Role of Securitization and of Special Purpose Vehicles in the 2008 Financial Crisis

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The purpose of this survey is to show the idea of securitization related to the house equity mortgage. It will explain the reason why Assets Back Securities (ABS) were created and how this was supposed to create a better and efficient market by reducing the risk. Additionally, it will help to acknowledge how ABS base on subprime mortgages affected the entire economic system and how securitisation has led to the Financial Crisis of 2007-08.

The survey will also cover how the crisis started in the U.S. in 2007 and how it affected the whole U.S. banking industry. Moreover, it will help to understand how Lehman Brothers bank collapsed in 2008 and why big firms had to rescued by the U.S. Federal Government.

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One of the biggest financial crises happened thirteen-fourteen years ago in U.S., at the time researches could not understand the reasons behind it but nowadays everything is clear. U.S. 2007-08 financial crisis has affected all the countries economises around the world and caused really negative effect in the developing countries at the time, and those countries are still suffering and struggling to recover after so many years. Thousands of people have lost their job and thousands of borrowers have lost their home, many investors have lost their investments and savings, the unemployment rate went up dramatically and led countries to recessions. During this huge crisis also one of the biggest banks failed, the Lehman Brothers, and many commercial banks started to fail too. So many reasons have led to the crisis, borrowers have overestimated their ability to pay back the mortgage, bankers were too confident and were selling subprime mortgagees to people that had no abilities to repay them and credit rating agencies were giving the highest AAA rating to securities without actually checking them instead of supporting the investors with their decisions and protecting them from taking too much risk in their investments.

The Financial Crisis of 2007-08

A financial crisis is a situation in which some financial assets suddenly lose a large part of their nominal value. A financial crisis usually is associated with banking panics or bank run, this happens when depositors withdraws their savings and therefore cause the bank to run out of cash and to not have enough money to pay back all the depositors.

The U.S. financial crisis started in 2007 with a crisis in the subprime mortgage market and became an international banking crisis. Additionally, to this crisis the failure of the Lehman Brothers investment bank had intensified the catastrophic consequences globally.

The main causes were the increasing in the housing market in US and the rising in subprime lending. The amount of the low-quality subprime mortgages rose from the historical 8% to almost 20% from 2004 to 2006. And, the rising demand for new houses had pushed the prices up significantly. In US the average price increased between 60% to 100% or higher during the years 2000-07. Housing market was overpriced and overestimated. Banks lowered their credit requirements in order to attract new borrowers, it was possible for low-income and minority to get a house mortgage. All those new loans were securitised straight after issuing. Subprime mortgage origination in 2005 and 2006 was about $1.2 trillion of which 80 percent was securitized. Banks believed that borrowers could finance and refinance their homes based on capital gains due to the increasing in house pricing over short horizons and then turning this into collateral for new mortgages. Banks also assumed that in case of bad mortgage they could have sold the collateral with better profit as the house price were only going up. None of the financial institutions wanted to believe in the crash on the housing market. However, in 2007 the number of bad mortgages were enormous and as the interest rate was rising and therefore the price of houses started to drop in many parts of US, borrowers were unable to repay their loans. Investors demanded additional collaterals from banks, and they started to sell the securities they were holding, and all these has led to the financial crush. The losses experienced by financial institutions on their mortgage securities impacted the ability to lend which has slowed the economic activity. Concern about the stability of the key financial institutions pushed central banks to take action to provide funds to encourage lending and restore faith in the commercial paper markets.

Securitisations

We can conclude from the introduction and the brief description of financial crisis that what happened was caused by bad mortgage lending. However, without securitisation, bad mortgage would only have affected lenders and not the whole economy.

Securitisation is the process of creating asset back securities which means that an issuer creates a financial instrument by combing other financial assets and then sell different parts of the new combined instrument to investors. This process can incorporate any type of financial assets but usually, it is a financial asset with a periodic cash flow. Mortgage back securities are the perfect example due to the fact that financial institutions have combined mortgages into one large pool and then divided it into smaller sections according to their risk to default and then sold them to investors.

