Securization and The Global Economy

Securitization and
the Global Economy

History and Prospects
for the Future
BO NNIE G. BU C H ANAN
Securitization and the Global Economy
Bonnie G. Buchanan
Securitization and the

Global Economy
History and Prospects for the Future
Bonnie G. Buchanan
Seattle, Washington, USA
ISBN 978-1-137-34972-9 ISBN 978-1-137-34287-4 (eBook)

DOI 10.1057/978-1-137-34287-4
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Preface
In 1858 William Gladstone wrote, “Finance is, as it were, the stomach of

the country, from which all other organs take their tone.”1 Over a cen-
tury and a half later, this has essentially remained true and securitization
has become regarded as one of the biggest financial innovations during
that time…2,3 According to the Securities Industry and Financial Markets
Association (SIFMA [2010]), between 2000 and 2010 the size of the
global securitization market increased from $4.8 trillion to $13.6 tril-
lion. Apart from the transformation of mortgages, securitization has also
become a popular method of financing the consumer credit market. In
2007, over half of credit cards and student loans were securitized in the
USA.4 Moreover, with active securitization markets throughout Europe
and Asia securitization is without doubt a global phenomenon.
However, since the 2007 financial crisis many aspects of the global
securitization market such as its associated risks, servicing abilities,
credit ratings, and regulatory issues have become regular media features.
Securitization has been suggested as a contributory factor to the financial
crisis because in recent years it has become an extremely complex, opaque
process that integrated virtually every aspect of the global financial system.
It is even considered to have had a contributory role in the Eurozone
debt crisis. Consider the case of Greece where the government securitized
many assets including: highway tolls, airport landing fees, future receipts
from the national lottery, and even grants from the European Union.
The recent financial crisis leaves no doubt that securitization has radi-
cally transformed the global financial landscape over the last decade.
Soros (2008) claims that securitization became a “mania” around 2005:
vii
viii PREFACE
“Securitization was meant to reduce risks through risk-tiering and geo-

graphic diversification. As it turned out, securitization increased the risks
by transferring ownership of mortgages from bankers who knew their
customers to investors who did not.” One fatal flaw with securitization
revealed in the latest crisis is what happens when the essential link between
credit decisions and subsequent credit risk is broken. If financial institu-
tions continued to pump out bad loans just to sell them, trouble would
indeed eventually follow but it would be some other party’s trouble. And
this is what indeed happened.
Yet the securitization market is viewed by many regulators as essential
to the economic recovery from the recent financial crisis. This is particu-
larly applicable in the context of the Eurozone debt crisis. The structure
and risk profile of many asset classes is being carefully assessed as interna-
tional regulators consider sweeping reforms of the securitization market.
Interestingly in the literature there is a dearth of surveys of securitization
that incorporate the history, the current status of securitization (including
sources of value and risks), alternative markets and the future outlook for
the global securitization market. This book is an attempt to bridge that
gap in the literature. In this book I will define securitization as the sale of
underlying assets or debt so that they are removed off the issuer’s balance
sheet, the pooling of illiquid assets, credit enhancement, and tranching
of the underlying pool. Basically, anything that is expected to bring in
a steady stream of revenue can be securitized. In recent years the more
popular securitized assets have included: mortgages, accounts receivables,
business equipment leases, small business loans, credit-card receivables,
automobile loans, emerging market loans, computer and truck leases, farm
and energy loans, mutual-fund management fees, and even the royalties
paid on music.5 In this book I also plan to discuss securitization markets
that have shown some degree of promise since 2010.
As financial regulators around the world plan a sweeping overhaul of
securitization markets with tough new rules designed to restore market
confidence it is essential to consider the benefits and costs of securiti-
zation. The future of securitization remains very uncertain and is under
scrutiny for many reasons.
Securitization is a controversial issue partly because it is interpreted in
different contexts. In this book I propose to examine the issue of secu-
ritization in a global, historical context. I will detail my findings along a
number of dimensions. Firstly, I will trace the origins of securitization
from the twelfth century to the present. Secondly, I will compare evidence
regarding securitization across countries, linking differences to variations
PREFACE ix
in legal, political, and cultural regimes. For example, why have securiti-
zation attempts been more successful in Europe rather than the USA?
Ultimately I will provide an overall assessment of the costs and benefits of
securitization in the current global economy, particularly in the aftermath
of the recent financial crisis. I also intend to offer a roadmap for future
research. The book is structured as follows:
In the first chapter I focus on securitization, viewed as both a catalyst
and solution to the global financial crisis, or to quote Haldane (2013)—“a
financing vehicle for all seasons”. Securitization also shed new light on the
nature of money as debt (Dodd 2015). In the first chapter I examine finan-
cialization and the key transformation of securitization in global markets. I
also detail how the modern securitization market boomed after the 1980s.
Two mini cases—Carrington Capital Asset Management and Northern
Rock—are provided to highlight the early casualties of the financial crisis.
In Chap. 2 I examine securitization in a global historical context. I argue
that securitization is not the relatively new phenomenon many believe it
to be. What can be termed “crude”6 forms of securitization trace their ori-
gins back to the twelfth-century Genoa. Snowden (1995) describes early
US attempts prior to World War II at rebundling mortgages as tradable
securities as “a fundamental misreading of the European experience”. In
1877, The New York Times provides an account of failing assets based on
mortgages in the Western part of the United States, “…it is quite clear
that investors cannot be over-vigilant in connection with a system which
practically takes the management of their money out of their own hands
and places them at the mercy of agencies whose responsibility is seldom
or never equal to the responsibilities they assume”. Frederiksen (1894b)
documents new Western loan companies in 1887 disposing of mortgages
in the form of securities to investors in the Eastern states. Lance (1983)
and Goetzmann and Newman (2009) describe a smaller situation in the
1920s that was generated by a mortgage pooling experiment and its sub-
sequent collapse. Although these events may be described a “crude” form
of securitization, they highlight a flaw that we see repeated in the current
crisis. Quite simply, when the link between those who sell mortgages and
those who bear the risk of default is broken, lax lending ensues with disas-
trous consequences as witnessed in 1880s as well as more recently. The
earliest use of this style of structured financing was largely confined to a
localized market in twelfth-century Italy. Kohn (1999) acknowledges this
as an early attempt at securitization.
In Chap. 3 I discuss the evolution of asset-backed securitizations beyond
the more familiar mortgage-backed securities market. I will include exam-
x PREFACE
ples such as accounts receivables securitization market and student loan

