The Role of Securitization during the On-Going Financial Crisis - Essay Example

The role of securitization during the on-going financial crisis Student Name Tutor Course Code Date Table of Contents The role of securitization during the on-going financial crisis 1 Introduction 3 The subprime crisis and the housing bubble 3 Securitization 5 The Securitization of mortgages in United States 6 Impact of securitization on investors, consumers, capital markets, 6 and financial institutions 6 Impact of securitization on cost of credit 9 Impact of securitization on availability of credit 10 Impact of securitization on dispersion of risk 11 The credit crisis and the function of securitization 12 Effect of securitization on incentives 13 Housing prices as the major trigger of the credit crisis 15 Conclusion 16 Bibliography 17 Introduction The ongoing financial global financial crisis was triggered by the liquidity shortfall in the US banking system. Financial crisis has led to collapse of huge banking and financial institutions, bailout of banks by state governments and downturns in the stock markets around the globe. The house market has suffered form the financial crisis resulting to several foreclosures, evictions and prolonged vacancies of houses. The started in July 2007, with credit crunch, with the credit squeeze, when a loss of confidence by the US investors in the worth of Sub-prime resulted to a liquidity crisis, which in turn led to federal bank bringing in an increased amount of capital into monetary markets. In September 2008, the disaster had deteriorated as stock markets around the globe crashed and became more volatile1. The subprime crisis and the housing bubble The United States housing market greatly suffered as several home owners who had taken sub-prime loans recognized that they were not able to meet mortgage repayments. The subprime significantly increased the rate of ownership in United States and approximately five million people shifted from tenants to homeowners. Consequently, rents decreased and prices of houses increased and reached untenable levels relative to tents2. Nevertheless, in contrast to stock market, in real estate market when the prices of assets rise, more assets are developed through construction. Between 2001 and 2007 building of new home units significantly exceeded the new household constructions and this housing bubble couldn’t grow up substantially. Therefore, when the increase in prices of housing ended in 2006, inescapably several subprime borrowers experienced problems in repaying their mortgages. The housing bubble and especially the extremes of subprime mortgage market became more evident when several subprime lenders started declaring bankruptcy in March 2007. This difficulty begun to attain crisis proportions and Federal Reserve and financial authorities saw it as an isolated phenomenon. Instead in June of 2007, losses within subprime mortgage markets elicited astonishing mayhem throughout global financial scheme, given the assumed small size of United States subprime market in contrast to the international financial markets. The crisis extended with an amazing rate to additional markets and to financial institutions that did not have direct exposure to subprime mortgage market. Confidence in numerous monetary institutions was reduced and stock market experienced systemic weakness across fiscal sectors. The share prices f small, investment and large banks all considerably went down and between July 2007 to March 2008, lost approximately a third of their worth. Banks stopped trusting each other and lending between banks was disrupted. As home values plummeted, borrowers’ experienced negative equity and with many borrowers defaulting on their loans, banks found themselves in a situation whereby the repossessed land and houses were worth less on modern market than the banks had initially loaned out. The banks were faced with liquidity crisis and obtaining and giving loan became greatly had as fallout from subprime lending bubble exploded. March 2008 was marked with downfall of Bear Stearns, in July the same year IndyMac Bank went to receivership, and the greatest fall was the bankruptcy of the Lehman Brothers in September of 2008. On 28 September 2008, it was pronounced that Fortis, a large finance and banking firm was to be semi-nationalized with the Luxembourg, Belgium and Netherlands investing more than 1.1 billion Euros into the firm. On September 29, it was pronounced that the United States bank Wachovia would be sold to Citigroup but the bank picked on a more suitable bid from Wells Fargo and the values of stock markets dramatically fell in both Europe and United States. The financial scheme was in critical situation and following the events in September 2008, the crisis went up and the financial crisis spread far beyond financial markets, now directly affecting the mainstream too. Securitization Securitization is a financial undertaking of pooling several forms of contractual debts like, commercial mortgages, residential mortgages, credit card debts or auto loans obligations and selling the said debts as pass through securities, bonds or collateralized mortgage obligation to numerous investors. Since 1980s, securitization has been used as a tool of generating liquidity for lenders and increasing availability of capital for various corporations and consumers. The mortgage market is the greatest in employment of securitization technology. The process of securitization entails the development of a special purpose vehicle entity or the trust, which then becomes the owner of loans. The trust is often a bankruptcy remote, special purpose vehicle which underwrites securities. This trust structure is employed since it is exempted form taxes, enhances originator to treat a transaction as a loan sale and protects investors from liabilities of issuer and originator. A mortgage backed security is refers to a bond whose flow of cash is attained form the principal and the interest payment of the mortgages. The Securitization of mortgages in United States The emergence of securitization market over the last years has had numerous beneficial impacts on capital markets. Through introducing a novel class of debt instruments, and permitting access to novel participants to the market, securitization has deepened capital markets. It enhances Originators to