So basically, what happened was, banks gave out mortgage loans to borrowers and each loan had the house as collateral. The banks 1 did not want to wait years to be repaid so they decided to sell those financial assets to another financial institution 2 which was a great opportunity for the bank as they would have more liquid cash to invest into new projects/loans. Now the financial institutions 2 have the mortgages and they know that each mortgage have a different level of risks. The risks are different because banks 1 were lending to different clients, some of them were good clients with long and excellent credit scores, other were clients with short credit history who might have faced difficult doing repayments in the past and additionally the banks 1 were leading to new borrowers with no credit history. Institutions 2 divided them into three categories: Senior, Mezzanine and Junior. Anyway, the financial institutions 2 did not want to keep those assets too, but they wanted to make a little bit of profit from them, so they decided to create a new asset called Mortgage Back Security (MBS) and sell it to investors. The new assets are better than the loans together as the risk was shared between the three groups (trenches) and the investor could choose which assets to buy according on how much they wanted to risk and how much interest they wanted to gain (the higher risks one had would pay more interest, the mortgage of borrowers with no credit history).

The structure of the tranches is known as the waterfall as well. Cash paid by collateral falls first to the most senior tranche, then down through the mezzanine to the junior (David Murphy (2009) Unravelling the credit crunch, CRC Press. Chapter 6). Now let’s suppose that the issued securities would pay interest every three months. At the start of each quarter, the payment goes into the senior tranche and once this account has got enough money on it to meet its interest the flow of cash is redirect into the mezzanine tranche, same happens with the Junior tranche. In other words, cash comes from the top down, paying first the senior, then the mezzanine, then the junior securities. Differently, losses come from the bottom up which means that if the original borrowers fail to repay the mortgages investors that have junior tranche will suffer the loss first.

In 2006 securitisation become a huge business, three trillion dollars of ABS were issued during this year. The structure of the securities was not as simple as explained in the previous paragraph, but it had become more complex and with more tranches, increasingly sophisticated forms of credit enhancement and a widening range of collateral. This diversification of the securities had misled investors into buying assets extremely risky. Moreover, banks had decided to create many other financial instruments such as RMS, commercial mortgages, credit card, bonds, corporate bonds.

Special purpose vehicle (SPV) in securitisation is the trust, so is the trust investors had into credit rating agencies and credit rating.

How did invertors know in what they were investing into? Most of the investors did not understood at all the new structure of the new assets and they relied on credit ratings. When investors were offered a complex instrument, which seems to offer a good return, some lazy investors failed to try to understand what they were investing and just believed fully in the high credit rating. The problem with credit rating was that a single rating could not express all the behaviour of a complicated financial instrument. Furthermore, the credit rating agencies were giving fake information (higher rate even to risky assets) as they were paid by the issuers. Even the riskier assets could have been rated as AAA. The primary ABS market was controlled by a handful of banks and brokers. The credit rating agencies had to keep them happy as they derived more than twice as much revenue from rating ABS as from any other business line. Moreover, the agencies gave access to their models to the structuring banks which means that ABS structures could be remodelled to get the best rating for each tranche and therefore the investors would had always saw the best rating available. Furthermore, if one of the three biggest agencies, Moody’s Investors Services, Standard & Poor’s and Fitch Ratings, used to use a particular feature this feature would have been simply used for rating securities. This process is as ratings shopping. Banks has used those 3 agencies to get an almost complete absence of unsolicited ABS ratings.

Everything happening in US between the years 2005-07 seems like screaming danger, from the big increase in securitisation, the lack of the investors understanding about the new financial instrument, the fake information provided to the investors from credit rating agencies, banks paying the agencies to get a better and attractive rate for their assets and the failing in house market pricing. When the average house prices started to collapse many borrowers stopped to repay their mortgages and the main problem with this was that the investors who bought those MBS did not get any payment and there were no funds or any plan to keep up their payments. This was the begging of the panic for all the investors holding mortgage backed securities.

