Securitization And The 2008 Financial Crisis Essay.

Understanding Asset-Backed Securities and their role in financial markets

The purpose of this report is to explain and analyze the market for securitization, specially assets which were related to equity mortgages. The role of Asset Backed Securities also known as ABS were explained explaining their purpose and impact on the conduct of the financial markets. The process of securitization and its contribution towards the losses that were incurred as a result of the financial crisis, were explained in a comprehensive manner. ABS that were based on the subprime mortgages and had a negative impact on the financial system were explained in a comprehensive manner. The report further goes on to explain the beginning of the crisis in the year 2007 and how it progressed and engulfed every other industry and sector including the banking sector across the globe. The concluding portion of the report describes the events that led to a collapse of the biggest investment bank in the country and how the US Fed played an active role in rescuing the banks before it could collapse.

The financial crisis took place between the years of 2008 to 2009 and is considered one big crisis where multiple institutions and countries were at the risk of being financially destroyed. The crisis had its negative impacts on several developed economies of the world and restricted the growth of many developing countries. Some of the countries and institutions bearing the impacts of the financial crisis are still suffering in some way or the other. Countries like Portugal and Greece have been suffering due to high levels of unemployment and an extremely low levels of economic growth (Silva, Muniz and Tabak 2022). People suffered job losses, loss of savings and heavy losses inflicted on equity investments around the globe. In today’s world it is easy to understand the primary reasons behind the crisis and a proper assessment of risk factors can be conducted to avoid such crisis in the future periods as well (Boubaker, Jouini and Lahiani 2016). A number of institutions and their conduct in the financial markets were the primary reason behind the financial crisis as these institutions were involved in selling subprime mortgages to individual creditors who were incapable of returning back the loan made to them. The banks and financial institutions had an incentive system put in place which allowed them to earn more after every sale of loan and mortgage securities. A major blame is to be put on credit rating agencies which had the responsibility to protect the investors from investing into assets which are financially risky. The regulatory authorities are also to take the blame for the mishap caused as they had the responsibility to exercise prudent oversight over the conduct of the financial institutions. The institutions including the US Fed failed to gauge the impacts of the financial transactions taking place in the economy and should have imposed stringent regulations in place when the market for securitizations showed signs of heating up (Mohti et al 2019). Several other institutions which had the potential to impact the economy were involved in taking additional risks which eventually led to the biggest financial disaster the world has ever witnessed.

The process of securitization and its contribution to the 2008 financial crisis

The crisis of 2007 -2008 is also called the credit crisis across the globe as it has one of the greatest negative impacts on the world’s economy which has effects seen till date. It is believed by several experts that the crisis was no less than the great depression of 1930s. The beginning of the crisis was in 2007 where the subprime mortgage market was booming in the United States eventually collapsing and leading to a large-scale banking disaster. The collapse of Lehman Brothers in the year 2008 was one the major losses to the US economy. The unhedged risk-taking tendency of the banks in the United States increased the gravity of the disaster and resulted in increased losses (Markham 2015).

The housing market in the US was booming like never before in the year 2007 which eventually became the main reason behind the disaster that took place afterwards. The demand for new houses in the country was increasing with an increase of more than 100 percent in the prices over the past seven years before the crisis unfolded. As a result, the access to credit for acquiring homes became easier for old as well as new borrowers. The financial situation of the borrower was ignored by the banks and individuals having no jobs, no income and assets. As discussed earlier, the bankers who sold the new loans to new borrowers were paid commissions which incentivized the bankers to provide more loans to borrowers irrespective of the risks associated with the borrower. The bankers assumed that taking the house which was to be purchased using the loan disbursed would itself act as a mortgage due to rising prices of houses across the nation. The banks had a notion that if anything goes wrong, the banks have the houses as collateral which can be sold at a profit in the market recovering the bad loans. All the major financial institutions and banks had a belief that the current boom in the house prices would not subside and a crash was not possible. In the beginning of 2007, the banks began to suffer defaults as people with poor financial situations defaulted in large numbers. In theory, only those banks should have been affected by the crash which had underestimated the risk of the crash and given out loans to undeserved borrowers. But the crash had an impact on almost of the banks and financial institutions which had sound risk management procedures installed within them mainly due to the securitization. The period of 2000 to 2007 was not regulated as soundly as it should have been which would have protected the banks from lending subprime mortgages and further creating assets based on those loans which were sold to clients and investors. The instruments which were made out of those loans and further complicated matters are called securitized products and the process of converting the loans into those assets is called securitization. The financial crisis that unfolded in that year not only had an impact on the US financial sector but it had spread its arms on the financial sectors of multiple countries.

