Asset Securitization in the Aftermath of the Current Financial Crisis: Lessons for Emerging

Economies

S.G. Badrinath

Professor of Finance

San Diego State University

and

S. Gubellini

Assistant Professor of Finance

San Diego State University

First Draft

May 2010

Please do not quote.

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ABSTRACT

This paper explores the implications of the current financial crisis for asset securitization

activities. It begins with a brief review of securitization and how it enabled the management and

transfer of interest-rate and credit risks. It documents the close relationship between

securitization and various pieces of rule-making, FASB, Basel I and II, bankruptcy law, and

derivatives regulation. It discusses the financial crisis from the perspective of the shadow

banking system that emerged over the last few decades. Finally, it examines how the lessons

learnt from the experience of developed economies can and should impact how emerging

markets adopt securitization practices.

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1. Introduction.

The market for asset securitization has been dramatically affected by the financial crisis of the

last few years. Media attention initially focused on plummeting housing prices and mortgage

meltdown and is now focused on sweeping financial reform. Comprehensive reform is

motivated largely by the inextricable links of asset securitization to different corners of the

financial system.

Securitization has historically provided favorable outcomes for many market participants. Sabry

and Okongwi (2009) document that a 10 percent increase in securitization activity resulted in a

decrease of between 4 and 64 basis points on yield spreads, depending on the specific type of the

loan. Moreover, a 10 percent increase in secondary market purchases (of loans) increases

mortgage loans per capita by 6.43 percent. This suggests that securitization provides individual

borrowers with better access to credit and at cheaper terms. For investors, securitization

structures offer a menu of choices from a diverse pool of mortgages and loans which are low in

correlation so that in the event of a default, the senior tranches will continue to be paid out from

the cash flows that are not lost in that default. Investors thus benefit from the ability to select

from a menu of structured finance products that meet their desired level of risk tolerance and

diversification. For banks and financial institutions that originate these loans, securitization

provides a lower cost method of funding than the typical secured lending activity that they have

historically engaged in. Gorton and Souleles (2005) argue that access to securitization markets

also enables banks to reduce their bankruptcy costs.

As recent events have demonstrated, these benefits have now resulted in large social costs as

global central banks have accumulated large levels of debt in their bailouts of the Fannie Mae,

Freddie Mac and AIG- three players that are central to mortgage securitizations. From a welfare

perspective, the ability of securitization to make loans appear less risky is a market imperfection

and a cost-benefit analysis of securitization should form a part of any reform agenda in the

developed world. Lessons learnt from the political economy of securitization also translate

directly to emerging economies as they attempt to balance the benefits of securitization with its

potential for systemic risk.

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Accordingly, Section 2 of this paper begins with an overview of securitization and how financial

institutions attempted to manage credit risk and interest rate risk. Section 3 discusses the

emergence of a shadow banking system over many years of integration in financial markets

culminating in the financial crisis and the global response to it. Section 4 provides a historical

overview of various pieces of rule-making that continue to affect securitization. Section 5

provides an operational perspective on how emerging economics can adapt the lessons learnt in

the West as they consider how securitization activities can improve their economic performance.

2. An overview of securitization.

As is well known, securitization refers to the transformation of illiquid individual loans into

securities. To provide a perspective on securitization, it is useful to viewing lending activity on a

risk continuum. At one extreme is the traditional banking model where lenders originate the loan,

service the loan and hold it till maturity. The loan is funded with deposits and the lender assumes

both the credit risk of the borrower and the risk of changing interest rates. 1At the other end of

this continuum is a 100% “originate and distribute” model where, instead of being concentrated,

all the risk is distributed in the secondary market to investors. Lenders provide an intermediary

function and have no incentive to monitor and manage loan quality as they merely pass the cash

flows forward. Issues of asymmetric information and the possibility of adverse selection are not

a concern since the investors take all that risk. Securitization lies in the middle of this conceptual

continuum, with its exact location shrouded by the opacity surrounding lender risk retention, the

complex series of off-balance transactions to shelter that risk and the lack of transparency in the

over-the-counter markets where many of these deals are made.

Securitization is commonly seen as a three-step process. First, originated loans are pooled

together into mortgage-backed or asset-backed securities enabling a diversification of borrower

risk. Second, these assets are transferred in a true-sale to a special purpose vehicle (SPV) so that

1 The maturity mis-match caused by borrowing short (via deposits) and lending long (to 30-year fixed rate mortgages) contributed to the Savings and Loans crisis of the 1980s.

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the cash flows from these assets cannot be attached in the event of originator bankruptcy.2 Third,

the SPV issues different tranches or slices of bonds where the cash flow is passed through from

the original collateral assets according to different rules of priority. Typically, the senior and the

largest tranches are paid first and bear the least risk. The lowest or equity tranche is the first to be

affected by default in the underlying collateral pool. In this manner, securitization provides

access to funding sources from secondary capital markets.

