Securitisation The Banking Crisis Finance Essay
The financial innovation that helped banks such as Northern Rock Bank to grow so fast (The Economist 2007) was based on transforming credit cards, mortgages and other sorts of financial assets into a pool of marketable asset-backed securities that spread globally. It was the same reason that brought huge costs which made banks suffer later on and caused the worst financial crisis since decades (The Economist 2010).
Innovation of securitisation was supposed to help disperse loan risk by sharing it among banks and other investors; it was meant to make the financial system more resilient by taking the loan off the banks' balance sheets (figure 1) and spreading it among different groups of investors (The Economist 2007).
Figure 1: Securitisation used to free banks' balance sheets (The Economist 2007)
In reality, securitization concentrated the risk in the banking sector; when the financial crisis started to reveal, risks returned back to the banks since the toxic assets were back on the banks' balance sheets. During that period, the process of securitisation funded an estimated USD 8.7 trillion assets; most of the loans in America were securitised and many European banks used securitisation to fund the massive expansion of lending during the financial boom (The Economist 2009) (figure 2).
Figure 2: percentage of loans compared to deposits during the boom in European Banks (The Economist 2009)
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So what went wrong? Has the securitisation theory proved to be wrong? Instead of spreading risk, it just concentrated it and created a loan bubble that burst into a global crisis? Or applying the theory was exploited to the extent that turned a great benign practice into epidemic that widely spread among the developed countries causing one of the biggest recessions in years?
This assignment is meant to further reveal the essence of the role played by securitisation and structured finance products in the recently global banking crisis in developed countries, with focus on USA, and further understand the "moral hazard" borne by this process that resulted in creating irresponsible decisions that gave birth to a global crisis. Finally, it will be concluded by personal thoughts and recommendations about the future of practicing securitisation and could be done to avoid future disasters.
2.0 Role of Securitisation
Traditionally, structured finance products had feasible funding tools that improved the growth of economy over the last three decades; they helped in separating risk from loan issuers by creating a "bankruptcy-remote" structure and by tranching a pool of assets according to the underlying risk. The increased use of securitisation created customized low-cost mortgages with risk-modified pricing that suited a wider range of borrowers. It consisted of pools of home equity loans, credit cards, student loans and many other debts. Theoretically, this risk was supposed to be comparatively low since the assets were highly uncorrelated.
Still, this innovation is not "flaw free". It sent an invitation to greed and fraud which ultimately burst into a financial disaster. While the correlation assumptions should have been made according to the full understanding of the underlying assets and the relationship between lenders and borrowers, banks started to release subprime credits without verifying the credibility of the borrowers; the belief of no risk and that the credit will be rated AAA by private agencies then sold through CDOs made banks less responsible when issuing loans (EL Boghdady 2009). The emerge of the once rated AAA CDOs technology made the process of tranching more complicated and opaque; the subprime crisis was created. Eventually investors' confidence diminished and rating agencies' techniques were proved to be reckless (Wheeler et al. 2008).
The crisis gradually started when investors began exploring alternatives for investments to corporate debt. So they switched to securitisations for higher returns. Consequently, balance sheets of banks, money market funds and hedge funds grew dramatically. At the beginning of the year 2005, securitisation spreads narrowed leaving investors with limited profit. Therefore, investors lowered their costs of funding and "Liars'" loans, 62% of USA mortgage loans, started to show up. As a result, use of SIV and MBS highly increased. This created huge imbalance which forced many lenders to withdraw. In 2007, and after the bankruptcy of the Lehman, loss of confidence spread and it became difficult to obtain any kind of funding. This resulted in government to take action to ensure the continuation of banks which were affected by the toxic assets lying under the name of SIV which risk was considered an off balance (Wheeler et al. 2008).
Nevertheless, the recent economic boom, before the crisis, was the result of: strong global growth, low inflation and interest rates, stable macro volatility and easy foreign borrowing, which reached 300% in USA in fifteen years (Figure 3). All those factors pushed spending and asset prices up (The Economist 2010). As a result, the supply of and demand for credit in many developed countries mounted; in order for investors to remain competitive in fierce competition for high returns, they accepted higher risks (Wheeler et al 2008) which resulted in rising the subprime mortgages in USA, for example, from USD 190 trillion in 2001 to USD 600 billion in 2006 (The Economist 2008).
Figure 3: Debt as % of developed countries GDP, 2008 (The Economist 2010)
Over time, the problem of the weak inflated structured banks' balance sheets, which exceeded the real economy growth rate, started to reveal through: the doubtful quality, value, and liquidity of many assets, the low capital levels compared to the true risk lying in balance sheets and, most significantly, the "Black Swan" effect of the previously "miss-calculated" correlation of firms working in the global financial system (Wheeler et al 2008).
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When interest rates started to increase and borrowers wanted to refinance their loans, as they always used to, the more difficult mortgage finance requirements caused a credit shock. Forced selling of houses started so prices of houses declined. This caused imbalance; investors started to realise the great loss in subprime AAA rated CDOs. The economy eventually stopped issuing CDOs, ABS and RMBS and investors started to sell bonds to avoid further losses. It was a massive spread of faith loss (The Economist 2010).
