Securitization: How It Caused Global Financial Crisis?

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Securitization refers to the process of consolidating or pooling together debts such as mortgages, bank loans, and other types of debts and then selling these debts to investors as securities or some cases as bonds. The investors that buy out the debts are the one who takes the responsibility of collecting the principal and interest from the debtors. Examples are mortgage-backed securities (MBS) which are securities backed by various mortgages and asset-backed securities (ABS) that are backed by another form of credit. (Jobst, 2009.p49) This paper explores and analyses the history and the process of securitization and the securitization practices that resulted in the global financial crisis in the year 2007.

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Securitization has its origins in the United States in the 1970s. The exercise started as a process of pulling together mortgages by a United States government-backed agency as a measure of spreading risk and diversifying investments. By the year 1980s, the industry had grown to include other income-generating assets in the securitization process. The industry has grown since then to become a big business not just in the United States. The industry also grew in other countries as well (GECRC, 2009, p25)

Financial institutions employ this method of securitization to lessen the risk of credit by transferring the risk to other investors. It is easier for financial institutions to raise money through the process of securitization than other methods. Securitization also allows for spreading of risk for financial institutions and reduces the risk concentrations and the vulnerability of risk to financial institutions (IMF, 2010 P. 100).

Since its birth in the early 1970s, the securitization industry has grown by leaps and bounds and has grown even in other countries including Europe, Asia and Australia. Many financial institutions were very quick to cash in on the opportunities the securitization offered like freeing up of capital base, support of additional underwriting funds, reduction of credit costs and allowing broadening the base of sourcing for funding. In its early years, the securitization process was very successful because the securitization structures were very simple easy to comprehend and guaranteed competitive returns for the financial instructions involved. The risks involved in the securitization process were also very clear and comprehensible (Kolb, 2010, p72).

Diversification of the industry to include fixed income investors forced the investors to diversify the portfolios to include consumer credit and with a short time, variable securitization packages were developed and customized to satisfy the specific target investments of the investors. In around 30 years, the industry had grown to become a permanent feature of the money markets with great acceptance that by the year 2006, 55 percent of all mortgages in the United States were securitized. Between the years 2005 and 2007 many United States financial institutions securitized about 46 percent of the total Mortgage debts (PWC, 2011).

Before the global financial crisis unfolded in the year 2007,the only problem that was associated with the securitization process was the deterioration of the standards for prudent lending and risk management by the financial institutions involved in subprime lending and investments. Low default rates coupled with availability of many hedging tools allowed the financial institutions in the securitization business to risk more to achieve bigger yields (Shin, 2010 p321).

Many securitization firms started not keeping the loans and mortgages in their balance sheets to make the securitizing companies relax their screening and monitoring of borrowers to attract more firms into the securitization business. The financial institutions utilized this chance to grant loans and mortgages to non-creditworthy clients due to less scrutiny by the securitization companies resulting in a very systematic deterioration of the collateral and the lending standards (Shin, 2010 P. 322).

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Initially, the mortgages and other financial institutions involved in the securitization process were under critical scrutiny and robust underwriting from the securitization companies. However, as the securitization, the process became bigger and many players got into the industry, the time of the origination of loans and securitization lessened. This shortened period of securitization of loans and the desire to make more in the securitization business resulted in the slippage of discipline that surrounded the credit evaluation and underwriting process (Wolfgang, 2009. p123).

More and more investors entered the securitization market and some of the investors started using limited evaluation and screening of their mortgaged and debt products resulting in exposure to more risk. Many of these new investors in the securitization business relied only on the ratings released by the Nationally Recognized Rating Organizations (NRSROs) (Jobst, 2009. p52)

The demand for new products in the securitization business resulted in the entry of many brokers who performed the functions, which were traditionally performed by the banks and mortgage firms. These independent securitization firms were not subject to strict regulation resulting in the rapid growth of the securitization firm’s network. Many of these new entrants firms into the securitization business did not have incentives beyond the point of origination of the loans (GECRC, 2009. P72).

With all the innovation that came with the increased number of players in the securitization industry, the innovation became advantageous to investors, and in an attempt to cash more; the securitization firms were therefore inventing new products that had not been tested before in the markets that were experiencing some form of economic stress (PWC, 2011).

The securitization industry relied on the decreased credit enhancement levels and complicated securitization structures to transact business. This resulted in the advent of the originate and sell a model of the business where lenders experienced little risk once they securitized their loans because of the high risk that was associated with sup prime mortgagees. Many of the lenders were therefore motivated to securitize a significant portion of the subprime mortgages and loans they originated (IMF, 2009.P 112).