As the loans that comprise the pool are identified and warehoused, an iterative process involving

the credit rating agencies attempts to maintain portfolio risk at acceptable levels. The special

purpose vehicle finds an asset manager to trade the assets in the pool, a guarantor to provide

credit guarantees on the performance of that pool and a servicer to process the cash flows

generated from the pool and a trustee to oversee its activities. Figure 2 provides a pictorial

representation of the entire process.

As comfort with securitization products and structures grew, other types of financial assets were

included in the assembly of the diversified portfolio. In addition to the usual individual fixed-rate

and adjustable-rate mortgages and mortgage backed securities (MBS), the assets pooled into the

securitization began to include loans and leveraged loans, high-yield corporate bonds as well as

asset-backed securities (ABS). Thus the early collateralized mortgage backed obligation (CMO),

were augmented by collateralized loan obligations (CLO), then by collateralized bond

obligations (CBO), and later their aggregated version- the collateralized debt obligation (CDO).

Figure 2 documents the recent growth in these assets.

Once the securitization infrastructure was in place at most banks, new product development even

involved the re-securitization of the lower (and more risky) CDO tranches into CDO-squared

structures. Demand from private investors seeking yield in an environment of low interest rates

began to mean that every conceivable cash flow stream was prone to being securitized.

2.1 Securitization and risk management.

2 These entities have been variously described as special purpose entities (SPE), structured investment vehicles (SIV), or Asset Backed Commercial Paper (ABCP) conduits. While there are differences in the way the different entities operate, their common feature is that they all are bankruptcy remote.

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The process of tranching securities is the typical method by which the risks of securitization are

managed. In a typical mortgage securitization, the collateralized mortgage obligation (CMO) is a

multi-class bond where tranche investors receive cash flows from reference assets in a collateral

pool according to strict definitions of priority. Some tranches received only interest or only

principal. Others allocated fixed rate payments to a floating rate and an inverse floating rate

tranche, with different exposures to interest rate risk. Still others had explicit planned payment

schedules, similar to a sinking fund to reduce uncertainty in payment times caused by variation

in the speed at which mortgages are pre-paid. At times, some of the tranches were retained by

the originating banks.3

However, as part of a mandate to promote home ownership, Fannie Mae initially issued its own

debt and retained the interest rate risk rather than passing it through to investors. Typically, the

debt issued to finance the mortgage acquisition was of a shorter duration than the mortgage that

it finances. Declines in interest rates triggered refinancing by borrowers in fixed-rate mortgages.

Although the mortgage gets prepaid, the financing must still pay off at the higher original rate

causing a loss to Fannie Mae. If interest rates rise, the borrower retains the mortgage and Fannie

Mae still bears the loss of having to refinance its loan at the new higher rate. This feature of

mortgages is curiously referred to as negative convexity. The bank-like behavior of the GSE has

inevitably resulted in the bank-like consequences of maturity mis-match that plagued the S&Ls.

In response, the GSE’s initially increased the issuance of callable debt to counter the impact of

interest rate changes and later to access the over-the-counter interest rate swap market to

accomplish maturity transformation. Ironically, the SPV’s that were structured as ABCP

conduits became subject to similar maturity mis-match problems in 2009 when money market

funds lost confidence in the safety of that paper. 4

3 Recent proposals for financial reform are attempting to make the extent of this risk retention explicit. Some versions call for 5% ownership of the riskiest tranches while others call for retention of a portion of each tranche in a securitization.

4 Kacperczyk and Schnabl (2009) document the characteristics of the asset-backed commercial paper during the financial crisis.

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Credit risk was initially managed by the GSE’s by strictly adhering to loan size, conformity and

underwriting standards. As the mortgage market expanded, the guarantee business became a

larger part of GSE operations. Loans that were bundled and sold as MBS came with a guarantee

that the unpaid balances to security holders on individual mortgage defaults would be paid by the

GSE. The GSE would then attempt to recover that amount through the foreclosure process.

Therefore, the security holder would not have any exposure to credit risk. The Collateralized

Debt Obligation (CDO) enabled the management of credit risk in much the same manner as the

CMO. The extent of originator involvement in each tranche has remained opaque. From a

signaling standpoint, originator ownership of the riskiest tranche could send a strong signal about

the quality of the structured product to investors interested in the safer tranches. Table 1

documents the growth of this CDO structure in the last decade.

As CDOs and other private lenders entered the securitization space, various types of credit

enhancements began to proliferate.5 The quality of the collateral asset pool and concerns

regarding adverse selection by pool originators resulted in several assurances, both internal and

external.6 Internal guarantees include a cash reserve from setting aside a portion of the

underwriting fee for creating the collateralized structure, or a portion of the interest received

from the collateral assets, after paying interest on the tranches, or even by deliberate over-

collateralization where the volume of collateral assets placed in the structure is greater than the

volume of liabilities, thereby providing a layer of protection when some assets default. In

addition to credit guarantees from the GSEs issuing the MBS, external guarantees were obtained

from the sponsor and by the direct purchase of credit insurance from mono-line insurance

companies or over-the-counter insurance through credit default swaps.7

2.2 Securitization and credit risk transfer-the credit derivatives market.5 Credit enhancement is a wonderful euphemism for loss distribution.

