Securitization

Securitization describes the process of pooling varying debt instruments and selling their cash flows (receivables) to third party investors. Examples include residential mortgages, commercial mortgages, student loans, auto loans or credit card debt obligations. These cash flows can be bond type payments, or pass-through securities which funnel amortized principal and interest payment. Collateralized debt obligations (CDOs) slice and dice payments so a hierarchical flow prioritize payment first to some investors but not all. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Securitization and the Credit Crisis 2008 - 2011

Securitization was set up in the United States to largely benefit homeowners, lenders, investment bankers, and investors. Although ultimately the latter paid a heavy price in terms of losses to portfolios in the 2008 - 2011 period. Lenders earned fees for originating and selling loans. Investment banks earned fees for issuing mortgage-backed or CDO securities. Structurers, raters and CDS sales personnel all extracted fees from securitization. Securitization is a excellent technique for managing (1) Cost of funds and profitability (2) Asset-Liability mismatches (3) Credit Risk however during the go-go years of the early 2000s excesses built up and the key actors in the securitization process seemed to lack skin in an increasingly fragmented and disaggregated process.

Derivative and Banking Deregulation and Reregulation

These securities commanded a higher price than if the underlying loans were sold individually. They may have been more fairly priced if a clear policy of health coverage unified completing political interests. Markets were rigged with a regulatory nod and investors bought it because in theory there were getting a more diversified and seemingly liquid portfolio of instruments guaranteed by government agencies or wall street engineered CDSs. The CFMA and private law set out by ISDA master agreement was hardly ever challenged in the courts. Purchasers of the safer CDO tranches ostensibly produced a higher rate of return than ultra-safe Treasury notes without much extra perceived risk. While roadblocks appeared in Washington to put into effect Canadian style Health Insurance - no similar roadblocks disrupted policies designed to encourages home-ownership. However, the financial engineering behind these investments made them inscrutable and difficult to value relative individual loans. To determine likely returns, investors had to calculate the statistical probabilities that certain kinds of mortgages might default, and to estimate the revenues that would be forfeited implicit in those defaults. This complexity transformed the fortunes of the three leading credit rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—into key players in the process. Like many other stakeholders they lacked real skin in the game and collected a fee based on volume. Before securitization became common, the credit rating agencies advocated for investors protections and evaluated the safety of municipal and corporate bonds and commercial paper. Securitization permitted banks to engage in regulatory arbitrage and obviate the need to subject oneself to Basle capital charges. This fueled growth in Banking and then Derivatives until the property market tanked. This inevitably produced a volte face at Capitol Hill and regulation was tightened. Dodd Frank (2010) set out key provisions that forced the hand of OTC trades to be executed through CCPs.