Ivan Karamelski ECO 215 A April 21, 2008 Securitization – impact on global international banking The term ”securitization” implies the structured financial process, in which bank assets are repackaged in marketable forms and traded in options and other derivative securities. The origins of the asset backed securities can be traced to the late 70s and the period when the banks were looking for new ways to finance the rise in the demand for housing credits. Key aspect of the securitized financial assets is that they are always associated with cash flow. The process of issuing asset-backed securities diversifies the risk of the assets making them much more attractive for the investors. The key factor in the securitization process is the so called ”special purpose unit”, which have the purpose of reducing the bankruptcy risk of the assets giving them a lot of advantages compared with the others. It is quite interesting that Enron used to rely on special purpose units in order to “minimize financial-statement loses and volatility, accelerate profits and avoid adding debt to its balance sheet”. 1 Such corporate bodies as the special purpose units have been primarily used for accounting reasons. Banks or loan agencies are the main financial institutions developing these special purpose units for issuing mortgage-backed securities from the pool of their loans. The scheme of the securitization works as the banks transfer their debt assets to a special purpose unit, which gives bankruptcy insurance making these debt instruments no longer liability to the bank and the banks are able to remove them from their balance sheets. One of the main key aspects of the SPU is that they are credit enhancing by increasing the credit quality and rating of the loans that are pooled for the asset-backed security. There are many reasons why the securitization is growing in numbers since the late 70s when it was first introduced. First of all, firms or individuals with bad credit ratings are still able to borrow money for low costs because the originating institutions combine their debt instruments in assets, which are “usually highly rated due to the presence of several different banks and insurance companies which guarantee the credit quality of the whole operation” 2. Also bank institutions can reduce their balance mismatch in duration and interests by putting away the danger assets of their balance sheets. Another key aspect of the securitization is the transfer of risk form entities that does not want to bear it to other financial institutions that are more able to deal with it. The investors have gained a lot of advantages from the asset backed securities and as a consequence mutual funds and hedge funds are primarily using such financial instruments. The asset-backed securities give higher rate of return to the investors and also have primarily very good ratings so the people were feeling more secured in choosing them. Moreover investing companies used securitization because it gave them the chance of diversifying their portfolios. In the current situation is quite feasible of obtaining financial instruments from every region of the world thanks to the fact that securitized assets are traded in high quantity. For example investors do not need to
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Steven Schwarcs - ,, Enron and Use and Abuse of Special Purpose entities in corporate structure” R. Mansini - ,, A multidimensional knapsack model for asset based securities”
depend on a certain region or economic sector and by diversifying they can balance their portfolios. On the other hand, the investors face the risks of the securitization. They might face the challenge of the liquidity risk, which can have terrible effects on the health of the institution as whole. A drop in the trade of a certain assets can result in liquidity risks, so in such situation institutions with high cash reserves could get predominant role. The moral hazard is another problem for the banking sector because they have to rely on the deal manager to price the portfolio assets, which might result in loans that should have never been made. It gives loose restrictions for giving loans and fewer incentives for monitoring the borrowers. Although securitization has a lot of benefits in the investment process it also has a lot of disadvantages to the proper way of working of the banking sector bringing new trends to the development of global crisis. Due to the development of the securitization practice, a financial crisis in certain sector or a region will have much deeper impact on the whole global economy. The lack of transparency of the portfolio assets and the increase of the moral hazards in the lending sector pose a real chance for developing crisis. Also the information technologies and the increase in interdependence of the different regions made the speed with which global crises now emerge much faster. The result of the recent credit crunch crisis in USA posed the question whether the world economy is now more vulnerable to crises because of the securitization and whether there must be regulation preventing the bank crises. The international banking has much loose restrictions than the national financial markets. The rise of offshore banking made the regulation of the capital in banking heavens much difficult to put constraints on it. The central banks and the governments of the different countries have regulatory commissions, which are trying to keep the smooth running of their national economies, but the international market lack any central authority. Also many institutions have entities in several countries, which can help them avoid the regulation of the different states. The investment in asset based securities originated in different countries is very lucrative and might give chances for earning higher rate of returns. One of the main issues connected with the mortgage based assets is that rating that these got from some of the credit agencies in the period before the crisis. In reality many of the mortgage loans taken by the households in USA were very risky but the mortgage based assets kept being valued as strong assets, which created asymmetric information provoking the financial crisis and the bank failures. It was very interesting that the countries in Europe were very seriously affected by the mortgage crisis in USA. In England there was a serious bank crisis, in which there was a run on several banks. Northern Rock bank was the most seriously affected bank as many depositors started withdrawing their money out of the bank, which put it in a serious risk. The Bank of England had to step up and act as a lender of last resort providing liquidity for Northern Rock because the British government regarded the bank as too big to fall and expecting future spreading of the bank crisis if Northern Rock had bankrupt. The Securitization has become an essential part of the investment in the world. The asset based securities have had huge impact on the global production growth by channeling money to every sector of the economy. On the other hand there is a need of improvement of the regulations on these assets in order to increase the transparency and to eliminate the moral hazard problem.