dispose off assets in an effective manner and to attain an increased financing profile and improved funding terms. It enables investors to spend on assets, and has highly resulted to availability of exceedingly rated bonds to investors. Securitinization has assisted in developing and promoting other markets. For example, the United States government, via two governmental agencies, the federal home loan mortgage corporation (Freddie Mac), and the federal national mortgage association (Fannie Mae), has been capable to promote ownership of home through stimulating mortgage market. Freddie Mac and Fannie Mae purchase mortgages from the lenders and fund their undertakings through securitizing these mortgages3. Impact of securitization on investors, consumers, capital markets, and financial institutions Securitization generates value through reduction of intermediation costs and increasing chances for sharing of risk and risk diversification. Securitization develops a novel source of liquidity for originators of numerous forms of loans through enhancing them to transform illiuid loans into saleable securities. Securitization permits originators to monetize assets, therefore minimizing their sensitivity to the shifts in the accessibility of exterior sources of funds and minimizing the threats of origination. Securitization acts as an innovative instrument in lowering the cost of financing and expands sources of credit that are available to monetary institutions. Securitization efficiently disperses risk amongst several investors and reduces information irregularities, which come up when a single party has better or more information than the other parties4. Securitization plays significance in minimizing information asymmetries. Securitizations are more favorable to deposits as a finance mechanism for banks. This is because when a banking institution has better or more information than the investor or depositor, securitization can solve any information irregularities through permitting banks to indicate their assets quality by the amount of credit enhancements. In this approach, in an atmosphere where there is no government deposit insurance, banking institutions would choose to securitize the superior credits and maintain the poorer quality banking institutions in their records. Nevertheless, with complete deposit insurance that is cheaply priced and with low requirements of bank capital, bank deposits are the principal source of financing, even in the case of higher quality banks. Securitization allows several corporations to obtain finances at a reduced cost than through equity and debt. The cost of debt financing is dependent on the credit rating which is based upon the quality of credit of the corporation. Financing is greatly expensive for corporations that have low ratings since they are required to put in credit enhancement or increase coupon on their bonds. Securitization allows financing institutions to change their assets to a special purpose vehicle, which offers bonds, which possess credit ratings based only on performance of underlying collection loans pool and any extra credit enhancement utilized5. Institutions that have low credit rating choose to securitize their assets when the cost of financing via securitization is low compared to cost of other forms of funding. Securitization may also allow particular companies to attain an authentic reduction in funding costs, by offering admission capital markets that have lower funding. This is particularly beneficial for corporations that won’t otherwise be capable of accessing capital markets. The capital composition of a corporation do not have any impact on its worth and thus securitization is not supposed to exist within perfect markets. Nevertheless, securitization has two major benefits in perfect markets. Firstly, securitization might minimize the costs of information for investors and sellers in securities and therefore lessen lemons problem. By economies of scale and standardization of the procedure of acquiring and reporting information, securitization reduces the cost of the bank of telling the investors that the securities of the bank aren’t lemons. Corporations that experience grater information irregularities, like firms with limited availability of civic information of firms that are under financial distress, can greatly benefit form securitization6. Secondly, securitization might lessen the firms regulatory and agency costs. Through allowing servicers or originators to specialize. Securitization can lessen agency prices, which are the charges linked with servicing and origination process. Specialization allows improvement of evaluation, payment collection methods, and loan monitoring, and therefore enhances the overall minimization of costs. Securitization may also lessen regulatory costs connected with the maintenance of the capital sufficiency ratio of a bank. Banks are needed to sustain a particular amount of capital, given riskiness of their assets and loans. Assets which are securitized by government sponsored enterprises need less capital than that required for complete loans or non agency mortgage backed security and thus, banks might take advantage of these diversities to lessen capital. A major motivation for utilizing special purpose vehicles in commercial finance is to lessen bankruptcy costs. Under securitization, whereby loans are relocated and sold to a special private vehicle, a bank may minimize the quantity of assets factored to any probable bankruptcy costs. The special purpose vehicle is beneficial to riskier banks since due to their lower credit rating, securitize more. In addition, investors are concerned with credit quality of securities issued by banks special purpose vehicles and with default risks of issuing bank7. Impact of securitization on cost of credit Securitization lessens the cost of borrowing for consumers. It increases the supply of mortgage credit accessible to lenders which consequently drives down mortgage interest rate provided to consumers. The government-sponsored enterprises are the chief participants in securitization market. They have a financing advantage via their inherent backing by government and always enjoy a reduced cost of borrowing. Therefore, government sponsored enterprises are capable of securitizing mortgages without use of credit enhancement. Centralized lenders