6 If originators have the most information about the quality of the underlying financial claims then it is reasonable to expect adverse selection on their part, only keeping the good loans and selling the bad ones. In the extreme, loan quality will decline across the board as demand for loans from securitizers weakens the incentive for originators to screen the loans This leads to issues of information asymmetry causing rational lenders to demand a lemons-premium, Duffie (2007).

7 Understandably, the level of these credit-enhancements was critical to obtaining a favorable rating from the rating agencies.

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The credit default swap (CDS) emerged as the primary vehicle through which credit risk is

transferred and traded.8 Simply stated, a CDS is a put option on credit risk.9 Buyers of

protection from a credit event pay a periodic premium. If there is a relevant credit event that

affects the value of the underlying asset, then the protection buyers are made whole by the

protection seller and in this fashion they have shed the credit risk. Sellers of protection assume

the credit risk in exchange for that periodic premium income. The appeal of the CDS becomes

clear when it is compared with corresponding bond market transactions. Exposure to credit risk

can be achieved either by owning the bond or selling the CDS. Owning the bond requires capital

and also creates interest rate risk exposure while selling the CDS only requires mark-to-market

adjustments and periodic collateral. Likewise, being short credit risk implies being either short

the bond or buying the CDS. Again, the former is difficult to do while the latter is easy. In both

cases, the CDS offers leverage and liquidity and is thus an easy expression of a view on credit in

a manner that has not been possible in the secondary bond market.

This “insurance” product has received considerable notoriety in the media. First, the direct

purchase of a CDS without owning the underlying credit is akin to a short sale.10 Second, owners

of the underlying credit can purchase protection against its possible default- an application

similar to that of a protective put option. 11 Third, from initially insuring the default risk of bonds,

the CDS market soon rapidly expanded to include CDS products on loans, mortgage-backed and

asset-backed securities. Portfolio versions of these known as basket CDS and index CDS

products traded in the middle of the decade. The now notorious ABX and TABX indexes, are

8 Although other structures like the Total return swap (TRS) and the Credit-Linked Note (CLN) are also related vehicles, we confine our discussion to the CDS instrument in the interest of brevity.

9 Contract terms and definitions of the credit event are standardized by the International Swap Dealer’s Association (ISDA). More details on the CDS are available at www.isda.org.

10 Some commentators have urged that this use of a CDS is similar to taking out insurance on some one’s home and then burning it down to realize its value. The criticism here is not of the CDS instrument at all, but more an expression of discontent with the short selling in general.

11 Traditional forms of insurance incorporate the notion of “insurable” interest where the primary purchasers of insurance are those owners of assets who deem it necessary to seek protection against its loss of value. Restricting CDS purchases to this class of market participants is identical to only permitting protective put options to be traded and would thus limit the flexibility of market participants.

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securities that take one or two deals from 20 different ABS programs, with 5 different rating

classes-AAA, AA, AA, BBB, BBB-. The bottom two are further combined into the TABX which

is the most sub-prime and experienced the most rapid declines in value at the beginning of the

financial crisis.12

The synthetic CDO is a special purpose securitization vehicle that makes extensive use of the

CDS instrument. The Bistro structure conceived initially by JPMorgan in 1997 became a

template by which the cash flows to tranches of securitizations were generated from the

premiums received by selling credit default swaps on a portfolio of underlying securitizable

assets. In other words, instead of a pool of assets generating cash flows, the insurance premium

representing their likelihood of default is itself distributed directly to the tranches. Since the

default rate of the collateral pool governs the amount of the premium that will be received from

credit default swaps sold on those assets, this amounts to essentially the same bet.13

3. Securitization and the financial crisis.

Critics of securitization (Levitin, Pavlov and Wachter, 2009) argue that the securitization process

was corrupted by the emergence of a shadow banking system in the late 1990s. These shadow

banks are mortgage real estate investment trusts, insurance companies, private equity funds, the,

money market funds, mutual funds, pension funds and hedge funds. Investment dollars from

many of these institutions served as the “deposits” that the special purpose vehicles, CDOs and

the housing GSE’s employed to fund securitizations. Gorton (2009) argues that this shadow

banking system has developed as a consequence of several decades of integration of the

traditional banking system with capital markets. By some measures about 60% of the credit

system is facilitated by shadow banking (Date and Konczal, 2010). Indeed, commercial banks

12 As an illustration, the ABX.HE.A-06-01is an index of asset-backed (AB), home-equity loans (HE) assembled from ABS programs originating in the first half of 2006.

13 The charges filed by the SEC in April 2010 against Goldman’s Sachs pertain to their lack of disclosure of information while such a synthetic structure was being created.

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had little choice but to compete in this arena, since holding loans and funding them with deposits

was not a profitable business for them anymore.14

The financial crisis of the last few years involved a series of runs on this shadow banking system.