asset-backed (or SLABs) market. The SLABs market has received closer
attention in the last few years, as US student debt now exceeds $1.2 tril-
lion dollars and the student debt mountain has been compared to the
mortgage bubble. Intellectual property securitization accelerated after
1997 with Bowie Bonds, which are discussed at length along with film
rights and brand name securitization. Finally, the chapter concludes with a
short mini-case based discussion on sovereign debt securitization, specifi-
cally that of Greece in the run-up to the 2010 Eurozone debt crisis.
A study of the securitization industry in ethical terms is not just impor-
tant because of the complex ethical relationships that exist between origi-
nators, special purpose vehicles (SPVs), ratings agencies, investors, and
regulators but also because of the role it plays in the global financial sys-
tem. When assessing securitization and the financial crisis a less explored
aspect of the literature is the ethics of risk transfer. In Chap. 4 I explore
the ethics of risk transfer and securitization.
In Chap. 5 I examine the history and development of emerging mar-
kets securitization. While the US securitization market developed as a
means to accelerate liquidity, much of the emerging market securitization
was initially established to deal with non-performing loans (NPLs). I trace
the development of Latin American and Asian securitization. Additionally,
I provide a mini-case of the Chinese securitization market which became
the largest Asian securitization market in 2014. I trace the evolution of
the Chinese market from its pilot securitization program in 2005 to the
present. The mini case provided makes it clear that at first glance, it may
appear that the surging collateralized loan obligation (CLO) market in
China has a sense of déjà vu about it, especially if we recall the CLO prod-
uct track record in US markets during the financial crisis. However, CLOs
were introduced into the US and China for very different reasons.
In Chap. 6 I investigate other structured finance markets that have
received more scrutiny since the recent financial crisis such as the covered
bond market. This also includes the Islamic structured finance market,
such as the sukuk bond market that has received increased media attention.
In Chap. 7 I discuss at length the global regulatory reforms that have
taken place since 2008 with respect to the securitization markets. This
includes analysis of the 2010 Dodd-Frank reforms, the G20 reforms, the
response of the Financial Stability Board, and Basel III (the final results
of which will be made public in December 2012). Chapter 8 concludes
the book.
Acknowledgments
Many people have provided me with feedback and encouragement on my

securitization research the last few years. I am grateful for early feedback
on ideas to: Meenakshi Rishi, Karen Gilles and Jacqueline Miller (all of
Seattle University), Gerard Russello, Sharon Reier and Hal Davis. I am
also grateful for feedback from the NYU Re-Enlightenment Workshop,
the Behavioural Finance Working Group (London) and the Dauphine
Amundi Asset Management Workshop. I gratefully acknowledge a research
grant from Dauphine Amundi. I also thank Tom Berglund and my col-
leagues at the Hanken School of Economics for feedback at school semi-
nars and workshops. I also extend my gratitude to the Bank of Finland
for the opportunity to be a visiting scholar. Finally, I thank Cathy Xuying
Cao, Sunday Stanley, Eric Kartevold and Jason Schadler for their friend-
ship during this project.
Notes
1. The Oxford Dictionary of Quotations, Partington, Angela (ed.),
Oxford University Press, 1992.
2. Ferguson, Charles, Predator Nation, Crown Publishing, 2012.
3. Gordon, G. and A. Metrick (2011), Securitization. Working paper.
McConnell, J. and S. Buser (2011), The Origins and Evolution of
the Market for Mortgage Backed Securities, Annual Review of
Financial Economics.
4. Too Big to Swallow, The Economist, May 2007.
xi
xii ACKNOWLEDGMENTS
5. An example of this is Bowie bonds based on music royalties of David

Bowie.
6. I say “crude” because the basic steps of securitization are there:
bundling and pooling assets/debt; converting the pool to tradable
securities and the provision of some type of credit enhancement.
Contents
1 Securitization and the Way We Live Now1
2 What History Informs Us About Securitization49
3 Beyond Mortgage-Backed Securities77
4 Securitization and Risk Transfer111
5 Securitization in Emerging Markets141
6 Alternatives to Securitization173
7 Reforming the Global Securitization Market191
8 Conclusion221
References229
Index245
xiii
List of Figures
Fig. 1.1 Topography of the conceptual field of financialization 3

Fig. 1.2 US total credit/GDP (%) 8
Fig. 1.3 US financial and non-financial debt 8
Fig. 1.4 Private sector credit as a % of GDP 1990–2013 9
Fig. 1.5 Public sector debt as a % of GDP 2007–2013 10
Fig. 1.6 US mortgage debt/GDP (%) 10
Fig. 1.7 Finance, insurance, and real estate (FIRE)/GDP 11
Fig. 1.8 US mortgage securitization issuance 1996–2015/
(USD billions) 26
Fig. 1.9 US ABS issuance (USD $millions) 27
Fig. 1.10 American securitization issuance 1996–2014, USD bn 28
Fig. 1.11 American securitization outstanding, 2002–2014, USD bn 28
Fig. 1.12 US asset-backed securitization—Collateral type 29
Fig. 1.13 Global CDO issuances (USD millions) 29
Fig. 1.14 Total European securitization issuance (USD millions) 30
Fig. 1.15 European securitization issuance (by collateral type) 31
Fig. 1.16 European securitization issuance (by country) 32
Fig. 1.17 Securitization outstanding—Australia and New Zealand
(USD millions) 33
Fig. 3.1 US mortgage securities issuance 79
Fig. 3.2 Accounts receivable securitization 82
Fig. 3.3 Student loans ABS—Outstanding 86
Fig. 3.4 US student loans—Securitization issuance 87
Fig. 3.5 Spread between Greek bonds and German bunds 100
Fig. 3.6 Greece—Securitization issuances 104
Fig. 3.7 Greece—Securitization outstanding 104
Fig. 4.1 Global CDO issuance 115
xv
xvi List of Figures
Fig. 5.1 Chinese Bank non-performing loans to total gross loans 156
Fig. 6.1 CB issuance (mill. EUR) by country excl. total 174
Fig. 6.2 CB new issuers by country excl. total 174
Fig. 7.1 Credit crisis filings 192
Fig. 7.2 American securitization issuance 1996–2014, USD bn 196
Fig. 7.3 Total assets of the US Federal Reserve 198
Fig. 7.4 European issuance—placed versus retained 2007–2015 205
Fig. 7.5 Total assets of European Central Bank 211
Fig. 7.6 A Summary of the European Comission’s framework
on securitization Regulation and Amendments to the
Capital Requirements Directive 214
Fig. 8.1 European securitization issuance—% Retained 2007–2015 225
List of Tables
Table 3.1 Examples of securitized asset classes 80

Table 4.1 Climbing the securitization complexity tree—Typical
contract details 119
Table 4.2 Selected CDO Deals 135
Table 6.1 Differences between asset-backed securities and covered bonds 176
Table 8.1 Ratings of European securitization issues in 2015 224
xvii
CHAPTER 1
Securitization and the Way We Live Now
1 Introduction
In 1858 William Gladstone wrote, “Finance is, as it were, the stomach
of the country, from which all other organs take their tone.”1 This sen-
timent still rings true (Mason 2015; Turner 2015). Mukunda (2014)
describes the financial system as the “economy’s circulatory system” and
the large banks as “the heart”. Furthermore, (Mukunda 2014) attributes
the “enlarged heart” of the US economy to the impact of financializa-
tion. Financialization is a term used to describe the expansion of finan-
cial trading associated with the abundance of new financial instruments
(Phillips 1994; Orhangazi 2008; Krippner 2009). The increasing influ-
ence of financial markets and institutions impacts other societal institu-
tions (including the government) placing a reliance on short-term liquid
assets. Eventually, investment in real assets is crowded out by financial
asset investment, an activity Orhangazi (2008) describes as “distributive”
rather than “creative”. Due to the transference of income from the real
sector to the financial sector, financialization is also credited with contrib-
uting to increased income inequality, wage stagnation, increased private
and public debt, ownership concentration, and destabilizing economies
due to an increasingly complex and opaque financial system (Palley 2007;
Engelen 2008; Kindleberger 2011; Giron and Chapoy 2013; Rajan 2010;
Lagoarde-Segot 2015b). Since 1973, in many developed countries, debt
© The Author(s) 2017 1