who finance mortgages through securitization are capable of responding more swiftly to shifts in interest rates compared to lenders who securitize who finance mortgages via bank deposits or depository institutions. This allows lenders who securitize to quickly transfer changes in interest rates to borrowers. Impact of securitization on availability of credit Securitization expands liquidity of banks and therefore credit availability. Securitization enables banks issuing loans to transform conventionally illiquid loans into saleable securities, and therefore liberates capital for more lendings. In examining the function of securitization on reduction on the effect of a financial condition of a bank on its compliance to offer credit, conforming loans have a greater liquidity than jumbo loans as a result of the market developed by the government sponsored enterprises for these loans8. The acceptance levels of conforming loans don’t vary with the funding and liquidity costs of a bank and the financial condition of a bank do not have an effect on its compliance to give conforming loans. However, the jumbo loans depend on bank conditions. Banks that have n increased liquidity of balanced sheet and lower costs of financing approve an increased proportion of jumbo lendings relative to the non-jumbo loans. The reduced costs of financing and raised liquidity of balanced sheet increase the probability that banking institutions grant jumbo loans. Securitization makes access to financing less susceptible to constraints of domestic credit supply. Securitization allows banks to engage in advanced management of credit risk on their target loan levels since banks adjust the values of their current loans relative to the previous years to get a loans target level. Banks that fully take part in advanced risk management of credit techniques have an increased target loans levels. Issuing of collateralized loan obligation is an indication that a banking institution is engaged in advanced management of credit risk and collateralized loan obligations are among the major mechanisms through which banks might transfer huge quantities of risk off balance sheets. Banks that use advance management of credit risk techniques have a permanent rise in target loan levels of approximately 50 percent and the real loan levels is extended over several years. The three explanations of the expansion in subprime mortgages and the consequent increase in defaults were the improvements in credit worthiness of the subprime borrowers as revealed by improved income prospects, an outward change in supply of mortgages credit and the increased price growth anticipations that would reduce the approximated the losses granted evasion for lenders and thus relaxed standards of lending. The growth in mortgages has resulted form securitizations, particularly from subprime zip codes9. Impact of securitization on dispersion of risk Banking institutions securitize their assets since tranching and pooling can lead to diversification of risk and effective sharing of risk among several investors. Increased securitization lessens risk adjusted capital ratios. The general risk of a issuing banking institution depends on how its settles on reinvesting the advances from securitization. Banks that reinvests in assets are risk free are expected to have a reduced overall risk, in comparison to banks that increase their loan origination and therefore expand their risk exposure. Securitization is a mechanism of hedging the risk of interest rate. It enhances banking institutions to react to shifts in interest rate atmosphere in numerous ways. It also grants banks alternatives on the way to hedge their assets. For instance, they may achieve this by shifting the period of assets via tranching and pooling loans into securities, through purchasing investment grade tranches of the deal or maintaining residual tranche. Securitization also offers greater availability to capital. This is so because banking institutions are capable of securitizing more simply have increased liquidity and thus less susceptible to shocks that emerge form shifts in financial policy10. The effect of maintaining the initial loss piece within a securitization procedure is that since possible moral risk and unfavorable selection problem, the banks issuing loans usually embrace residual tranche of the securitization. Through sale of senior tranches to investors, banking institutions lessen their tail hazard, which is the hazard of severe unanticipated losses. The combined effect of tranches can efficiently lessen the exposure of a bank to severe losses11. The credit crisis and the function of securitization Lack of transparency in financial institutions and complexity of securitization are the major factors that led to the ongoing global financial crisis. However, securitization is a significant risk sharing instrument and it generated cross market linkages which resulted to contagion and shocks being shifted from one business sector to another. Housing prices was a major contributing factor to the credit crisis. The consistent rise in housing costs and its divergence form building costs and rents since late 1990s generated the housing bubble that exploded in the year 2006. A decline in costs of housing prevented borrowers form refunding and raised rates of defaults. Another cause of the financial crisis was the inability of credit rating agencies to precisely price risk and regulation failed to keep up with innovation. In addition Leverage magnified losses and generated spirals in which prices of assets continue to go down and accounting, particularly fair value accounting was impractical during these turbulent periods12. Effect of securitization on incentives An agency difficulties in the originator to distribute model of banks might have led to the global financial crisis and the mortgage originators interests were not in line with those of shareholders. In several cases, mortgage originators maintain equity tranches which assists in alignment of interests of investors and interest of originators. Nevertheless, in many instances did not eliminate the credits and other risks connected with securitized mortgages form the sponsors/originators books. Usually, other portion of banks purchased the AAA tranches of securities13. However, the significance of securitization is a helpful tool and