This was first visible in the asset-back commercial paper (ABCP) market and then in the

repurchase market where institutions obtained short-term financing. The inability of the GSE’s

to honor their guarantees on mortgage securitizations and that of AIG to meet its obligations

from selling CDS insurance reverberated through the financial system.

The response of the central banks to this ongoing crisis was coordinated and strong. The

European Central Bank, The Bank of England, Her Majesty’s Treasury, the U.S Federal Reserve,

and the U.S Department of the Treasury initiated several programs whose purpose was to “bail-

out” the shadow banks. Outright purchases of secured commercial paper and GSE obligations,

the acceptance of securitized paper as collateral, the provision of liquidity facilities, capital and

financing to private entities to purchase CMBS and private RMBS as well as non-mortgage MBS

via the PPIP, TALF and TARP programs were some of the steps taken during the Fall of 2008

and Spring of 2009. The thinking behind these bailouts is that the Federal Reserve was better

able to hold these assets either until maturity or until some point where the housing market

recovered. The GSE’s are still requesting supplemental funds and thus far proposals for financial

reform do not address their situation. This socialization of debt with all its welfare implications

continues to this day with the recent events surrounding the PIIGS countries in Europe.

With hindsight, it is easy to recognize that one implication of the diversification benefits that

securitization provides to the senior and super-senior tranches is that it makes them effectively

short correlation. Additionally, mortgage products are well known to exhibit negative convexity

or concavity. Negative convexity essentially implies that they lose value when interest rates fall,

partly because the rush of borrowers to refinance reduces the duration of the bonds. With

correlated defaults, this effect becomes even more severe. At times of financial crisis, all

14 This was one of the motivations behind the Gramm-Leach-Bliley Act of 1999, which relaxed the separation of commercial and investment banking activities that were enshrined in the Depression Era Glass-Steagall Act.

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correlations tend towards to unity, and it should not be surprising that these tranches that were

rated as “safe” were adversely impaired.15

4. Securitization and regulation.

Securitization is very closely linked to several aspects of rule-making. This section discusses

how the various rules embodied in the bankruptcy code, derivatives regulation, Basel Accords

and FASB guidelines have interacted with securitization activities.

First is the remoteness from originator bankruptcy of the special purpose vehicles (SPV) that

acquire assets via a “true-sale.” Early securitizations sometimes required multiple SPVs to

accomplish this transaction. Legal opinions establishing the transfer of those assets were not

clear and unambiguous, but carefully reasoned, very specific to the assets under consideration

and often 40-50 pages long. In 2000, the FDIC issued the “securitization rule” stating that the

FDIC would not use its statutory authority to repudiate “true-sale” contracts entered into during a

securitization as long as GAAP principles were met. In 2005, the Bankruptcy Abuse Prevention

and Consumer Protection Act explicitly amended Section 541 of the Bankruptcy code to exclude

assets transferred in an asset-backed securitization from the debtor’s estate, lending further

support for securitization activities. Assets were deemed eligible for exclusion if they were rated

as investment grade by one or more credit rating agencies.

Second, accounting conventions pertaining to assets transferred to an SPV as a true-sale have

undergone multiple changes in recent years, with modifications made pursuant to Enron’s abuse

of the true-sale concept. Different incarnations of these rules were aimed at providing clarity

regarding when the financial statements of an SPV should be consolidated with those of the

financial institution sponsoring that securitization. FASB 167 adopted in June 2009, links

consolidation more directly to the SPV’s purpose and design and a sponsor’s ability to direct the

activities of the SPV that most significantly impact its economic performance. In March 2010,

the FDIC introduced an extension to the 2000 securitization rule until September 2010

essentially grandfathering securitizations that commenced before these new GAAP standards 15 The assumptions regarding default and correlation in the models used by rating agencies did not anticipate this outcome resulting in a rash of severe ratings downgrades once the effect was noticed.

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were defined. Rating agencies have expressed concern that these guidelines make it less likely

for senior tranches of securitizations to garner above investment grade ratings.

Third, the risk transfers that make securitization possible received considerable impetus from

derivatives regulation. Historically, the Commodity Exchange Act (CEA) of 1936 required

agricultural futures contracts to be exchange-traded. Under the Commodity and Futures Trading

Commission Act of 1974, the CFTC became the new regulator whose role was expanded to

include all exchange-traded futures contracts including financial futures. The adoption of a

proposal from the U.S Treasury, called the Treasury Amendment, resulted in the exclusion of

forward contracts such as those in foreign currency markets from regulatory supervision by the

CFTC, ostensibly because they were over-the-counter instruments. The Futures Practices Act of

1992 extended this exclusion to interest rate swaps. Despite concerns regarding the OTC volume

in these instruments, the Commodity Futures Modernization Act of 2000 specified that any OTC

derivative transactions between “sophisticated parties” would not be regulated as “futures” under

the Commodity Exchange Act (CEA) of 1934 or as “securities” under the federal securities laws.