The beginning of the crisis and how it progressed

It is fairly clear to our minds that the crisis took place because of the bad mortgages problem and the financial institutions and banks were the major sufferers of the implications. Although, banks have sufficient capital and assets with them to handle mortgages default and similar to what happened in the financial crisis of 2008, the whole system is not exposed to crash due to defaults on loans. The sources of income for banks are diverse as they have multiple operations from which they can generate revenue, hence defaults on a few loans does not have the potential to challenge the existence of the banks. Issues related to liquidity and bad debtors can be easily handled by a bank operating within a jurisdiction. This is where the role of securitization comes into play which was the sole culprit behind the massive crash.

Securitization can be defined as a process by which a lender converts another sort of financial asset into a distinct financial instrument eventually selling the parts of the newly created instrument amongst investors (Sassen 2016). The process of securitization can take place with any sort of financial asset but generally securitization is done with assets having a stable stream of cash flows like loans on houses or cars. An example of securitization can be Mortgage Backed Securities (Neilson et al 2021). A lender takes all the individual mortgage loans, combines them into a single pool and then divide the pool into smaller securities on the basis of the risks associated with each mortgage, selling the pieces to interested investors (Caviness et al 2021).

The history of Asset backed securities can be traced back to the year 1970 and at that time the structure was fairly simple unlike today’s complexities involved with it (Zuiddam 2018). The concept of Asset Backed Securities can be explained using the following example. Assuming a company named X is involved into providing loans for purchasing automobiles in the country. Once an investor wants to buy an automobile, the role of the company is to provide capital to the individual and the person has the duty to repay the loan within the mentioned time period decided at the time of disbursing the loan. Suppose, Company X has run into troubles and have started losing cash from its business which is necessary for the bank to maintain liquidity. The company may decide to create a pool of all the loans disbursed to individuals package them and sell them to an interested investor named Firm Y, in exchange of cash which would the cash crunch problem of company x. The company can use the cash in order to disburse out more loans and carry on the operations. The primary role of the Firm Y would be to sort the pool of loans from company x into different category called tranches. Tranches can be defined as a collection of loans with similar characteristic like maturity, risk of default, interest rate and the rate of delinquency. Firm Y then chooses to issue securities on the basis of the tranches of the loans that it had created. Just as in the case of bonds, each tranches of loans is assigned a rating based on the level of risks associated with the loans which represents the likelihood of the bonds defaulting in near future. The securities created are then sold to individual investors and the investors in return are paid periodic cash flows from the pool of loans. Firm Y may charge an administrative fee which can be treated as revenue for the firm. An asset backed security is majorly divided into three tranches: which are called as class A, B and C. The class A tranche are considered to be the highest quality tranche with a high investment rating specifically to attract investors.

The negative impacts of the 2008 financial crisis on different countries

In the year 2006, the market of securitizations witnessed a great jump and the ABS business created new assets worth around three trillion dollars. The total worth of the securitized assets in the year 2002 was equal to $1 billion (Lysandrou and Nesvetailova 2017). Banks of that period had decided to create new complete security as much as possible specially out of loans such as mortgage residential, commercial mortgages, bonds, corporate loans and credit card receivables. The majority of the assets were based on risky assets with a volatile path of prices the assets may take. The new instruments that were created by the bank were far riskier than the traditional assets which were present in the 90’s. The securitized assets were diversified in nature and the movement in the price of the assets were unpredictable which made it further riskier to invest into (Avery and Brevoort 2015). The portfolio managers always looked for assets which were new to the market in order to gain the early mover advantage and this resulted in firms holding riskier assets in the portfolio. During the period of 2008, the balance sheet of multiple financial institutions and banks in the country contained a large number of riskier assets.