B.G. Buchanan, Securitization and the Global Economy,
DOI 10.1057/978-1-137-34287-4_1
2 B.G. BUCHANAN
has soared and wages have stagnated. If wages stagnate and more profits
are generated from mortgage and credit card loans, there will reach a
point where this is clearly not sustainable.
It is clear that we live in a financial system that bears little resemblance
to previous generations (FCIC Report 2011). Between 2000 and 2007,
global financial assets soared from US$94 trillion to US$196 trillion, a
phenomenon that Former Chairman of the US Federal Reserve, Paul
Volcker refers to as the “modern alchemy of financial engineering.”2 This
transformation of financial markets at both the macro and micro level may
be attributed to both globalization and financialization.
Globalization describes the process by which national economies have
become increasingly interdependent. Economic, political, and techno-
logical changes are influential drivers of the process (SIFMA 2015).3
Financialization may be defined as the expansion of financial trading and
abundance of new financial instruments (Phillips 2008; Epstein 2001;
Orhangazi 2008; Krippner 2005; Engelen 2008; Krippner 2009; Giron
and Chapoy 2013; Buchanan 2015b; Aalbers 2015). Globalization and
financialization are not the same thing (Montgomerie 2008; Engelen
2008; Aalbers 2009a, b). Financialization needs globalization and, in turn,
globalization takes place through financialization (Aalbers 2009a, b).
One example of the complexity that results from financialization
is securitization. Securitization is a technique which has come to be
epitomized as a key trigger of the 2007–2008 financial crisis (FCIC
Report 2011). Once referred to as the “alchemy” by Lewis Ranieri4
at the Salomon Bros mortgage-backed securities (MBS) trading desk,
securitization became the funding model and risk transfer method of
choice for many global investors over the last four decades. Prior to
the financial crisis two thirds of the outstanding US home mortgages
were securitized (Aalbers 2009a, b) and between 30 and 75 percent of
consumer loans were securitized (Gorton and Metrick 2012). By 2007,
more than half of student and credit card loans were securitized in the
USA (Arnold et al. 2012).
Collier and Mahon (1993) argue that financialization may reverberate
with globalization and securitization, viewing financialization as a higher-
order concept, while securitization may be thought of as a tertiary con-
cept. Thus securitization refers to a set of techniques or a process which
is a precondition for financialization but does not in itself contain all the
properties financialization purports to possess. This is best illustrated in
Fig. 1.1.
SECURITIZATION AND THE WAY WE LIVE NOW 3
Globalization
Financialization Commodification
Securitization Disintermediation Liquidification Liberalization Privatization
Fig. 1.1 Topography of the conceptual field of financialization.

Source: Engelen (2008)
So, where does securitization fit in? I will start by broadly defining
securitization as the sale of underlying assets or debt so that they are
removed off the issuer’s balance sheet [usually to a special purpose vehi-
cle (SPV)], by pooling of illiquid assets, credit enhancement, and tranch-
ing of the underlying pool. To make the securitized products more
palatable to international investors, the tranches are assigned a rating
by the major credit ratings agencies (such as Moody’s and Standard and
Poor’s). The securitization process should be able to sell and redistribute
risk (especially credit risk and liquidity risk) to those investors who are
more capable of bearing it. Results should include improved functional-
ity and stability of the markets. In theory, anything that is expected to
bring in a steady stream of revenue can be securitized. In recent years,
the more popular securitized assets have included: mortgages, accounts
receivables, student loans, business equipment leases, small business
loans, credit-card receivables, automobile loans, computer and truck
leases, farm and energy loans, gold, carbon emission rights, mutual-
fund management fees, taxi medallions, and even the royalties paid on
music.5 In addition, during the last decade, governments (for example,
Greece) securitized many assets including highway tolls, airport landing
fees, future national lottery receipts, and even grants from the European
Union (Buchanan 2015b).
Securitization is the result of the globalization of finance and the declin-
ing role of banks in favor of managed money (Minsky 2008). Prior to the
1970s, banks retained loans on their own books and had to grow either
through mergers or by attracting new deposits. Securitization changed
this (Sellon and VanNahmen 1988; Minsky 2008; Buchanan 2015b) and
brought about a new way for banks to accelerate lending, as well as gener-
ating more fees and income. This would be balanced against liquidity needs
and capital regulatory requirements. By redistributing loans, banks could
cut their capital needs which allowed them to lend more. Securitization
4 B.G. BUCHANAN
became a popular method of financing not only in the mortgage market

but also for the consumer credit market. Eight years later, we are still deal-
ing with the economic and social impact.
Securitization came to be regarded as one of the biggest financial inno-
vations during the last century (McConnell and Buser 2011; FCIC Report
2011; Gorton and Metrick 2012). It is also viewed as an example of a
credit boom that typically precedes a financial crisis (Eggert 2009; Gorton
and Metrick 2012; Donaldson 2012). When BNP Paribas cited “evapora-
tion of liquidity in certain segments of the US securitization market” on
August 9, 2007 (Cassidy 2009), financial contagion spread rapidly around
the globe. Housing risks increasingly became financial risks affecting
investors including Dutch pension funds, Swiss investment banks, Chinese
sovereign wealth funds, and Norwegian municipalities (Aalbers 2009a, b).
Events that initially appeared to be viewed as liquidity problems in the
summer of 2007 became a full-blown credit crisis within the following
year.
The fallout also included allegations that securitized instruments
were flawed or even designed to incur losses. In 2010, the SEC took
action against Goldman Sachs, alleging that the investment bank delib-
erately designed a synthetic collateralized debt obligation (CDO),
based on mortgage-backed products so that it would fall to the benefit
of third parties who wanted to short it.6 In 2013, JP Morgan Chase
paid a $13 billion fine associated with MBS losses. The following year
Citigroup paid a $7 billion fine, followed by Bank of America with a
$17 billion penalty. The securitization lawsuits continue unabated. In
2015, Morgan Stanley paid a $2.6 billion settlement over claims that
it mis-sold MBS in the run-up to the financial crisis. To date, the total
mortgage-related penalties by the big banks to the US Department of
Justice have reached approximately $40 billion.7 Lawsuit settlements
continue to accumulate.
Financialization and securitization have changed the operation and
structure of global financial markets (Palley 2007). In the run-up to
the financial crisis securitization embodied the financialization of the
mortgage market, fueling an unsustainable increase in credit. The 2007
financial crisis continues to have a lasting impact on financial markets and
institutions, consumer behavior, government policies, and cross-border
interactions. The societal impact has been immense (Turner 2015). Due
to unaffordable debts, millions have lost their homes; banks have failed;
there have been costly financial institutional bailouts; millions around
the global have suffered unemployment, and the figure remains dismal.
For example, in 2007, the Spanish unemployment rate was 8 percent
and rose to 26 percent in 2013 (Turner 2015). In addition, real wages
continue to fall, as does per capita income. Public debt figures have
soared since 2007, leaving global markets facing a weak and unbalanced
recovery.
In terms of the securitization market, many aspects such as home
equity loans, mortgages and CDOs have been decimated. In the USA,
the Federal National Mortgage Association, Fannie Mae (FNMA), the
Government National Mortgage Association, Ginnie Mae (GNMA), and
the Federal Home Loan Mortgage Association, Freddie Mac (FHLMA)
are presently funding more than 80 percent of the nation’s mortgages.8
Growth in the private label securitization (PLS) market continues to
remain weak. The failures of Countrywide Financial, New Century
Financial, Indymac, Ameriquest, Bear Stearns, Lehman Brothers, Merrill
Lynch, AIG, and Washington Mutual quickly became linked to toxic
securitized products. Since then more than 1300 US mortgage-related
entities have declared bankruptcy, have been acquired, or have closed.9
The IMF estimates that US banks alone have lost more than $885 billion
due to credit write-downs.10 Many key segments of the European securi-
tization market continue to rely on the European Central Bank’s liquid-
ity program. China banned the sale of asset-backed securities (ABS) in
2009 when the global financial crisis tarnished the market’s reputation.
However, the ban was lifted in early 2013. There are still concerns about
the sustainability of the market due to China’s growing debt moun-
tain and non-performing loans. Despite this, China became the largest
securitization market in Asia in 2014, surpassing both Japan and South
Korea (Buchanan 2015a).
Reflecting on the role of financialization and securitization in the
financial crisis, Palley (2007) and Giron and Chapoy (2013) suggest
that there is a need to restore effective control over financial markets.
In the next sections I focus on securitization, viewed as both a catalyst
and a solution to the global financial crisis. Or, in terms of Haldane’s
more optimistic quote at the start of this chapter, “a financing vehicle
for all seasons”. Securitization also shed new light on the nature of
money as debt (Dodd 2015). In this chapter I examine financializa-
tion and the key transformation of securitization in global markets.
In the next section, I outline the evolution of the research area of
financialization.
6 B.G. BUCHANAN
2 Financialization
Financialization has changed the structure and operation of the financial
system. Financialization results from intensified competition during peri-
ods of hegemonic transition where profit in the economy is generated
through financial channels rather than productive channels (Arrighi 1994).
Lin and Tomaskovic-Devey (2011) describe financialization as the merg-
ing of two processes after the 1970s, namely the increasing dominance of
the finance sector in the US economy and the increased participation of
non-finance firms in the financial sector.
Since the mid-1990s there has been a growing literature around finan-
cialization (Engelen 2008). Historically, financialization is usually dis-
cussed by economic geographers, sociologists, historians, and political
scientists, but rarely in the finance literature. This has recently changed
with more discussions appearing in finance-related literature, such as
Mason (2015), Kay (2015), Plender (2015), Turner (2015), Buchanan
(2015c), and Lagoarde-Segot (2015).
Epstein (2001) offers the following definition of financialization:
Financialization refers to the increasing importance of financial markets,

