Global Financial Crises and the Future of Securitization

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GLOBAL FINANCIAL CRISES AND THE FUTURE OF SECURITIZATION

Contents

1. Introduction……………………………………………………………………...3 2. Overview………………………………………………………………………...3 3. Structured-finance securitization ………………………………………………..5 4. Key segments of the securitization market………………………………………6 5. Rating Agencies Deficiencies....................………………………………………8 6. Future of Structured-finance securitization……………………………..……...10 7. Conclusion................................................…………………………………...…11 8. References………………………………………………………………….......12

LIST OF FIGURES

Figure 1. Securitization markets: key participants…………………………………4 Figure 2. European securitization issuance 2002-2010…………………………….7 Figure 3. American securitization issuance 2002-2010…………………...………..7

1. Introduction

This case describes and analyzes how securitization and structured products work and the value they add to finance, and how structured products are constructed, their value and how they are used in finance. The 2007 – 2009 financial crisis was a key catalyst for the global liquidity crisis that mutated into a full-blown credit crisis, bringing the international financial system to the edge of the abyss. In hindsight, the numerous structural shortcomings of the structured- finance securitisation market - particularly in the US - may have seemed obvious. The misalignment of incentives was evident in every link along the structured-finance securitization chain. Proper risk evaluation was not always undertaken by professional investors and intermediaries, while too much faith was put in credit rating agencies whose own methodologies for valuing complex structured finance products were at times flawed. In addition, other gatekeepers of the public trust including auditors, securities lawyers, regulators and supervisors failed, to varying degrees.

2. Overview

In general, securitized instruments can be defined through three distinct characteristics[1]: 1) pooling of assets (either cash-based or synthetically created); 2) delinking of the credit risk of the collateral asset pool from that of the originator, usually through the transfer of the underlying assets to a finite-lived, standalone special purpose vehicle (SPV); 3) tranching of liabilities (ie issuance of claims with different levels of seniority) that are backed by the asset pool. One implication of the pooling and tranching that characterizes securitization markets is the need to involve a relatively large number of parties in the securitization process (Figure 1). Figure 1. Securitization markets: key participants

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The process starts with the originators, who extend loans or other forms of credit to ultimate borrowers. Those originators who, in the ordinary course of business, do not retain a portion of the loans that they have extended will have weakened screening incentives, something that may be exacerbated by business models emphasising volume over quality. Credit rating agencies have been another important part of the process, supplying investors with assessments of the credit risk (expressed as expected loss or probability of default) of securitized instruments. Because of the high proportion of their rating revenues derived from structured finance prior to the crisis, rating agencies may have been encouraged to rate highly complex products for which little or no historical performance data existed. At the end of the securitization chain, investors are usually expected to exert discipline on other parties involved in the production process through the price mechanism.

3. Structured-finance securitization

Securitization has traditionally offered banks with a key source of long-term funding, and thereby allowed for improved balance sheet management. It has been credited with increasing the availability of credit, while decreasing its cost. Investors also benefit from securitization by gaining direct risk exposure to diversified sectors of the economy. More...
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