The reasons for buying an asset for including into the portfolio was that they were expected to outperform the market and some even considered them to be safe. The major credit rating agencies in the world included Moody’s investor service, Standard & Poor’s and Fitch ratings had the primary responsibility of assigning credit rating to those newly created assets based on the market available data and understanding of the products by the companies (Cuckierman 2019). However, the agencies were involved in fraud as they began to rate the securities as safe and profitable in lieu of money received from the banks to do so. ABS and MBS were the securities which received superior ratings despite being very risky and volatile in nature. The element of independence was not present while assigning a rating to the assets by the credit rating agencies. Junk quality bonds were sold to investors with a tag of being high quality in nature, which made the investors feel confident and safe. The following factors were responsible for the crisis to build up and eventually burst in the year 2008:

• Increase in the number of securitized assets in the economy resulted in the investors being exposed to new and volatile assets.
• Lack of knowledge about the products that were introduced in the market increased the risk of buying without knowledge and prior risk assessment. The investors began to pour their money on purchasing the new assets without assessing the risk characteristics of the assets.
• Increased use of off-balance sheet accounting technique by the banks and financial institutions leading to a build of ABS securities worth hundreds of millions hidden within the books.
• Fall in the prices of the houses which was once thought to be growing forever by all the major banks and institutions in the country.

As soon as the price of the bonds began to fall investors who had bought the house using loaned capital began to realize of overpaying for the houses and began defaulting on their loan obligations. The defaults which began to happen more frequently and in large numbers the payment on the securitized ABS and MBS began to get difficult as the stream of cash flows were interrupted from the source. This resulted in humongous losses to those investors who had initially invested in the ABS and MBS securities on the basis of high credit ratings assigned to them by big agencies.

As a result, a security that was introduced in the 70’s to diversify and limit the risks of the investors in various forms, was the biggest reason behind the fall of markets in the year 2008. There were various banks and financial institutions like the UBS and AIG which faced huge financial troubles as they had a huge number of open positions in securities like ABS and MBS. The government felt it as their responsibility to save the banks and institutions which were too big to fail to protect the system from collapsing but it failed to protect all the banks. As a result, many of them ceased to exist or lost the market position it enjoyed earlier within one year of the crisis starting. Banks like Lehman Brothers felt down due to increased exposure to securitized assets but the bank was not rescued by the government by any infusion of capital (Singh and Parneet 2015). The crisis spread its arms around the world effecting banks and other institutions of developed as well as developing countries. After the onset of the crisis the largest banks in the world suffered losses to the extent of $600 billion. The primary things to notice here was that even if a single bank was exposed to the volatile and risky assets, other banks and financial institutions had to bear the brunt of the losses due to the linkages and the correlations between banks.

Conclusion

Conclusion

The primary lesson that is learned here is that no matter how confidence the market has on the riskiness and profitability of a particular type of asset in the market, it can always prove to be wrong. Institutions around the world should exercise caution or avoid to invest in assets which are new to the market and the risk aspects are not clearly defined. Financial institutions of that time had huge dependency on pricing models and calculation of risks measures. The firms have to analyze and understand that the risk calculations and the models are not really accurate in the real world. They also have to understand the fact that help is not available at wish and the public does not wants their money to be spent on bail out packages to rescue suffering organizations, hence they should take risks after careful considerations.

As the crisis had developed and the impacts of the crisis subsided, the role of securitization was well understood amongst the banking sector. It was understood that securitized assets may exhibit extreme volatility and hence the process of securitization may be exercised with caution (Zhou 2017). The securitization of assets is a great diversifier asset and provide the necessary exposure to asset classes which are safe and have the potential to yield more. There are a lot to learn from the crisis that was unfolded in the year 2007-2008 and if we follow proper care and exercise prudence, crisis of similar types can be avoided.

 References

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