This fragmented regulation implied instead that banks and securities firms who are the major

dealers in these products would instead be supervised under the “safety and soundness”

standards of banking law and is at least partially responsible for the growth in the credit default

swap market for transferring securitization risk. In August 2009, after the financial crisis and the

collapse of securitization, regulation took a 180-degree turn when the US Treasury proposed

legislation that essentially repeals many of the CEA exemptions above and argues for an

exchange-traded market for CDS.

Fourth, the evolution of minimum capital standards for banks, proposed in the various Basel

accords were an attempt to globally regulate risk taking in the banking industry. Basel I had

overly broad risk categories and did not tie regulatory capital charges to economic risk. Under

Basel II, banks with deposits of over $250 billion had more stringent requirements which were

optional for the smaller banks. Differential regulatory criteria for different banks created an

incentive for regulatory capital arbitrage whereby such banks have “an incentive to sell the credit

risk on loans whose regulatory capital exceeds their economic capital to institutions not bound

by the same capital regulations, and also to hold the credit risk on loans whose regulatory capital

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is below their economic capital,” [Hancock et al. (2005)]. Furthermore, the regulatory capital

requirements gave considerable importance to the role of credit ratings. Capital charges were set

at 8% and risk-weighted based on long-term credit ratings with weights ranging from 20% for

AAA ratings to 350% for BB ratings. This implied that a $100 million loan would require $1.6

million in capital if it was rated AAA and $28 million in capital if the loan was rated BB.

However, with the purchase of a CDS, a BB rated security could be transformed into a AAA

rated one.16 Bake et al. (2010) document recent modifications to the Basel II capital

requirements regime in response to the financial crisis. These include a treatment of re-

securitization exposures designed to treat CDO structures, better stress testing, a value-at-risk

framework and other operating constraints.

4.1 Commentary.

Two key facets emerge from the evolution of regulation documented above. First, there is a

reluctance to regulate that stems from the political philosophy of deregulation prevalent over the

last few decades. The belief is that reputational considerations within the banking establishment

will serve to monitor and limit excessive risk taking- a faith that appears misguided in light of

the collapse of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers and AIG. Reliance on

rules-based legislation has also made it easier for the affected parties to circumvent them.

Second, the centrality of rating agencies in the securitization process is clearly evident. Their

importance is highlighted in bankruptcy law guidelines that exclude asset-backed securities from

attachment in originator bankruptcy, in the risk-weighting schemes for banking regulation in the

Basel accord and in the crafting of FASB standards for consolidating financial statements. While

the enactment of the Credit Rating Agency Reform of Act of 2006 attempts to remove barriers to

entry in the ratings market, concerns about conflict of interest still persist. These concerns were

evident during past disruptions as well and essentially arise from a business model where the

party desirous of obtaining a rating is the one that pays for the rating service. One proposal to

16 The poster child for this activity was AIG and a quote from their 2007 10-K report states clearly that they sold CDS protection to European banks, “…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”.

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limit this conflict of interest is to make the ratings a two-step process. An issuer desirous of a

rating would pay the fee to a regulator (rather than directly to the rating agency) and the

regulator would then assign one of several rating agencies to make the determination of credit

quality. The choice of rating agency could be random or depend upon the complexity of the

transaction and the rater’s ability to deal with that complexity.

5. Adapting securitization for emerging markets.

Until the financial crisis, market participants in emerging markets expressed considerable

optimism for securitization. As global markets have recovered, sporadic activity is visible in

several locations, with investment banks, the ISDA and other industry professionals are setting

up offices and recruiting staff. However, the progress in terms of official approvals and their

commitment is slow. Without an institutional structure, efficient legal system, well-defined

bankruptcy laws, and accounting practices, principal-agent conflicts and information symmetry

will continue to be significant issues in market development. This section first surveys

securitization activity in different emerging markets and then provide some guidelines in terms

of how these activities may be developed further.

5.1 Market Development.

In emerging markets, the need for long-term projects in infrastructure,- roads, bridges, power

and water facilities, oil and gas facilities and telecommunications energy, create securitization

opportunities for the associated receivables. As one would expect, the progress of securitization

efforts varies within individual emerging economies and depends largely on their laws,

regulatory frameworks and the range of activities that domestic institutional investors are

permitted. In the Middle East and North Africa (MENA) region, is permitting foreign ownership

of real estate and Saudi Arabia had declared an intention to create a Fannie Mae like structure.

Some Asian countries have some form of government-sponsored mortgage corporations while

others do not. Domestic pension funds, insurance companies and hedge funds in Latin America

are natural consumers for different securitized tranches but are not so active in some parts of

Asia.

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The benefits of a local currency CDS market for bank management of credit risk are widely

recognized and there is some preference for synthetic products. Relationship banking is

extremely entrenched in many countries and it is often not considered culturally appropriate to

transfer risk in the manner that credit derivatives enable. Non-performing loans were first

securitized in some regions while others targeted the residential and commercial mortgage

market. Early structured products were aimed at institutional investors in the developed world

who might desire exposure to the region but these efforts are broadening towards the

development of domestic markets.

Asian assets for CDO structures appear to be generally lower quality and less diversified.

