It is an innovative fund raising process which came into existence in the late 1970’s and has multiplied phenomenally over the years. The crux of the concept on which this process is based is the grouping or pooling of assets with predictable and pre-defined cash flows structure or rights on future expected cash streams and the re-engineering or re-packaging of such cash flows into financial instruments or securities that are then sold to investors. Such cash flows can accrue out of loans, trade receivables, mortgages, royalties etc.
The term “securitization”, itself is derived from the fact that securities are the final mode of financial instruments which are issued to investors to obtain funds.
As any asset with an associated stream of cash flows can be securitized the securities which result from a securitization transaction are termed as Asset Backed Securities and the transaction itself is termed an Asset Backed Securitization (ABS). With more such issuances being based on underlying mortgage based loans, Mortgage Based Securitization (MBS) became widely popular.
Once mortgage backed securities started flooding the markets, the banks and financial institutions also resorted to securitization of the pool of assets to shift the risk to investors in these securities as well as to obtain funds well ahead of the scheduled tenor of these assets. This implied that originators/issuers could repeatedly re-lend a given sum, greatly increasing their fee income and providing a multiplier effect of the underlying notional. Securitization resulted in a secondary market for mortgages, and the lenders were no longer required to hold them to maturity. With increasing securitization deals being struck, and the resultant transfer of default risk, the issuers lowered their underwriting practices to increase their loan disbursements.
The flair for securitization i.e. mortgage backed securities accelerated in the 1990s and total amount of mortgage-backed securities issued tripled between 1996 and 2007, to $7.3 trillion. Alan Greenspan has commented that credit crisis cannot be blamed on sub-prime mortgages alone, but rather on the securitization of such mortgages which created a notional far exceeding the actual value of the underlying assets actually available. The credit risk in sub-prime mortgages got passed on to other investors through the securitization mechanism and with a wide arena of investors globally, the impact of the credit crisis is felt on a global level.
During 2004 to 2007, further to the drop in interest rates, many investment banks opted to leverage on the situation as they found it beneficial to raise large amounts of debt at cheaper rates and invest in mortgage backed securities on the impression that housing boom will continue.
During the boom the traders in Wall Street were eying on the bonuses available end of year and not the long term impact on the firm or the market. According to the New York State Comptroller’s office, Wall Street executives have bagged in bonuses totaling @23.9 billion in 2006.
Though profitable during boom, it had adverse impact on such institutions during drop in housing rates and increase in mortgage delinquencies and foreclosures.
After an SEC ruling in 2004 which relaxed the amount that can be raised as debt by investment banks, debt issuances multiplied. Leveraging by top five US investment banks rose phenomenally to over $4.1 trillion for fiscal year 2007, which is about 30% of US nominal GDP of 2007. These were the 5 banks which crumble under the weight of the crisis. One of them viz. Lehman Brothers went bankrupt. Two of them viz., Bear Stearns and Merrill Lynch were sold of at dead low prices.
Two more viz. Morgan Stanley and Goldman Sachs converted themselves into Commercial Banks to avail financial support from the Federal Reserve succumbing to stringent regulation.
Lowering of interest rates in the early 2000s was taken up by the Federal Reserve to negate the effect of the Information Technology bubble earlier based on the premises that the rate could be lowered as long as the inflationary pressure was being kept low.
The low interest rates contributed to the housing bubble.
US government got more inclined towards the mortgage industry to make home purchases more favorable and ended up fanning the boom by relaxing lending standards of Fannie Mae and Freddie Mac.
This has increased the ownership in residential mortgages of the government sponsored enterprises viz. Fannie Mae and Freddie Mac to a staggering $5.1 trillion.
This assumes importance when looked at in relation to net-worth of GSE’s as of 30th June 2008 which was a mere $114 million which raises serious doubts on their ability to service their guarantees.