The transmission of small/medium sized risks around the financial market is a good thing as none of the institution is endangered by the risk and there is still confidence. However, the ABS risk was too large and would have been better to not be distributed into the market because most of the firms miss-assessed the risk due to lies and unreal credit rating and many of those firms have taken the risk without actually knowing it. The risk of the mortgage lending was misjudged due to historical data that had indicated that mortgage was safe, but those data did not include the effects of lending to everyone and did not gave insight into what would happened when the house pricing would have failed. ABS then just passed the risk into the financial system.

Most of the business based on ABS lost an enormous amount of money since the crisis started In August 2007. Few of those firms were necessary for the stability of the entire US economy, were considered too big to fail and therefore the federal government decided to help them by applying the bailout plan. Due to the losses caused by securitisation Lehman Brothers, one of the biggest investment banks, failed in 2008 and the government could not help them. This crisis did not stop in US, but it went all around the world and it caused serious damages in the developing European countries like Greece, Italy, Spain and Portugal.

By the end of 2008 the world 100 biggest banks have reached nearly $600B of losses related to subprime mortgage. The larger losses came from some of the largest banks like Citigroup write down $60.8B. Firms that have not written down have struggled to attract and convince investors that their exposure to subprime was contained and truly valued. Rating agencies had to downgrade many businesses involved and businesses that did not prove that they had clear information fell as none wanted to invest into those firms anymore. Many people in banking sector lost their job and the unemployment rate were increasing.

After the crisis regulatory institutions understood that they have to concern more about the macro-economy instead of the micro-economy as the it was more important to analyse the decisions taken by governments in order to prevent the failure of the banking system and also to prevent the domino effect to other countries financial institutions, maybe it will not affect the whole world as nowadays there are more regulations and legislation in order to block another economic crisis. Additionally, financial institutions hopefully have understood to not spread the risk into the market, if one financial institution keep their risk instead of passing it into the market the financial institutions will be the only one to be affected if anything bad happens and the rest of the market would be safe or not get impacted fully. Banks also understood to not fully rely on historical data in order to invest in new assets because historical data do not give an accurate insight about the assets. Furthermore, financial institutions should not believe that a certain type of assets would have the same value for longer terms as it might lose value in some point in the time therefore, they should try to diversify their investment into different assets instead of investing everything on the same one. Lastly, financial institutions have to always keep updated their data with the new information available in the market in order to have a better pricing and risk calculating models and credit rating agencies should only use their knowledge and the information available to them when rating an assets instead of doing it to achieve personal gains because their main job is to help investors to invest their money as safely as possible.

The role of securitisation in banking sector have been fully understood after the crisis happened. Now we know that banks have to do more checks and be more careful when securitising mortgages and mainly carry out a deep credit check before giving out any mortgage or loan because some borrowers can be too risky to be trusted. In my opinion securitisation is a good financial instrument if it is used properly and it can help many investors to get safer assets, but regulatory institutions have to make sure that the data provided regarding the new assets are reflecting the truth.

References:

  1. En.wikipedia.org. 2020. Financial Crisis. [online] Available at: [Accessed 06 May 2020].
  2. En.wikipedia.org. 2020. Subprime Mortgage Crisis. [online] Available at: [Accessed 06 May 2020].
  3. Murphy, D., 2009. Unravelling The Credit Crunch. Boca Raton: CRC Press/Taylor & Francis Group. (Chapter 1, Chapter 6 & Chapter 8)
  4. THE PANIC OF 2007 Gary B. Gorton. Working Paper 14358 http://www.nber.org/papers/w14358
  5. Special Purpose Vehicles and Securitization* Gary Gorton and Nicholas S. Souleles. May 24, 2003 This Version: September 2005

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