It would appear that equity tranches would have to be thicker to accommodate the high

correlations that are perceived to exist in credits even across countries in the region. In Hong

Kong and Singapore, there is some evidence of customized single-tranches for institutional

clients. Some securitizations aggregate assets from local as well as developed markets. In

addition to Singapore, Taiwan, Korea, Hong Kong, Mexico and Brazil are the most accepting of

credit derivative products.

Unique circumstances in each region have spawned the development of specific products.

Singapore has attempted securitization of loans to small and medium sized enterprises (SME). In

Russia, second-tier banks are warehousing mortgages until the pool is big enough to tap capital

markets. Microfinance securitizations are being proposed in other countries with a recent success

in India in the fall of 2009.

In China, regulatory oversight and rules for mortgage securities are being discussed and pilot

projects for securitization trials are underway. Some securitizations of domestic non-performing

loans have been completed. In 2005, a specific asset management plan (SAMP) was introduced

where a domestic securities firm would raise capital from investors and allocate it to specified

corporate (non-bank) assets. While similar in spirit to the SPV securitization structure, the

SAMP’s status as a legal entity with features of bankruptcy-remoteness are still unclear. Some

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rulings regarding the simplification of tax treatments involving VAT and stamp duty have been

announced.

In India, following the success of the rupee swap market, the Reserve Bank of India has recently

released guidelines for the use of rupee denominated, plain-vanilla credit default swaps (CDS) by

resident institutions. As presently conceived, this will pertain to a single reference entity (such as

a bond or bank loan). Both cash and physical settlement are permitted and the focus is on

hedging and diversifying balance sheet assets. Banks are not yet permitted trading and market-

making activities, but it is hoped that this will eventually pave the way for broader market

participation. In 2009, the first micro-finance securitization was rolled out by ICICI bank which

pools together small loans made micro-finance lending agencies and tranches out the cash flows

to mutual funds. Here again, securitization provides a funding source to promote lending.

5.2 Issues and processes related to managing credit risk.

Structured credit securitization creates new risks at the same time that it enables the market

players to diversify pre-payment risk or credit risk. Many of these new risks are linked. As

always, they arise from the conduct and practices of participants as they operate in and attempt to

price complex securities during times of market turbulence. The section below briefly describes

these risks and urges attempts to redefine and refine existing conventions as well as efforts to

develop new processes for risk management.

5.2.1 Operating considerations.

The use of credit derivatives will require a drastic re-thinking of the way banks currently process

their operations. Risk management structures must be in put in place to deal with operating risk.

Operating risk results from the trading and conduct of market participants during clearing,

confirmation and settlement—again processes that are particularly vulnerable at times of market

stress. In most emerging markets, there is a large gap between the sophistication of financial

products and the level of financial literacy. Local staff, skilled in credit products and

securitizations may be hard to find and have to be trained. Best practices and codes of conduct

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for market participants throughout clearing, confirmation and settlement are necessary. Before

the transaction, these would include a knowledge of the counterparties’ familiarity with complex

trades, agreements on how open positions are carried and a review of the main contractual terms.

Execution should be confirmed in a timely fashion. If it is delayed, all parties should be notified

and provided reasons. Valuation information should be exchanged after the transaction. Reliable

systems for internal reporting should be developed and maintained. Electronic platforms for

clearing and settlement should be devised as appropriate.

5.2.2 Mark-to-market accounting practices

The need for greater transparency of complex financial transactions and their globalization has

catalyzed a move towards the adoption of “fair value” or mark-to-market accounting by both the

International Accounting Standards Board (IASB) and the Financial Accounting Standards

Board (FASB). To its adherents, fair value accounting reflects the true value of assets on the

balance sheet and thus permits investors to better assess the risks therein and allows policy

makers to better adjust their responses.

In the US, FASB 157 came into effect in November 2007. Under FASB 157, assets are broken

up into three classes. Level I assets are those that have observable market prices and are

“marked-to-market.” Level II assets may not have observable secondary market prices, but the

models that price them should have market data as inputs. This is more commonly referred to as

“marked-to-model” and is quite a ubiquitous phenomenon. For instance, bond markets are

notoriously thin and even in the U.S, less than 3% of the outstanding stock trades on a given day.

Level III assets are those for whom even observable market inputs are not available. These

would obviously include assets such as complex CDO tranches and CPDOs. Valuation practices

in this class are little more than guesses and are sometimes referred to as “marked-by-

management.” Quite naturally, this leads to concerns about how financial institutions might

game favorable reporting outcomes17.

17 Weil (2007) describes that Wells Fargo Bank in a recent filing reported $2.24 billion of losses in Level I and Level II assets while simultaneously reporting $2.04 billion of gains in Level III assets. The latter are much harder to verify than the former.

17

Critics of fair value accounting have long maintained that it is not altogether without flaws and

transmits the volatility in market prices to balance sheets and to corporate earnings. In other

words, market prices cannot be trusted at times of crisis. Allen and Carletti (2006) argue that

marking assets to market prices is particularly unreliable if the underlying markets that generate

those prices are illiquid. Rather than reflecting future cash flows, illiquid prices may merely

reflect the cash available to market participants. In their model, mark-to-market accounting

contributes towards the onset of contagion in ways that historical cost accounting does not.