financial motives, financial institutions, and financial elites in the operation
of the economy and its governing institutions, both at the national and
international level.
Similar definitions are offered by Phillips (2008), Krippner (2005, 2009),

Orhangazi (2008), Pani and Holman (2013), and Giron and Chapoy
(2013). Since it encourages financial market deregulation and elimina-
tion of capital controls, there is a strong global dimension to financial-
ization (Palley 2007; Pani and Holman 2013). There are three conduits
of financialization: financial markets, corporate behavior, and economic
policy (Palley 2007). Another financialization definition is presented by
Aalbers (2015):
the increasing dominance of financial actors, markets, practices, measure-

ments and narratives at various scales, resulting in a structural transformation
of economies, forms (including financial institutions) states and households.
Aalbers (2015) offers three conceptualizations of the term: (1) financializa-

tion as a regime of accumulation, (2) financialization as the rise of share-
holder value, and (3) the financialization of daily life. Stock market turnover
has increased dramatically as a percentage of GDP (Turner 2015).
Financialization changed the relationship between banks and compa-
nies and was marked by four changes that started in the 1980s (Mason
2015). Firstly, companies went to the open markets to fund expansion
rather than turn directly to banks. Next, banks turned to investment bank-
ing for high-risk and complex activities. Banks also placed more emphasis
on their customers as a source of profit with credit cards, student loans,
mortgages, car loans, home equity loans, and overdrafts representing a
growing proportion of profit. Finally, these loans were then used in more
complex financial arrangements where the payments were packaged into
financial instruments.
To see how the influence of the financial sector has grown as a percent
of GDP, we can measure it using financial assets, employment, or average
wages. Greenwood and Scharfstein (2013) measure the financial sector
as a percent of US GDP and observe a substantial change rising from
2.8 percent in 1950 to 4.9 percent in 1980 and 8.3 percent in 2006.
They also observe that the rate of increase is much faster after 1980 (at
13 basis points per annum) compared with 7 basis points in the previous
30 years.
The finance sector share of profits soared between 1980 and 2007, tri-
pling from a stable postwar average of 15 percent to a peak of 45 percent
in 2007 (Krippner 2011; Lin and Tomaskovic-Devey 2011). According to
Pasquale (2015), while the US finance sector accounts for 29 percent (or
$57.7 billion) of overall profits, it accounted for less than 10 percent to
the value added in the US economy in 2010.
Is the current financial system any better at transferring borrowers’
funds to savers than the financial system 100 years ago? Apparently not,
according to Philippon (2012), who cites financial intermediary total
compensation as 9 percent of GDP.
Financialization studies also examine credit availability changes and
how these impact macroeconomic changes and the business cycle. An
increase in the volume of debt and credit has been defining features of
financialization in the USA and developed countries. To illustrate the
rapid rise of financialization in the USA, Fig. 1.2 shows the evolution of
total US credit market debt outstanding between 1973 and 2014. During
this period, total debt as a percent of US GDP rose from 157.1 percent
to 337.0 percent.
8 B.G. BUCHANAN
400.0%
350.0%
300.0%
250.0%
Perecnt of GDP
200.0%
150.0%
100.0%
50.0%
0.0%
Year
Fig. 1.2 US total credit/GDP (%).

Source: Economic Report of the President and Board of Governors of the Federal
Reserve
Figure 1.3 shows the evolution of financial sector debt and non-financial
sector debt during the same period. US financial sector debt rose much
faster than non-financial sector debt during the same period. Specifically,
financial sector debt rose from 9.7 to 24.1 percent of total debt.
100.0%
90.0%
80.0%
70.0%
% of US GDP
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Year
Financial Sector debt/GDP (%) Non-Financial Sector debt/GDP (%)
Fig. 1.3 US financial and non-financial debt.

Reserve
Financial innovation has made it easier to provide credit to companies

and households. In the lead up to the financial crisis, the private sector
became more leveraged as households owed more relative to their income.
Figure 1.4 illustrates the growth in US private sector debt between 1990
and 2013. Private debt increased in all OECD countries. Turner (2015)
outlines the rise of the UK private sector debt which increased from 50
percent of national income in 1950 to 170 percent in 2006. In the USA,
UK, Germany, France, and Italy private debt has exceeded more than 150
percent of GDP.
Figure 1.5 displays the growth in public debt during the financial crisis.
There are some especially steep rises in Portugal, Spain, Italy, Ireland,
Greece, the UK, and the USA. Bank rescue packages during this period
explain much of this rise in public sector debt.
Figure 1.6 indicates that between 1973 and 2009, US mortgage debt as
a percent of GDP rose especially rapidly, rising from 48.8 percent to 102.8
percent. The increase in mortgage debt was especially sharp between 2000
and 2007 (rising from 67.9 percent to 103.8 percent) reflecting the US
housing bubble and increasing credit availability. Mian and Sufi (2015)
confirm that in the run-up to the 2007 crisis, more home equity lines were
250
200
150
100
50
1990 2013
Fig. 1.4 Private sector credit as a % of GDP 1990–2013.

Source: WDI - World Development Indicators
10 B.G. BUCHANAN
250.0
200.0
150.0
100.0
50.0
0.0
2007 2013
Fig. 1.5 Public sector debt as a % of GDP 2007–2013.

