Securitization an Art or a curse?

 

Securitization an Art or a curse?

             -by Abhishek Maity

 

Securitization is a procedure where an issuer creates a financial instrument by pooling together various financial assets into one group. An advanced form of the above process is a mortgage-backed security which is a pool of only mortgages exclusively.

Assume that a bank has a lot of housing loans on the book which provide returns in terms of interests and principal payments to the bank plus these loans are also guaranteed by the underlying housing properties known as mortgages. But then an investment bank approaches the older bank to create a new financial instrument by pooling all the housing loans into different tranches according to their credit-worthiness, known as collateralized debit obligations (CDOs) and then selling units of these CDOs to a different class of investors.

So, our traditional bank get returns from the usual interest payments plus the money received by selling the pooled assets and the investment bank who gets the fair share of the deal.

Why it became so famous before the housing crises of 2008?

After the dot-com burst of 2000’s the USA government swing into motion to tackle the economic challenges posed by this crash. The measures included lower interest rates on loans, policies to promote house ownerships, excess inflow of funds into the housing market which all together fueled the demand and valuation of the housing properties to astronomical heights, the price of a house on an average in USA was around $314,000 in 2007.

Buoyed by such an encouraging milieu in the housing market, such properties were considered as the safest asset class, even if the person defaulted the banks could get the highly valued property. Hence the CDOs consisting of these properties were given triple A ratings by most of the credit rating agencies and a number of investment banks started acting as third parties brokering deals between the investors and the owners of such housing loans.

 

What caused the investment banks to lose their money?

But as it became clear that the banks were making loans to groups who were highly likely to default on loan payments and the investment bankers creating pooled assets of such low-quality loans, but these were shown as assets backed by real estates on the firm’s books which further amplified the firm’s valuations. But firms like Lehman Brothers and others also borrowed funds to create new types of instruments like synthetic-CDOs, super seniors, Repo 105, square-CDOs so on, all of whose earnings were dependent on the blossoming housing market and when the weather turned against the cordial surroundings in real estate market which diminished the valuation of the underlying assets and   these assets which where once considered the safest categories now were seen by banks as highly toxic assets. As a result the supply of houses in the market  swelled as lot of people were defaulting but the demand for these were less, depressing the prices further and magnifying the sentiment in the economy against the housing market.

Since investment banks operated on leverage to earn profits this problem of moral hazard hit the ones hardest who weren’t prudent with their lending practices and risk management solutions. During the first half of 2008 Lehman Brothers had a total-assets of $680 billion supported by only $22.5 billion of firm capital along with a $4.3 billion in only mortgage securities which implied how vulnerable was this firm to the gyrations in the market. And close to 100 hedge fund firms were dealing with Lehman as result the erosion of financial assets quickly spread through the U.S economy, like Freddie Mac had to write off $400 million and Framer Mac had to let go of around $54.5 million as a result of Lehman bankruptcy.

It is really bewitching that an instrument which reduce the risk of default and increased returns ended up spreading that risk among larger number of market participants creating channels of transmission for market sentiments which finally lead to the 2008 financial crises.