The securitization industry was not flexible to respond to the changing needs of the securitization market. Securitization firms relied on the structure and pricing models that utilized historical information and did not in any way prepare or anticipate the impact of the merging trends in the behavior of their consumers. This resulted in the securitization market not assessing the credit risk of loans and the mortgages they lend to their clients. The credit quality of borrowers did deteriorate over time and the performance of payment declined over time (Jobst, 2010, p53).

The model used by the securitization firms in determining the rates of securitization utilized historical information and trends. These Firms assumed that the securitization market would continue to follow the same trends in future just as they had done in the past. The prime mortgage market did not fully anticipate the unprecedented number of mortgage-based securities that were backed by supreme mortgages and non-regulated processes of underwriting (Jobst, 2010, p54)

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By the year 2006, the number of subprime-backed securitizations stood at 40 percent. Of all securitizations, the pricing model of securitization did not also factor in the decoration in the markets associated with a decline in house prices and market forces. Before the financial crisis began in the year 2007 all securitization, deals were assigned a rating of AAA by the NRSROs. In the early years of 2007, the credit rating firms changed the way they evaluated these supreme mortgage markets (Jobst, 2010, p54).

By June of 2007, the devaluation in the mortgage-backed securities value had made many securitization firms and financial institutions lose billions of their investments in the securitization market. The results of this upgrade were severe as the values of the securitized securities fell. Banks and other financial institutions started to fall under pressure and stress and the confidence of the investors in the capital markets diminished triggering the global financial crisis. The sup prime mortgage crisis undermined the financial stability of banks and other financial services institutions resulting in many homes facing foreclosures and many banks on the brink of collapse (Shin, 2010, p309).

The role played by the securitization market in the global financial crisis resulted in a change of opinion about the whole process of securitization. Prior to the global financial crisis, securitization was viewed as a way of enhancing the financial stability of financial institutions through the spreading of credit risk. After the global financial crisis, the securitization market was blamed for transferring the bad loans and credit to many unsuspecting securitization investors (Shin, 2010, p311).

However, securitization itself enables the expansion of credit through higher leveraging of financial institutions as a whole. Securitization itself may not enhance the spread of risk if the desire to earn more drives the market to engage in securitization through poor lending standards as evidenced by the United States securitization sector (Shin, 2010, p312).

From the events in the securitization industry in the United States, there are two features of the securitization business in the United States that are linked to triggering the global financial meltdown. One of them is that the sup prime financial sector firms continued to lend loans to borrowers of not very reputable creditworthiness and passed the risk to securitization firms. The sup prime mortgage firms continued to hold loans and mortgages in their own balance sheets resulting in the non-scrutiny and the screening of loans by the securitization firms. The main factors that have been attributed to the global financial crisis were the fall of quality of loans due to poor securitization practices (Wolfgang, 2009, p111).

The failure of the securitization business to understand the terms of lending and investment in hybrid adjustable-rate mortgages that have high rates of defaults is another factor that led to the sub prime mortgage crisis that triggered the global financial crisis. The main culprit however of the cause of the global financial crisis was therefore the lack of financial institutions to follow the best practices in securitization by transferring credit risk from their balance sheets to the balance sheets of the securitization market investors. The holding back of these securities tied to the mortgage-backed securities did make the financial intuition like UBS, Merrill Lynch, City group and many others experience huge losses when the value of these securities tumbled (IMF, 2009 P. 112).

The global financial made many governments introduce revaluation of the securitization sector through passing recommendations like the regulation Z of the federal reverse board of the United States that protects investors and consumers from predatory lending practices (IMF,2009.P,113).

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References

GECRC (2009). Global Economic Crisis Impact on accounting.London: Cengage Learning

IMF (2009). Global Financial Crisis Report. Stockholm: IMF.

Jaffe, Dwight (2008). Mortgage origination and securitization in the financial crisis. New York: New York university Stern school of business

Kolb, Robert (2010). Lessons from the financial crisis cause consequences and our Economic future. New York: Wiley inter science.

Jobst, Andreas. What is securitization? Finance and development journal.2009 (49-53).

PWC (2011). Transparency and accountability in securitization markets. Web.

Shin, Hyun (2010). Securitization and financial stability. The economic journal 2009 (119) 309-332

Wolfgang, Munchau (2009). The meltdown years the unfolding of the global financial Crisis.Cambridge: McGraw-Hill profession

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BusinessEssay. 2022. "Securitization: How It Caused Global Financial Crisis?" March 24, 2022. https://business-essay.com/securitization-how-it-caused-global-financial-crisis/.

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