Source: OECD national accounts
120.0%
100.0%
80.0%
% of GDP
60.0%
40.0%
20.0%
0.0%
Year
Fig. 1.6 US mortgage debt/GDP (%).

Reserve
being issued, which were subsequently securitized. Much of this incremen-

tal growth in household credit as a percentage of GDP was securitized. As
early as 1995, more than half of all outstanding single family mortgages
and a sizeable share of commercial mortgages and consumer credit were
securitized. This is not reflected in the Bureau of Economic Analysis data.
It did facilitate the growth of credit and also goes hand in hand with the
growth of the shadow banking system. A FRBNY staff report defines a
shadow bank as “financial intermediaries that conduct maturity, credit and
liquidity transformation without explicit access to central bank liquidity or
public sector credit guarantees”. Examples of shadow banks include hedge
funds, REITs, asset-backed commercial paper (ABCP) conduits, and auto-
mobile and equipment finance companies.
In Fig. 1.7 we see the growing importance of the financial sector in the
US economy over four decades. Between 1975 and 2009 the contribu-
tion of the finance, insurance, and real estate (FIRE) sectors to GDP rose
from 15.1 to 21.1 percent. While insurance has grown at a steady pace,
credit and securities intermediation have been the bigger growth areas.
Accounting for this have been financial claims and contracts which include
stocks, bonds, derivatives, and mutual fund shares. Turner (2015) states
the size of the global derivative contracts outstanding as a $400 trillion
25.0%
20.0%
FIRE/GDP (%)
15.0%
10.0%
5.0%
0.0%
Year
Fig. 1.7 Finance, insurance, and real estate (FIRE)/GDP.

Reserve
12 B.G. BUCHANAN
market. Much of this is attributable to the provision of household credit

and asset management. Mason (2015) observes that the finance, insur-
ance, and real estate sectors as a share of US GDP have risen from 15 to
24 percent making it the same size as the service sector and bigger than
the manufacturing sector.
Between 1997 and 2007, traditional banking (i.e., depository institu-
tions) as a percent of US GDP stayed fairly level. However, deposit taking
since the 1980s has been declining over time and shifting into MMMFs,
bond funds, and the stock market.
Financialization highlights the danger of breaking the link between
lending and saving. This also applies to securitization, which is detailed in
the next section.
3 Securitization
According to Krippner (2011) financialization was not a deliberate out-
come sought by policymakers but rather an inadvertent result of the
state’s attempts to solve other economic problems. Financialization was
a response to financial liberalization reforms occurring in the early 1980s
(Lagoarde-Segot 2015). These reforms were a response to low economic
growth rates, high and persistent inflation, and low investment in the
previous decade. As a result, interest rates, bond markets, capital flows,
stock market trading, and foreign exchange markets were all liberalized.
In addition, there was increasing deregulation in banking activities and
credit control policies were relaxed. This was perceived as a necessary step
for globalization and financialization. The same may be said of modern
securitization, which had its origins in government and government-
sponsored institutions like Fannie Mae (FNMA), Ginnie Mae (GNMA),
and Freddie Mac (FHLMC). These three government sponsored enti-
ties were instrumental in implementing and institutionalizing three other
important changes: secondary mortgage markets, credit scoring (or the
financialization of daily life), and risk-based pricing.
The more common presentation securitization is that it originated
approximately three decades ago at the Salomon Brothers’ mortgage trad-
ing desk. The typical description of the rise of securitization tends to fol-
low a pattern like the one by Zandi (2009) who describes three waves
of growth in the securitization market. Ginnie Mae started with mod-
ern securitization in 1970, by selling securities based on Federal Housing
Authority (FHA) and Veteran’s Authority (VA) loans and providing a
guarantee for the principal and interest. The following year Freddie Mac
took the lead in the securitization of conventional mortgages. In the
1970s, Fannie Mae, Freddie Mac, and the FHA dominated the mortgage
securitization market. In the late 1980s, the Resolution Trust Corporation
(RTC) (a regulatory response to the S&L crisis) securitized everything
from commercial mortgages to auto loans. Eventually, Wall Street firms
became the dominant players in the securitization market after the RTC
wound down its operations in 1995.
3.1 What’s in a Name?
Although the 2007 global financial crisis exhibits many boom and bust
characteristics, compared with other crises the role of securitization is
relatively new (Laeven and Valencia 2009). Securitization can be broadly
defined as a technique or process where a financial intermediary acquires
financial assets (such as equity or debt instruments), repackages the cash
flows on those equity or debt instruments, and issues marketable securities
representing claims on the repackaged cash flows. This allows the original
asset owners to remove the original items from their balance sheets and
free it up for more lending (Culp and Neves 1998; Cummins and Weiss
2009). Lipson (2012) states that the initial Dodd–Frank (2010) docu-
mentation does not provide a working definition of securitization.
Compared with other structured financial products, there is nothing
inherently injudicious about securitization as a technique process. Indeed,
the term “securitization” does not make its meaning immediately apparent
(Lanchester 2014). He refers to the “reversification” of financial words,
and in the case of securitization he states that what initially appears to be a
word that suggests security or reliability, ends up in the public conscious-
ness being associated with a product put to malign use.
The origins of the word “securitization” are mixed. One of the earliest
mentions in the literature is a 1981 edition of American Banker, which
refers to securitization as “those mortgages that tend to be securitized
through the secondary mortgage market pipeline and sold to a still reluc-
tant group of institutional investors”. However, Lewis Ranieri (2000)
takes credit for being the father of modern securitization and describes
the rather colourful history behind the origins of the word. He claims the
word first appeared in the Wall Street Journal in 1977 in the “Heard on
the Street” column. He goes on to say,
14 B.G. BUCHANAN
Ann Monroe, the reporter responsible for writing the column, called me
to discuss the underwriting by Salomon Brothers of the first conventional
mortgage pass-through security, the landmark Bank of America issue. She
asked what I called the process and, for want of a better term, I said secu-
ritization. Wall Street Journal editors are sticklers for good English, and
when the reporter’s column reached her editor, he said there was no such
word as securitization. He complained that Ms. Monroe was using improper
English and needed to find a better term. Late one night, I received another
call from Ann Monroe asking for a real word. I said, ‘But I don’t know any
other word to describe what we are doing. You’ll have to use it.’ The Wall
Street Journal did so in protest, noting that securitization was a term con-
cocted by Wall Street and was not a real word.
In the literature, the development of a consistent working definition of

securitization has also been rather uneven. One early attempt to define the
term in a rigorous way is by Shenker and Colletta (1991):
[A] serviceable definition is the sale of equity or debt instruments, repre-

senting ownership interests in, or secured by, a segregated, income produc-
ing asset or pool of assets, in a transaction structured to reduce or reallocate
certain risks inherent in owning or lending against the underlying assets and
to ensure that such interests are more readily marketable and, thus, more
liquid than ownership interests in and loans against the underlying assets.
Compare the previous definition with the SIFMA definition:
The term securitization refers to the process of converting assets with pre-
dictable cash flows into securities that can be bought and sold in finan-
cial markets. In other words, securitization allows financial institutions to
bundle and convert illiquid income-producing assets held on their balance
sheets, such as individual mortgage loans or credit card receivables, into
liquid securities.
However, the Office for the Comptroller of the Currency provides the
following definition:
Asset securitization is the structured process whereby interests in loans and

other receivables are packaged, underwritten, and sold in the form of “asset-
backed” securities. From the perspective of credit originators, this market
enables them to transfer some of the risks of ownership to parties more will-
ing or able to manage them. By doing so, originators can access the funding
markets at debt ratings higher than their overall corporate ratings,
which generally gives them access to broader funding sources at more

favorable rates. By removing the assets and supporting debt from their
balance sheets, they are able to save some of the costs of on-balance-
sheet financing and manage potential asset-liability mismatches and credit
concentrations.11
A reliable working definition of securitization needs to reflect the process’

critical elements, its inputs, structure, and outputs. Equally important is
the technique’s social function of connecting the buyers and sellers of cap-
ital more efficiently than other methods of financing (such as bank lend-
ing or issuing shares of stock). To that end, Lipson (2012) defines “true
securitization” as: “a purchase of primary payment rights by a special pur-
pose entity that (1) legally isolates such payment rights from a bankruptcy
(or similar insolvency) estate of the originator, and (2) results, directly or
indirectly, in the issuance of securities whose value is determined by the
payment rights so purchased”.
3.2 The Securitization Process