5.2.3 Model Risk.

Model risk refers to the increasing dependence on complex, often proprietary pricing models and

a lack of recognition of the model’s limitations. The key inputs into most models are

assumptions about default rates and recovery rates for single-name products and additionally,

default correlations for multi-name products. In some emerging markets, validated, reliable data

for comparative risk analysis, such as a time-series of loan-losses, default histories and recovery

rates may not be available. Even with historical data and an active secondary market to calibrate

model values, correlation assumptions in existing models for multi-name products do not provide

reliable and consistent results.

Model risk is exacerbated when tail events dominate markets as at present, and extant Value-at-

risk (VAR) models underperform significantly. Adjustments to model tolerances during such and

other regime shifts are often not made in a timely manner. Indeed even the tendency of modelers

to view the statistical world as Gaussian and therefore, departures from it as “tail” risk may need

to be re-examined. Ironically, model risk receives a bad name because model imperfections are

revealed at times when investors need them the most! Academics will argue however, that the

practice of modeling provides insights in to the types of risks that lurk in complex products.

Lastly, over-reliance on complex models can also be counterproductive in that they absolve risk

management executives from exercising judgment and conducting due diligence. VERMA

5.2.4 Counterparty risk

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Third-party or counterparty risk relates to the non-performance of loan originators, loan

servicers, asset managers and other counterparties. Hedge funds have been particularly active in

the subprime mortgage space. Some have already been liquidated, while others have received

capital infusions from sponsors to enable a more gradual unwinding of their positions. A recent

paper by Bollen and Pool (2007) argues that hedge fund managers avoid reporting losses to

retain investors. Specifically, they find that the frequency of small gains is higher than that of

small losses, and that this is not visible prior to an audit, or for funds that invest in liquid assets.

They do however speculate that hedge fund managers may be optimistic about the value of their

illiquid holdings.

5.2.5 Legal risks

Simply appealing to standardized documentation from ISDA in developing CDS markets is not

sufficient. Legal risk can arise when deal documents are modified by counterparty lawyers (often

subtly). The bankcruptcy-remote character of the SPE may not always be watertight. Shariah

law tends to be principles based and permits domestic courts considerable leeway interpretation

and applicability to specific transactions. While this may appear to be an advantage given the

failure of rules-based regulations in the West, the lack of clarity about legal title and enforcement

can result in unpredictable outcomes. For instance, Shariah law does not clearly separate legal

and equitable title, and, therefore, “true sales” in Shariah locations have to structured

appropriately so that a sale of the legal interest in the collateral to the SPE satisfies all applicable

Shariah requirements. Some legal systems have required that both a local and an offshore SPE

be created for a securitization to be in compliance.

5.2.6 Liquidity risk.

Liquidity risk is a concern both when transactions require funding and when transactions affect

prices. From a funding perspective, timing differences between collateral cash inflows and

tranche cash outflows are common in most securitizations. As mentioned earlier, ABCP and SIV

structures address this through some combination of short-term and long-term borrowing. Their

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ability to rollover debt, meet the cash, margin and collateral requirements of counterparties to the

transaction and manage withdrawals of capital are critical. In the current credit crunch, the

injections of liquidity by central banks represent a broader effort to maintain short-term liquidity

flows. Despite this, inter-bank spreads have continued to widen and financial institutions appear

to still “hoard” liquidity.

From a trading perspective, liquidity risk refers to the impact on prices when transactions are

executed. For instance, if there is considerable herding of market participants, then this form of

liquidity risk manifests itself as an inability to execute a transaction without significantly

affecting prices. This is typically because of the lack or unwillingness of parties to take the other

side. Both herding and liquidity risk contribute to the distress prices at which the few reported

transactions of sub-prime portfolios are currently taking place.

In emerging markets, the message of the Asian crisis of 1997 still resonates among policy

makers who view managing capital flows as an important concern. The focus has been on “hot

money’ hedge funds and their power to destabilize small capital markets. It is however becoming

apparent that the hedge funds sponsored by some of the larger and more reputed Western

financial institutions also operate in a similar manner. In other words, there is substantial herding

behavior amongst institutional investors and targeting specific entities for regulatory supervision

is likely to miss the larger picture. From a longer-term perspective, there is some evidence that

domestic institutions such as pension funds and insurance companies are likely to provide a

countervailing force against such capital flows. Fostering such an environment for domestic

institutions should continue to be a parallel goal for policy makers in emerging markets.

6. Conclusions.

This paper documents the linkages between asset securitization activities and the financial crisis

of the last few years. It provides an overview of the securitization process and how borrower

credit risks and market-wide interest rate risks are managed within that process. It documents the

legal and regulatory underpinnings in western societies that made securitization so accessible to

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market participants. The paper concludes with a review of how emerging economies can learn

from these developments in starting securitizations in their locations.