it helps in creation of housing bubble but if originators were capable of holding equity tranches of securitization and if, as a result of diversification and packaging, the possibility of the portfolio of the returns falling short would have been negligible, and moral risks would also have been negligible. Nevertheless, originating banking institutions did not hold equity tranches of portfolios that their securitizations generated. In addition, macroeconomic factors like national housing costs necessarily developed a correlation amid mortgages, even form diverse geographical locations. The moral hazard generated by securitization was one of the factors that contributed to the on going financial crisis. Several frictions in securitization procedure led to conflicting interests. There was complexity of numerous subprime products that resulted to misinterpretations to or misunderstandings of the borrowers. There were adequate distinctions between corporate and structured ratings. Another conflict was absence of due diligence by asset managers and this reduced incentives for arranger to perform an appropriate due diligence. Errors in credit ratings were another friction in securitization procedure and the rating bureaus dispersed ratings to the subprime monetary backed security with considerable errors. Securitization created a moral risk for originators. Securitization driven change in mortgages supply to the subprime borrowers greatly contributed to expansion in credit of mortgage from the year 2000 to the year 2007. The expansion in originations and the securitizations in the subprime zip codes occurred in spite of the deteriorating credit situations employment growth and negative income in these zip codes. Lower standards of lending were caused by distortions that originated form liquidity glut. Lenders aggressively competed for business and enhanced mortgagors to extensively borrow on the presumption of appreciation of home prices in future14. Mortgage models such as originate to distribute model was default and it failed to predict the increase in the subprime mortgage defaults in the 2000 to 2007 period. The models depended a lot on hard information on borrowers and greatly disregarded shifts in lenders incentives to gather soft information alike the probability of borrowers to lose jobs or other emerging expenditures for borrowers. Securitization expanded the gap between lenders and definitive party bearing default hazard of the loans. Moreover, the investors would not have verified the soft information and they would have solely depended on the hard information, which created a moral risk for lenders15. Housing prices as the major trigger of the credit crisis The burst of the house bubble is seen as the major cause of the ongoing financial crisis. Credit crisis took place when house prices were reduced and the subprime mortgages defaults increased. The introduction of the novel assets based on subprime and other forms of mortgages, which were securitized and regarded safe. However, they were not as safe as revealed by the ratings since they were based on house costs and whereas the prices of houses were increasing, the assets provided greater returns than assets with identical risk rating16. Nevertheless, as the prices of hoses began going down, foreclosures on mortgages started to increase and to worsen the matter, investors had accumulated risks through leveraging their mortgages holdings in securitized products resulting to great losses17. The issue of subprime mortgage crisis is more based on mortgage repayments. The continuous rise in housing costs since the year 1995 had a positive effect on the capability of subprime borrowers to pay back their and minimized the default rates. The increase in the house cost index resulted to a greater possibility of prepayment and a reduced possibility of default. The dramatic rise in foreclosures that happened in Massachusetts between 2006 and 2007 resulted from a fall in house costs in the year 2005. The loosening of the underwriting standards, together with declining home costs were the major immediate contributors to the increase in the mortgages defaults and home cost appreciation drove the growth in non-prime mortgage markets. The three major probable factors to the increasing subprime delinquency rates were riskier pool of borrowers, domestic economic weakness, and domestic home cost appreciation and the reduction in growth rates. Conclusion Securitization is an essential tool that can be used to generate liquidity for lenders and raising access of capital for consumers and several corporations in the on going financial crisis. The special purpose vehicle entity or trust exempts originators from taxes and enables them to treat transactions as loan sales and protect investors form liabilities of originator or issuer. Securitization enables banking institutions to react to changes I interest rate environments and grants them alternatives on ways of hedging their assets. Securitization also allows banks issuing loans to change conventionally illiquid loans into saleable securities, and thus liberates capital for more lending. Bibliography Ambrose, B, 2008, Local economics risk factors and the primary and secondary mortgage markets, Regional science and urban economics, 30(6); 683-701. Kothari, V., (209). Securitization: the financial instrument of the future. New York: John Wiley & Sons. Krainer, J., (2009). Mortgage loan securitization and relative loan performance, New Jersey: Transaction Publishers. Sanders, A., & Ambrose, B., (2008). A new spin on the jumbo or conforming loan rate differential, Journal of Real Estate Finance and Economics, 23(1): 309-315. Gisdakis, p, & Felsenheimer J, 2008, Credit crisis : from tainted loans to a global economic meltdown. New York: Nova Science. Robbe, J., (2008). Securitization Law and Practice in the Face of the Credit Crunch. New York: Hart Energy. Kolb, R., (2010). Lessons from the Financial Crisis: Causes, Consequences and our Economic future. New York: Wiley. Lee, K., (2008). Securitization and its Impact on banking business. London: Routledge. Fabozzi, F., (2009). Accessing capital markets through securitization. Amsterdam: North- Holland Publishing Company. Linsmann, K., & Jansen, L., (2009). US Subprime and financial crisis: To what extent you safeguard. California: GRIN Verlag. Read More