To qualify for securitization, assets or fixed income instruments must usu-
ally satisfy the following:
1. the cash flows must be regular and predictable;

2. the assets should be sufficiently similar for them to be pooled
together;
3. there should be a statistical history of any losses; and
4. the assets should be of low credit risk and of a highly saleable
quality.
In recent years the more popular securitized assets have included:

mortgages, accounts receivables, student loans, small business loans,
home equity loans, credit-card receivables, automobile loans, emerging
market loans, mutual-fund management fees, health club receivables,
hospital accounts, taxi medallion loans, and even the royalties paid on
music. In 1997, David Bowie was the first of this group who used secu-
ritization to raise $55 million backed by the current and future rev-
enues of his first 25 music albums (287 songs)—these were recorded
prior to 1990 and these securitized products became to be known as
“Bowie Bonds”. This subsequently spurred the growth of the intellectual
16 B.G. BUCHANAN
property (IP) securitization industry. In the last few years life insurance
contracts, solar energy contracts, microcredit, carbon emission rights,
and comic book leases have also shown growth potential for the secu-
ritization market. Prior to the Eurozone debt crisis the Greek govern-
ment securitized many assets including: highway tolls, airport landing
fees, future receipts from the national lottery, and even grants from the
European Union. What this allowed the Greek government to do was
to realize future revenues sooner and increase spending immediately.
Some Eurozone countries also securitized their sovereign debt, result-
ing in a lower debt/GDP ratio (Buchanan 2015b).12 For many emerg-
ing markets, securitization has proved a cost-effective way to deal with
non-performing loans.
After the mid-1990s, the PLS market started to rapidly accelerate
along with the creation of more elaborate securitized instruments, some
of which started to achieve quite bizarre levels of complexity. Therefore
it is not surprising that the securitized products came to be thought of
colloquially as an “alphabet soup”. Here is a sampling of other instru-
ments to emerge prior to 2007: CMO (collateralized mortgage obli-
gations where all the tranches drew their payouts from the same pool
of mortgages), CLO (collateralized loan obligations), CSO [collateral-
ized synthetic obligations (consisting of a synthetic asset pool)], CFO
(a CDO-like structure that acquires investments in hedge funds or pri-
vate equity funds), CCO (collateralized commodity obligation—this
acquires exposures in c ommodity derivatives) and CXO (collateralized
foreign exchange obligations which acquire exposure in exchange rate
derivatives).
Securitization requires not only an expanding market, but also the
deregulation and internationalization of domestic financial markets
(Sassen 2001). Schwarcz (2009) and Aalbers (2008, 2009a, b) have
focused on financialization and the mortgage markets and have placed
considerable emphasis on the technological development of securitization.
To Minsky (2008) both globalization and securitization reflect new com-
munication technology, computation, and record keeping. Lipson (2012)
even refers to “securitization” as a disruptive technology. Minsky (2008)
attributes the development of modern securitization to the globalization
of finance, the declining role of banks, and the increased importance of
managed money. Securitization altered the liquidity transformation role of
bank funding (Diamond 1984; Holstrom and Tirole 1997; Loutkina and
Strahan 2009). If we view securitization through the lens of financializa-

tion and disruptive technology, then we can better understand the shift
from the Originate-to-Hold model (OTH) to the Originate-to-Distribute
(OTD) Model.
3.3 Originate-to-Hold (OTH) versus Originate-to-Distribute

(OTD) Models
Historically, the common bank funding model is known as the “Originate-
to-Hold” (OTH) model. This means that banks usually had to retain loans
on their own books and either grew by attracting new deposits or through
mergers. Under this model, credit, income, and collateral were the main
criteria for a loan. And it was a more localized model, meaning that the par-
ticipants were usually located in the same geographic region. Securitization
changed all of this with the “Originate-to-Distribute” (OTD) model and
specifically the rise of securitization. A general framework for the process
can be viewed in Appendix 1 to this chapter. The securitization process
brought about a new way for banks to accelerate mortgage lending, as
well as generate more fees and income. This liquidity transformation role
would also be balanced against meeting capital requirements. Banks could
cut their capital needs by reallocating loans which allowed them to lend
more. The intention was also to reallocate credit risk to those who were
better able to understand and manage it.
Securitization usually requires the involvement of the following par-
ties: the issuer, the underwriter, the trustee, the ratings agency, servicer,
third-party servicers, as well as auditors and lawyers. Under the new OTD
model a pool of 30-year mortgage loans can be used to create tradable
securities that have varying maturities. Mortgages are moved off the bal-
ance sheet and pooled and bundled by a SPV. SPVs are responsible for
holding loans and ABS while being funded with short-term ABCP. If the
SPV issues equity securities, it is acting as a “pass-through” entity whereas
if the SPV issues debt instruments, it functions as a “pay-through” vehicle.
The SPV is responsible for slicing or “tranching” the pool of assets and
does not have to appear in annual accounts. In addition, because SPVs
are self-funding they do not count against a bank’s capital requirements
for prudential purposes. To make the securitized products more palat-
able, tradable securities, they require a rating. This is where Moody’s
and Standard and Poor’s fulfill a role (Scalet and Kelly 2012). For many
18 B.G. BUCHANAN
years the credit ratings agencies (CRA) played no explicit role in govern-
ment sponsored entities (GSE) MBS and collateralized mortgage obliga-
tions (CMO) issuance, because the GSE sponsorship denoted an implicit
government guarantee. In the late 1990s, as the private label market
in MBS and CMOs expanded, CRAs were called upon to provide rat-
ings of tranches. In theory, the investment grade tranche should have an
extremely remote chance of default. Securities could be structured accord-
ing to different tiers of risk.
Consider the following example based on a mortgage-backed security
structure. Assume there are 100 mortgage loans, each nominally worth
$1 million, totaling a mortgage pool worth $100 million. The loans have
a maturity of one year and all the loans have a zero recovery rate. This
means that if the borrower defaults, the lender loses the entire invest-
ment. Now under the OTD model, the MBS sets up a SPV which funds
the loan portfolio by debt. The SPV is legally insulated from the banks.
Credit default swaps (CDS) can also be purchased to protect structured
investment vehicle (SIV) commercial paper, residential mortgage-backed
securities (RMBS), and CDOs. Prior to 2007, popular monoline insurers
included Ambac Financial Corporation and MBIA.
Assume that the borrowers make their mortgage payment each month.
Netting out administration costs, each interest payment that the borrower
makes is then passed through to the investor via the MBS structure. The
MBS that is created is displayed in Appendix 2. Also assume that the MBS
structure has three tiers that are rated: senior tranche, mezzanine tranche,
and equity tranche. The same $100 million pool of loans collateralizes the
three different tranches.
The tranche breakdown of the loan pool creates a “waterfall” or a “cas-
cade” structure. The different tranches will appeal to different investors.
The senior tranche, or investment grade tranche, has the lowest default
risk and lowest yield. The equity tranche is considered to be high risk, high
yield, and is usually retained by the originator (although that changed in a
number of instances prior to 2007). The equity tranche holders will only
be paid after the more senior tranche holders have been paid. In this exam-
ple, the equity tranche holders will only be paid something if fewer than
10 mortgage loans default (and hence is called the “residual tranche”). If
between 10 and 30 mortgages default, the senior tranche holders will still
be paid in full while the mezzanine tranche holders will have their nominal
amounts reduced accordingly. In this instance the equity tranche holders
will receive nothing. If more than 30 loans default, the equity and mez-
zanine tranche holders will receive nothing and the senior tranche holders
will have their nominal amounts reduced accordingly. For an investor, a
MBS potentially offers higher yields compared to other low risk securities
(such as government securities).
Securitization also provided the possibility for the originator to improve
its credit rating. For example, an originator with an overall credit rating
of AA might be able to issue securities that are rated AAA. What this
signals to the market is that the securitized products pose less default risk
than does the originator’s credit. Since the securities are considered a safer
bet than the originator, investors will pay more for the AAA-rated securi-
tized bonds than they would if the AA-rated originator had borrowed the
money directly. The originator’s cost of capital should then be lower in the
securitization versus the secured loan because it receives a discount based
on the quality of the payment rights it sold.
The OTD model meant that the risk was now handled by the market
instead of by the banks themselves. Fueling the growth prior to 2007
was bank leverage and this was a debt explosion in terms of volume and
geographical scope. But the debt relation was fragmented and diffuse.
Securitization transformed a localized lending market into a global invest-
ment asset class.
Global financial institutions (FIs) of all sizes benefited from securiti-
zation. It appeared that gone were the days when the small regional bank
had no choice but to place concentrated bets on local housing markets.
What this financial innovation presented was the opportunity for the
same bank to dispatch credit risk to distant investors such as insurers
and hedge funds around the world. In the USA, approximately half of
the securitized assets such as CDOs and MBS were eventually sold to
foreign investors. The largest portion of these securitized assets ended
up in European banks’ (and their subsidiaries) portfolios. For banks such
as BNP Paribas and UBS, hedge funds attached to these banks placed
high-risk bets on a range of subprime securities. Gramlich (2007) finds
that during the subprime securitization market grew sizably. Mian and
Sufi (2009) find that securitization contributed to the growth of the
subprime mortgage market. For example, when a mortgage defaulted
in Las Vegas or Cleveland, it rippled up the securitization food chain,
affecting everyone from Norwegian pensioners to investment banks in
New Zealand (Buchanan 2015b).
20 B.G. BUCHANAN
3.4 Why Do Institutions Securitize?