21

References

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Date, R. and M. Konczal, 2010,” Out of the Shadows: Creating a 21st century Glass-Steagall,” in Make Markets, Be Markets, The Roosevelt Institute Project on Global Finance.

Duffie, 2007, “Innovations in Credit Risk Transfer: Implications for Financial Stability,” Working Paper, Stanford University.

Fender I. and S. Mitchell, 2009, “The Future of Securitization: How to align the incentives,” Bank of International Settlements, September.

Gorton, G. and A. Souleles, 2005,”Special Purpose Vehicles and Securitization,” National Bureau of Economic Research.

Gorton, G., 2009a, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” Remarks at the Financial Innovation and Crisis Conference, Federal Reserve Bank of Atlanta.

Gorton, Gary and Andrew Metrick 2009b, “Securitized Banking and the Run on Repo,”http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1440752.

Gorton, 2010, Questions and Answers about the Financial Crisis: Prepared for the U.S. Financial Crisis Inquiry Commission, 1-17.

Hancock, D., A. Lehnert, W. Passmore and S.M. Sherlund, 2005, “An Analysis of the Potential Competitive Impacts of Basel II Capital Standards on US Mortgage Rates and Mortgage Securitizations, Federal Reserve Board.

Kacperczyk M. and P. Schnabl, 2009, “When Safe Proved Risky: Commercial Paper Duringthe Financial Crisis of 2007-2009,” Working Paper, NYU Stern School of Business and NBER.

Levitin, A.J., A.D. Pavlov and S. Wachter, 2009, “Securitization: Cause or remedy of the financial crisis?” University of Pennsylvania Law School Research Paper No. 09-31.

Loutskina, E, 2005,”Does securitization affect bank lending?Evidence from bank responses to funding shocks,” Carroll School of Management, Boston College.

Jiangli, W. and M. Pritzker, 2008,” The impacts of securitization on US bank holding companies,” http://ssrn.com/abstract=1102284.

Robinson, K.J, 2009, “TALF: Jump-Starting the Securitization Markets,” Economic Letters, Federal Reserve Bank of Dallas 4(6), 1-7.

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Sabry, F. and C. Okongwu, 2009, “Study of the Impact of Securitization on Consumers, Investors, Financial Institutions and the Capital Markets,” NERA Economic Consulting for the American Securitization Forum, 1-241.

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Figure 1

The structure of securitization

Trades Assets Insures Tranches

True-sale assets funds from Bond sales

Funds payments from pool

Collects CF from pool Oversight

INVESTORS

Source: Adapted from Fender and Mitchell (2009)

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Asset Manager Man

Guarantor

Originator(sponsor, pools assets)

SPECIAL PURPOSE VEHICLE Assets | Liabilities

Loans

Mort-gages

Bonds

TrusteeServicer

Senior

Mezzanine

Equity

2000 2001 2002 2003 2004 2005 2006 2007 20080

500100015002000250030003500

Figure 2Types of securitization activities in US markets, 2000-08

Agency MBS Non-Agency MBS CMBSABS CDO

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Table 1 Global CDO Issuance ($ billions) through 2009

Panel A1 Panel B Panel C2

Total _______________________ _______________ _____________ Period CDO Cash and Synthetic Market Arbitrage Balance Long Short Issuance Hybrid Funded Value Sheet Term Term

CDO CDO (1) (2) (3) (4) (5) (6) (7) (8)

1H-04 67.8 44.6 23.2 0.0 62.8 5.0 50.1 17.7

2H-04 89.6 74.9 14.0 0.7 84.2 5.4 72.8 16.8

1H-05 108.5 90.8 17.5 0.2 93.2 15.3 105.3 3.2

2H-05 142.8 115.8 27.0 0.4 120.1 22.7 139.4 3.4

1H-06 214.8 178.8 33.1 2.9 190.6 24.1 210.3 4.5

2H-06 305.9 231.7 33.4 40.7 264.3 41.6 291.4 14.5

1H-07 345.1 256.1 40.4 48.6 308.6 36.6 331.5 13.7

2H-07 136.5 84.3 8.0 44.1 123.3 13.2 133.8 2.7

1H-08 41.9 28.6 1.2 12.1 34.0 7.9 41.9 0.0

2H-08 20.0 15.0 0.2 4.8 13.9 6.1 20.0 0.0

1H-09 2.6 1.5 0.1 1.0 2.5 0.1 2.6 0.0

2H-09 1.6 0.9 0.2 0.5 8.5 7.1 1.4 0.2______________________________________________________________________________

Panel A presents a breakdown of total issuance by CDO type. Panel B presents a breakdown of total issuance by CDO strategy. Panel C presents a breakdown of total issuance by CDO tranche maturity. The sum of the columns in each panel should equal the figures in Column (1).

1 Unfunded CDO’s are not included in the figures in Panel A. Therefore these estimates understate the volume of activity.

2 Long-term refers to tranches with more than 18 months to maturity.

Data are from the Securities Industry and Financial Markets Association (SIFMA).

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