LO 34.1: Discuss the flaws in the securitization o f subprime mortgages prior to the

LO 34.1: Discuss the flaws in the securitization o f subprime mortgages prior to the financial crisis o f 2007.
The financial credit crisis of 2007 is thought by some to have been caused by the process of transferring credit risk. However, during the credit crisis, the credit risk transfer mechanism did perform its intended function. The true issue was not the credit risk transfer process itself, but rather the underlying flaws in the pre-crisis securitization process.
Securitization in its most basic form is simply using financial engineering to repackage a pool of assets into a new asset that can be sold to investors. This innovation enables banks to transfer the credit risk inherent in mortgage lending to investors through mortgage- backed securities and similar investments. This process enhances the availability of loanable funds for borrowers, expands the pool of diversification options for investors, and minimizes the borrowing costs for a given risk-class of borrowers.
The securitization process enabled an active originate-to-distribute model where banks could originate a loan for the sole purpose of turning a quick profit and selling the securitized product to investors. This creates a conflict of interest because every link in the securitization chain, from the originator to the lender to the investment banker to the credit rating agency, had the potential to earn a relatively quick, short-term profit through securitization without retaining any of the risk, which was ultimately outsourced to investors. The gains in the securitization supply chain were linked solely to deal completion and not to the potential risk of the borrowers. In this process, U.S. financial institutions
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
misjudged the liquidity and credit concentration risks inherent in mortgage lending. This paradoxical deviation from the traditional risk-reward tradeoff created less incentive to monitor the creditworthiness of borrowers and reduced accountability. It is one of the key flaws in the securitization process.
Professors Note: According to the Joint Center for Housing Studies at Harvard University, from 2001 to 2006, conventional mortgages (30-year, fixed rate mortgages) fell from 57.1% o f all loan originations to 33.1% . Subprime loans rose from 7.2% to 18.8% ! Approximately 40% o f all mortgages purchased by Fannie Mae and Freddie Mac, from 2005 to 2007, were subprime loans. Demand increased substantially for loans built with adjustable interest rates, zero down payments, and no documentation o f income sources.
Another flaw in the securitization process is the opaqueness of the end product. Neither investors nor the rating agencies, whom the investors relied upon, fully understood how to evaluate the multilayered securitized products. Investors did not fully understand either the credit quality of the underlying loans or the potential correlation within the loan pool should an unexpected shock occur. This created a very fragile system based on trust, which was later broken when the expected low default rates exceeded a margin of safety.
A third flaw is that as time progressed without any initial problems, many banks elected to start retaining the risk of structured products. In fact, in mid-2007, U.S. financial institutions directly held $900 billion of subprime mortgage-backed products on their books. They used rolling short-term debts to finance purchases of long-term mortgage- backed structured products in off-balance-sheet entities known as structured investment vehicles (SIVs) partly because mortgages earned much higher returns than corporate bonds. Banks thought that they were earning a riskless spread over corporate bonds with comparable ratings. By using a leveraged SIV instead of holding the actual loans on their balance sheets, banks were able to use far less capital to hold a pool of mortgages. On one hand, this flaw appears to be a partial correction for the first flaw. Banks did start to retain some risk, but they used a mechanism that still prevented investors from evaluating the full extent of the risk.
In fairness, banks sometimes used SIVs as a warehouse for unsold structured products that were waiting to be matched with a willing buyer, but more often, the securitized products were seen as a sound investment by themselves. Some of the largest buyers of securitized U.S. subprime loans were European banks. For example, in 2006, subprime securities accounted for 90% of the profits of Sachsen Landesbank in Leipzig, Germany. This bank probably does not sound familiar, because it is no longer in existence. The bank ceased operations in 2007 due to its excessive level of leveraged risk exposure.
When structured with transparency, the credit risk transfer mechanism should assist the price discovery process for credit risk. If the three flaws identified can be adequately addressed, then financial institutions can once again use the credit transfer process to effectively manage risk.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
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