There are a number of reasons for securitization including: reducing infor-
mational asymmetries, servicing as a lower cost of financing source, reduc-
ing regulatory capital, and reducing bank risk (Greenbaum and Thakor
1987). Securitization will increase the institution’s risk profile only if the
most creditworthy assets are removed from the balance sheet through
securitization (Murray 2001).
Cantor and Demsetz (1993) and Calomiris and Mason (2004) mea-
sure the extent of the regulatory arbitrage argument in the securitiza-
tion framework. Regarding the role of securitization as a new source of
liquidity in bank management, securitization reduces the bank lending
sensitivity to the availability of external sources of funds (Loutskina 2011).
Securitization also has the potential to make banks more vulnerable to
economic shocks when the market for securitized loans is disrupted.
In a study of US banks, Uzun and Webb (2007) find that bank size is
an important determinant of whether or not a bank will securitize. Cerrato
et al. (2012) utilize a sample of UK banks and find that the need to secu-
ritize tends to be driven by the search for liquidity, followed by regulatory
arbitrage and credit risk transfer. They also find that banks which securi-
tized extensively prior to the 2007 financial crisis tended to incur more
defaults after the financial crisis was triggered and commercial banks were
more highly exposed to conditions in the securitization market. Cerrato
et al. (2012) research complements the theoretical work of DeMarzo
(2005) and DeMarzo and Duffie (1999). In terms of other international
empirical studies, Cardone-Riportella et al. (2010) also find that liquidity
needs are an important driver of securitization for Spanish banks. On the
other hand, Affinito and Tagliaferri (2008) find that capital requirements
play a driving role in loan securitization for Spanish banks.
Cheng et al. (2014) challenge the incentives based view of the finan-
cial crisis in order to incorporate a role for beliefs in securitization. The
authors study the individual purchase behavior of mid-level Wall Street
managers who worked directly in the mortgage securitization business.
They find that securitization mid-level agents neither managed to time
the market nor did they exhibit cautiousness in their home transactions.
The results apply especially for those agents living in the “bubblier”
areas of the USA and the agents may have been rather susceptible to
the potential source of belief distortion. This could include job environ-
ments that encourage group thinking, cognitive dissonance, and other
sources of overoptimism.
3.5 The Lemons Problem

Asset securitization may also be viewed as a means of avoiding the “lem-
ons problem” on security issues. Initially proposed by Akerlof (1970),
in the “lemons problem”, investors know that a company’s management
may well be incentivized and have the means to present the company in
a more favorable condition than facts currently warrant. A company can
reduce its cost of capital by reducing informational asymmetry, and cost
reductions will be largest for companies that have few financing alterna-
tives (Hill 1996). This potentially applies to small companies, companies
facing financial distress, companies that are difficult to apprise or com-
panies that operate in volatile industries. Companies entering emerging
markets may face an even more severe “lemons problem”.
To better understand the lemons problem in the securitization con-
text, consider the example of accounts receivables being securitized into
ABS. The issuer (borrower) is the seller of the receivables. The issuer
knows more about the underlying pool of receivables than the lender who
is looking to invest in ABS. Based on Akerlof (1970), the borrower has the
incentive to exaggerate the quality of the underlying receivables. Investors
will recognize the lemons problem as well as the fact that the originators
will want to securitize the poorer quality loans. Aware of this, the lend-
ers will offer the issuer a “lemons price”, which is based on a worst case
estimate of the receivables. Investors will be expected to be compensated
for that additional risk. Downing et al. (2009), Krainer and Lederman
(2009), and Demiroglu and James (2009) confirm this view. Then why
would the lender offer more for the ABS? If the borrower can convince
the lender the receivables pool does not contain lemons.
The taint of a “lemons” problem can be removed by securitization. The
issuer can securitize the bad loans (or lemons) and keep the good ones (or
securitize them elsewhere or down the line). This helps reduce the adverse
selection problem. Those originators with the biggest lemons problems
on their balance sheet, have the most to gain from securitization. Credit
enhancement techniques such as overcollateralization and insurance; the
originator’s reputation; and due diligence conducted by the portfolio
manager on the originator can mitigate the lemons problem.
In US Senate testimony, McCoy (2008) attributes the “lemons” prob-
lem to two flaws in the securitization framework. Firstly, there is the
misalignment of compensation and risk in securitization. Most compa-
nies in the securitization process are able to collect their fees upfront and
so this shifts the risk further downstream to investors. An investor can
22 B.G. BUCHANAN
protect himself through recourse clauses in the contract, or by requiring

that lenders retain the equity tranche of the securitization (i.e., the riski-
est tranche). However, both safeguard arrangements were susceptible to
breaking down. The lender could either hedge the equity tranche or could
resecuritize the equity tranche in the form of a CDO.
The second flaw is related to the demand for volume and volume-based
commissions in securitization. However, to maintain market share, the
chase for volume placed a downward pressure on lending standards. After
July 2004 interest rates rose ending the refinancing boom. To increase the
rate of securitization and fee income it generated, non-traditional mort-
gages became a more frequently tapped source by lenders. More relaxed
underwriting standards qualified more potential borrowers to non-
traditional mortgages that included interest-only loans and option pay-
ment ARMs offering negative amortization. To have an assured pipeline
of mortgages to eventually securitized, Lehman Brothers and Bear Stearns
purchased subprime lending companies. Private-label securitizations sold
more “lemons” over time. Over the course of the mortgage bubble, the
flawed incentive structure of securitization caused the lemons problem to
worsen.
3.6 Benefits and Costs of Securitization

