was based on a model in which they

granted credits and keep their value on their balance sheet until the maturity date. This model

called originate-to-hold has clearly been exceeded with the development of securitization: the

activity of the banks has indeed changed over the past decades, with the gradual development

of an originate-to-distribute model. They were able to free themselves from certain

constraints related to the production, distribution and marketing of credits. Thus securitization

allowed banks to clean up their balance sheets of risky credits that they were obliged to keep

in their balance sheets till the maturity date. Moreover, banks can even redeem credits granted

by other financial intermediaries, to unite them and then transfer them to off-balance sheet

vehicles to securitize them, securities so issued was then purchased by other banks, insurancecompanies and other investment corporations.

In theory, securitization is intended to improve the efficiency of the financial system as a

whole allowing a better spread of risk. In practice this technique could lead to substantial

increase of risks and complexities in the financial system. Indeed, risk transfers generated by

securitization has developed among the originator a lax attitude vis-à-vis the risk analysis

(screening) and tracking (monitoring). Therefore, the amount of the credits in the system

rises, their quality deteriorates, funds that guarantee them are more and more low, and the risk

taken by the purchaser of the securitized products increase.

The securitization process games many players, and operations in this process are complex

and costly. Securitization generates conflicts of interest between: the originator (the

transferor), arranger, Management Company, the paying agent (servicer), credit Enhancement

Companies, credit rating agencies, the guardianship authorities, and investors.

In their article, "understanding the securitization of sub-prime Mortgage Credit the" (2008),Aschcraft and Schuerman compile a list of sources of conflicts or frictions generated by

securitization which are represented in the following figure.


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Figure 5: Key players and Frictions in Subprime Mortgage credit securitization

Adam B. Aschcraft and Til Schuerman, March 2008,

1. Conflicts of interest between the mortgagor (the mortgage holder) and the originator:

abusive loan;

2 Conflict of interest between the originator and arranger: mortgage fraud;

3. Conflicts of interest between the arranger and third parties: adverse selection;

4 Conflicts of interest between the claimant and the mortgagor: moral hazard

5. Conflicts of interest between the claimant and third parties: moral hazard

6. Conflicts of interest between asset manager and investor: Agent-principal

7. Conflicts of interest the investor and the rating agencies: the model error

In the United States sub-prime crisis showed clearly the problems of information

asymmetry that can cause the securitization, thus causing a lack of general transparencywhich can be very dangerous for the financial system as a whole. Traditionally, these


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problems of information asymmetry were limited since securitization transactions were

generated by good quality loans. But in recent years these financial operations were generated

by subprime mortgage loans. The following two graphs illustrate this trend.

Figure 6: Portion of securitized prime credit mortgage and subprime credit mortgage

Patrick Arhtus et al, La crise des subprimes, conseil d’analyse économique, Paris(2008)


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The figure above illustrates not only the increase in subprime mortgage loans, but

particularly in the share of subprime mortgage loans securitized. We note that in 2001, the

securitization of premium products (approximately three-quarters of the originated products)

were more important than the subprime (about half of the originated products). Due tocompetition and declining interest rates, the share of securitized loans increased for both

categories, but not at the same rate, since the emission/origination of premium products ratio

known variation about 15 percent (from 76% in 2001 to 87% in 2006) against a change in

spectacular sub-prime by 63% (46% in 2001 to 75% in 2006).

The massive sub-prime securitization combined with the complexity of some products

amplified the problems of information asymmetry that locate mainly in the ring that binds the

originator and the investor in the chain of securitization.

Another problem related to the securitization is caused by the relationship between the

assignor and the specialized vehicle (located in a tax haven), in fact it is the grantor that

creates the vehicle for the occasion, which means that securitization does not allow an

important risk transfer as mentioned in theory.

Securitization allows Banks to transfer part of risk, nevertheless it incentive to take

advantage (Franke and Krahnen 2006). Accordingly, it seems that securitization, contrary tothe idea that it would foster the stability of the system by allowing a better spread of risks,

lead in fact to an amplification of these risks.