Consequently, huge numbers of ABS was downgraded. In 2007, Moody's downgraded 31% of ABS tranches it had rated before and 14% of them were previously rated AAA. (Coval, Jurek, and Stafford 2008). Mortgages started to default. As a result, the increase of mortgage defaults left gaps in the cash payment stream which backed the ABS. Since the entire process was opaque; no one knew the essence of the problem. No one could figure out which ABS was good and which were bad. Eventually most of ABS were treated like toxic waste and were downgraded. MBS reached a point where it couldn't be liquidated since it wasn't wanted because it wasn't possible to be valued. Investors panicked, many banks almost went bankrupt, house bubble was created, many borrowers defaulted and governments had to interfere to resolve the chaos.
Securitisation largely helped in the financial crisis as securitisation kept the issuer away from credit risk and consequently lowered loan standards. Also it has made banks create vast leverage which was absorbed by regulated and unregulated pools. The system was flooded with credit money. Private debt to GDP ratios has reached its highest numbers (Wheeler et al 2008). The whole financial system crashed.
3.0 With and Without
Securitisation products financed 30-75% of lending in the global market which totaled USD 16 trillion. For instance, most banks securitised 50-60% of the credit card loans. It also supported house owning; the US home ownership percentage peaked to reach almost 70% in 2005 (Wheeler et al 2008). (Figure 4)
Figure 4: House Ownership in USA from 168-2008 (Wheeler et al 2008)
Besides, securitisation never caused crisis in almost three decades. On the contrary, it helped in making the market more efficient and effective by distributing junk loans around the world. In some countries they avoided disastrous concentration of falling mortgages by using securitisation (Wheeler 2008).
Going back to history, depressions occurred to many countries as part of the ongoing cycle caused by the imbalance between supply and demand; like the Great Depression of USA in 1929 caused by the cut back of expenditures by consumers due to the great loss in the stock market same year (Hamelton 1987). Moreover, the current sovereign debt crisis in Greece was the result of huge foreign capital debt. After it was growing at an annual rate of 4.2%, it suffers now of huge structural deficit that led the country into recession (Walayat 2010).
From a personal point of view, securitisation is one of the main reasons that caused and accelerated the inevitable recession the developed countries were hitting, but it wasn't the only reason. The huge available foreign debt and the imbalance between the increasing supply of debt pushed economies further towards a crisis; securitisation made it flow above the surface.
We cannot deny the importance of securitisation in deleveraging banks' balance sheets to reduce risk. Securitisation may have given the boom to financial crises, but loose monetary regulations, greedy banks, careless investors and the failure of risk management were all the main failure of the securitisation theory when applied.
Nonetheless, securitisation process provided home owning to millions of families over 30 years, provided private corporations with relatively low cost financing to grow their businesses. The process is sound, but individuals misused it. At the same time it created entirely new markets where lenders and borrowers were linked from all over the world, lowered finance costs, freed up capital and gave birth to investment opportunities for pension funds, individuals and university endowments.
There are many possible solutions that could help the economy revive again and start trusting securitisation process since it is very essential to economy's growth. To start, the financial system will have to depend on the supervision of private counterparties to ensure safety as much as possible. The conventional governmental regulations will not be able to monitor the financial increasing complexity among banks. Also Inflation should include asset price increase beside the consumption increase. Consumption prices in countries like USA were kept low because of China, but asset prices were amplified after the debt growth (The Economist 2009). Rating agencies ought to find improved reliable new methodologies to rate the assets. Also they should be regulated.
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Moreover, CDOs should be gone forever; risk should be more predictable by emphasising on the quality of borrowers. Using this technique will make securitisation less opaque and computing the odds of default easier.
Also the moral hazard, securitisation biggest flaw, could be fixed by making issuers take the first loss, if any, of the default in the securitised pool of assets. Hence, issuers will have more incentive to choose the quality of the borrowers.
Finally, financial firms should start working on developing risk management and data consistency since the core of the financial crisis was due to misunderstanding of risk. This includes data transparency. Senior managements should learn that data transparency is very crucial to effectively evaluate credit exposure and more accurately associate the risk to assets more evaluate the underlying illiquid assets in the structured finance products.
The recent financial crisis will change regulations of firms and tendency of investors and borrowers. Maybe the financial crisis will change the tendency to own a house like what happened in Germany after the hyperinflation it went through. It has comparatively low rate of home ownership compared to USA and UK. During the recent financial crisis, some borrowers gave priority to their credit cards and auto loans rather than the mortgages (The Economist 2010), so in the future they may avoid home ownership to keep away from future losses. Banks now are more aware of the risks of such process; this will lead them to be more responsible when giving loans. As a result subprime lending will decrease, if not eliminated and ABS markets will shrink significantly. But the definite answer is that securitisation will never disappear from markets due to its great contribution to the expansion of economies.
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