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A brief note about Securitization Process and US Sub Prime Crisis

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I N D E X

Sr. NoParticularsPg. No

1.Introduction2

2.Meaning & Definition4

3.Quick Guide to Jargon11

4.The Securitization Process14

5.Key Players23

6.Merits & Demerits27

7.Securitization in India32

8.US Sub Prime Mortgage Crisesa. Introductionb. Background and timeline of eventsc. Causes of Crisisd. Implications

37

9.Conclusions52

10.Bibliography54

INTRODUCTION

Technological advancements have changed the face of the world of finance. It is today more a world of transactions than a world of relations. Most relations have been transactionalized.Transactions mean coming together of two entities with a common purpose, whereas relations mean keeping together of these two entities. For example, when a bank provides a loan of a sum of money to a user, the transaction leads to a relationship: that of a lender and a borrower. However, the relationship is terminated when the very loan is converted into a debenture. The relationship of being a debenture holder in the company is now capable of acquisition and termination by transactions."Securitization" in its widest sense implies every such process which converts a financial relation into a transaction.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 consolidated 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 (MBS), while those backed by other types of receivables are asset-backed securities (ABS).Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitize may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis. In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off-balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts. The granularity of pools of securitized assets is a litigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time - and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss. Securitization has evolved from its beginnings in the late eighteenth century to an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company.Securitization started as a way for financial institutions and corporations to find new sources of fundingeither by moving assets off their balance sheets or by borrowing against them to refinance their origination at a fair market rate. It reduced their borrowing costs and, in the case of banks, lowered regulatory minimum capital requirements.

For example, suppose a leasing company needed to raise cash. Under standard procedures, the company would take out a loan or sell bonds. Its ability to do so, and the cost, would depend on its overall financial health and credit rating. If it could find buyers, it could sell some of the leases directly, effectively converting a future income stream to cash. The problem is that there is virtually no secondary market for individual leases. But by pooling those leases, the company can raise cash by selling the package to an issuer, which in turn converts the pool of leases into a tradable security.

MEANING & DEFINITION

I. Definition

Below are some of the ways to define Securitization: -

1. The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.

2. Securitizationis the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into asecurity.

3. Securitization is a process by which a company clubs its different financial assets/debts to form a consolidated financial instrument which is issued to investors. In return, the investors in such securities get interest.

4. Asecuritizationis a financial transaction in which assets are pooled andsecuritiesrepresenting interests in the pool are issued.

II. Meaning and Explanation

History of evolution of finance, and corporate law, the latter being supportive for the former, is replete with instances where relations have been converted into transactions. In fact, this was the earliest, and by far unequalled, contribution of corporate law to the world of finance, viz., and the ordinary share, which implies piecemeal ownership of the company. Ownership of a company is a relation, packaged as a transaction by the creation of the ordinary share. This earliest instance of securitization was so instrumental in the growth of the corporate form of doing business, and hence, industrialization, that someone rated it as one of the two greatest inventions of the 19th century -the other one being the steam engine. That truly reflects the significance of the ordinary share, and if the same idea is extended, to the very concept of securitization: it as important to the world of finance as motive power is to industry.

Other instances of securitization of relationships are commercial paper, which securitizes a trade debt.

However, in the sense in which the term is used in present day capital market activity, securitization has acquired a typical meaning of its own, which is at times, for the sake of distinction, called asset securitization. It is taken to mean a device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collaterals, and thereby achieve the purpose of financing. Though the end-result of securitization is financing, but it is not "financing" as such, since the entity securitizing its assets it not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it.

Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

This process enhances liquidity in the market. This serves as a useful tool, especially for financial companies, as its helps them raise funds. If such a company has already issued a large number of loans to its customers and wants to further add to the number, then the practice of securitization can come to its rescue.

The simplest way to understand the concept of securitization is to take an example.

III. Example

1. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isn't aliquidsecondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a diversifiedpool of auto loans, which may be an attractive alternative to acorporate bondor other fixed income investment. The ultimate debtorsthe car ownersneed not be aware of the transaction. They continue making payments on their loans, but now those payments flow to the new investors as opposed to the financing company.

2. Let's start with a 10-year mortgage. (It's easier to see the chart with a 10-year mortgage than a 30-year mortgage, but it works the same way with any maturity). The mortgage consists of 12 payments a year, for 10 years. Let's group the payments together by year, so each box on the following chart constitutes 12 monthly payments.

Now let's throw four such mortgages together. They look like this:

Now let's pool those into one. Think of it this way. Each payment is represented by a coupon. The lender has 120 coupons f