2.4 Securitization and the liquidity problems

To be readily negotiable assets, it must become a common transaction product that is

standardized to some extent. More an asset has a transparent economic value, whose

characteristics can be easily understood by a broad base of investors, more its potential

liquidity is important. Indeed, the standardization of financial products reduced the need for

recourse to costly investments to obtain detailed information and reinforces the certainty of

the nominal value attached to any assets.

In this perspective, the creation and development of an organized market for derivatives

have simplified the process of negotiation of many products by defining a common investor’s

informational framework. When the base of the securitization process relies on homogeneous

claims. He can then generate information about the pool of underlying assets and reducesinformational costs to investors. The pooling of homogeneous assets is a way to reduce the


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problem of adverse selection because the performance of a group of pooled assets is more

predictable than those of individual assets. Indeed, investors can more easily distinguish

between the sellers of good and bad products. In addition, the slicing through revenues from

the pool of assets according to their risk of failure reduced moral hazard problems, when theseller agrees to bear the first losses.

However, for a large part, the creation of asset-backed securities (are OTC) not

accompanied by information necessary to market participants to control fully the risk of their

investments. Indeed structured products faced this cognitive problem which is increasing the

costs of information relating to those products which limits significantly the investor base. As

the centralization of information institutions, rating agencies can in principle alleviate this

cognitive problem without solving it. This observation is especially true for market liquidity

risk which can be apprehended by a simple rating.

It is remembered that the accumulation of several strata of securitization, which largely

characterizes complex products markets, tends to hide the amount of commitments and

leverage in the market. This situation causes significant valuation difficulties, especially for

products which are very rarely negotiated and which cannot be compared with similar assets.

Normally, or if these products are part of a strategy of detention to maturity (buy and hold),

this feature is not prejudicial to market liquidity. But it can become a serious threat in the case

urgent requests for liquidity.

The difficulty of assessing certain assets composed of structured products is in itself an

essential cause of the spread of liquidity crises. In General, the emergence of an important

flow of orders for sale on an asset is likely to give rise to the suspicion of privileged

information of donors of order on this asset quality, and bring potential buyers requiring a

significant haircut on the price in return. This fall in prices may even lead to the complete

disappearance of transactions, as demonstrated, particularly, in the compartment of

commercial paper (ABCP) asset to the United States when the subprime crisis-backed,

economic agents were being suddenly become reluctant to buy this type of securities.

More products are adapted to the needs of a specific client; they are more subject to such

access of mistrust on the part of investors. It is precisely for this reason that a liquidity crisis

which originated in complex structured products markets is manifested in a "flight to

simplicity" to benefit, including US Treasury bills. This rush to the simplest to understand

assets can have negative effects even for the markets it is likely that from now on, investors


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needs permanent liquidity (asset managers and funds related to the banks) will decide to turn

to forms simple or extremely standardized securitized instruments (securities-backed pools of

homogeneous assets). To other investors that may keep the assets maturity (life insurance

companies, pension funds) are in principle in a more favorable situation to invest in illiquidstructured products such as CDOs, because they are more interested in the flow of revenues

generated by these assets by their market value at a given time. Total securitized financial

system is particularly exposed in some standardized and opaque compartments, upgrading and

confidence crises. Where the risk of a sudden loss of confidence and an interruption the

activity of market (market-making) with disruptions affecting the liquidity of the assets

underlying markets.

2.5 Securitization and leverage effect

The lever effect that generate credit products and particularly structured credit CDOs or

ABS type, products had a major role in this crisis. Indeed, the creation and the multiplication

of these products is one of the most significant factors in the outbreak of this crisis.

Take it for instance the following example to explain this problem of leverage effect:

First suppose the existence of a hedge fund that has leverage of 2. At this point there is

nothing to worry about. Suppose now that a part of the equity capital of this Fund is provided

by a Fund of funds which has a leverage of 3. Finally, suppose that the hedge fund investing

in subordinate tranche CDO debt which got a leverage of 9. If we calculate the total of this

operation, we realize that each million of obligations of CDO is supported by less than

€20000 capital (or more specifically 1000000/54 = 18518.5). In this situation, if the price of

final investment, here the obligation falls more than 2%, all the capital that supports this

investment is completely lost.

Figure No. 9 shows the disastrous situation in which structured products were able to be

transformed into toxic and extremely dangerous products because of the unbridled use of the

mechanism of the leverage effect.


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Figure 7: Securitization and leverage effects in the United States

Federal Reserve Bank of St. Louis.


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American sub-prime mortgages have mixed with other categories of residential mortgages

(Alta A, premium, and the FHA / VA) forming products called RMBS (Residential Mortgage

Backed securities), RMBS were mixed too with other claims such auto loans, student loans,

etc. to form ABS (Asset Backed Securities) allowing the loan originators to avoid regulatory

constraints, but especially an optimization of their performance and risk transfer.

By analogy to the example of the hedge fund cited above, bonds backed with subprime

mortgage loans have in turn been resecuritized in new vehicles, forming a CDO of ABS, these

products have been resecuritized a second time forming CDO2, which are extremely complex

financial products securitized in its turn to form CDO3 purchased by American investors.

This situation of extreme complexity can be described as a glass of water completely filled

and who could not tolerate no bucket.

This situation had spread around the world through securitization causing catastrophic

losses in large financial institutions (too big to fail institutions) considered to be institutions as

being symbols of financial capitalism such as AIG, Meryl Lynch, UBS, BNP Paribas….


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CONCLUSION

In theory, securitization is intended to improve the entire financial system as, allowing a

better spread of risk. In practice the misuse of this technique leads to an increase of financial

risks and complexity in the financial system.

Securitization generates conflicts of interest between: the originator (the transferor), the

arranger, the management Corporation, the paying agent, credit agencies, the monetary and

financial authorities and investors.

The mass Securitization of sub-primes combined with the complexity of certain financial

products amplifies the problems of information asymmetry which is located primarily in the

ring that binds the originator and the investor in the securitization chain.

In other hand, securitization generates problems of draining of liquidity that may be

harmful to the entire financial system.

The leverage effect that generate credit products and particularly structured credit CDOs

and ABSs, had a major role in this crisis. Indeed, the creation and the multiplication of theseproducts is one of the most significant factors in the recent crisis outbreak and development.


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REFERENCES

[1] Adam B. Aschcraft and Til Schuerman. (2008) “understanding the securitization of theSubprime Mortgage” Credit, Staff report no. 318, Federal Reserve Bank of New York.

[2] Demyanyk, Yuliya S. and Van Hemert, Otto. (2008) ‘’Understanding the subprime

crisi’’ Available at SSRN: http://ssrn.com/abstract=1020396.

[3] Lamya Obay. (2000), “Financial innovation in the banking industry”, Garland Publiching

Inc. New York.

[4] Michel Aglietta et Antoine Rebérioux. (2004), ‘’Dérives du capitalisme financier’’,

Bibliothèque Albin Michel Economie.

[5] M. Aglietta. (2008), ‘’10 clés pour comprendre la crise, le nouvel observateur’’, n 2290.

[6] M. Aglietta. (2008), ‘’Comprendre la crise du crédit structuré, la lettre du Centre d’études

prospectives et d’information internationales’’, N 275.

[7] M. Aglietta, L. Moreau, M. Roche. (2008)), ‘’De la crise financière à l’enjeu d’une

meilleur évaluation des crédits structurés’’ Université Paris X Nanterre.

[8] Michel Dietsch et Joel Petey. (2003), ‘’ Mesure et gestion du risque de crédit dans les

institutions financière’’, Revue Banque édition.

[9] Monique Bourven et M. Yves Zehr. (2009), ‘’La crise bancaire et la régulation

financière’’, Avis et rapports du conseil économique, social et environnemental.

[10] Olivier Mellennec. (1999), ‘’Asset backed Securities, guide pratique pour investisseurs,Groupe’’, SG Paris.

[11] P. Arthus, J P Betbeze, C. De Boissieu, G. C .Blancard. (2008), ‘’La crise des

subprimes’’, rapport rélaisé au conseil d’analyse économique par Christine Carl, la

documentation française paris 2.

securitization and subprime crisis by falloul moulay el mehdi

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