The benefits of securitization have been documented by Kashyap and
Stein (2000) and Loutkina and Strahan (2009). The benefits of secu-
ritization include (1) cheaper funding costs, (2) credit risk diversifica-
tion, (3) freeing up equity for the FI, (4) creation of new asset classes,
and (5) the potential to accelerate earnings potential (Greenbaum and
Thakor 1987, Fabozzi 2005, Uzun and Webb 2007, Schwarz 1991).
Securitization is considered to be a major profit source of fee enhance-
ment and also came to be seen as a valuable source of enhancement for
asset managers (Ashcraft and Schuermann 2008). According to Dash
and Cresswell (2008), Citigroup generated fees of $6.3 billion in 2003
and $20 billion in 2005.
Securitization brought many advantages to both originators and
investors. For originators, securitization improves the return on capi-
tal (ROC) by converting an on-balance sheet lending business into
an off-balance sheet fee income stream that is less capital intensive.
Securitization also provides efficient access to the capital market. For
example, if a company is rated BBB but possesses an AAA worthy cash
flow from some of its assets, then based on the securitization of these
worthier cash flows a company would be able to borrow at AAA rate, or

investment grade. Other advantages for originators include: minimizing
issuer-specific limitations on ability to raise capital; converting illiquid
assets to cash; raising capital without prospectus—type disclosure (sen-
sitive information about business operations can be kept more confi-
dential); boosting firm’s earnings; and the transfer risk to third parties.
Minsky (2008) even argued that in principle there was no limit to the
bank’s capacity to create credit.
There are other potential drawbacks associated with the securitiza-
tion process (Schwarz 1991, Morrison 2005, Parlour and Plantin 2008,
Cerrato et al. 2012). The rebundling process could lead to a lack of trans-
parency and weakening of the due diligence process. Petersen and Rajan
(2002) find that securitization may have potentially reduced incentives for
lenders to carefully scrutinize and monitor borrowers due to the greater
distance between the borrower and those who finally bear the default risk.
They suggest that reputational concerns, regulatory oversight, and suf-
ficient balance sheet risk are ways to prevent moral hazard on the part of
the lenders. Piskorski et al. (2012) and Parlour and Plantin (2008) also tie
a lack of ex-post monitoring incentives to securitization.
Secondly, default correlations that are low in a healthy economy may
become very high during a recession and this means that the attempt to
diversify idiosyncratic risk may become rather illusory in nature. Finally,
while the process may provide liquidity in a good economy, as events in
2008 showed, liquidity in the market can suddenly dry up.
Another drawback is that the mortgage securitization chain is con-
sidered to be very opaque. As the aftermath of the recent crisis has
revealed, there is really no way for FIs to work backward and determine
what the valuations are based on the mortgages. Previously, the owners
had relied on the market to value securitization tranches. The pricing
system had essentially broken down. The market for many other ABS
also started to break down. This included the market based on credit
card receivables, student loans, and auto loans. This presented a prob-
lem for many FIs that relied on short-term financing as many other
credit markets started to operate at substantially reduced capacity. The
SIV conduits and other off-balance sheet entities were the first institu-
tions to be damaged after 2007.
It is the credit rating process that has come in for much criticism
in the aftermath of the financial crisis. Bolton et al. (2012) examine
the distortions that the credit rating agencies can create. They find
that it encourages ratings shopping and the ratings are more likely to
24 B.G. BUCHANAN
be inflated during boom times when investors are inclined to be more

trusting. He et al. (2012) examine the relation between issuer size and
market prices of MBS conditional on ratings. They find that for both
AAA- and AA-rated tranches that are sold by large issuers, the prices
drop by a larger magnitude than similarly rated tranches by smaller
issuers. Nini (2008) shows that the growth of institutional investors
increased the supply of credit to firms with speculative grade ratings.
Ashcraft and Schuermann (2008) note that credit ratings were assigned
to subprime MBS with substantial error. They also find that despite
the fact that ratings agencies publicly disclosed their ratings criteria
for subprime securities, investors lacked the skills to assess the efficacy
of the ratings models. Pagano and Volpin (2010) find that the credit
rating agencies can choose to be more or less opaque depending on
what the investor requests. Keys et al. (2010) find that existing securi-
tization practices tended to adversely affect the screening incentives of
subprime lenders.
3.7 Mortgage-Backed Securities (MBS)

To recap, with MBS there are three basic tranches: the senior tranche, the
mezzanine tranche, and the equity tranche. The senior tranche offers the
lowest rate of return because it has the least risk. It is the first tranche to be
paid and the last to incur any losses. The mezzanine tranche falls between
the senior tranche and the equity tranche in terms of both risk and return.
The equity tranche potentially offers the highest rate of return because it
has the highest risk. Any losses are absorbed at this tranche first and the
tranche is usually called the “toxic waste”.
Conduits, SPVs and ABCP are major buyers of RMBS. Money
market mutual funds (MMMF) purchase ABCP from SPVs. The com-
mercial paper receipts serve to fund the purchase of collaterals, includ-
ing structured finance products. As a result, long-term mortgages are
transformed into shorter-term risky instruments. Once mortgages are
moved from the issuer’s balance sheet to a SPV, the issuer is generally
subject to lower capital requirements that may be imposed by internal
risk models or by regulators. For the issuer, this frees up more capital
to make more loans. Diversification benefits can be obtained if the
mortgages are pooled into RMBS because it diversifies risk exposures
among numerous individual mortgages spread among different geo-
graphical areas. The risk reducing mechanism is no longer risk sharing
but rather risk shifting.
Since the 1980s, MBS have taken on many permutations, including

commercial mortgage-backed securities (CMBS) and RMBS. There are
MBS which are payable only from the principal payments made on the
mortgages (known as principal-only mortgages). Secondly, there are MBS
that are payable only from the interest payments made on the mortgages
(I/O mortgages). MBS can carry either a fixed or floating rate of interest.
In the lead up to the financial crisis “inverse floaters” became a popular
form of MBS, and these were instruments that carried an interest rate that
declined when interest rates increased.
3.8 CDO Securitization
So where do CDOs fit into the securitization story? CDOs are not really
that new either. Collateral debt obligations will include collateralized
bond obligations (CBO) and CLO. Back in the late 1980s, Drexel
Burnham Lambert assembled CDOs out of different companies’ junk
bonds and investors could pick their preferred level of risk and return
from the resulting tradable securities. The term “collateralized loan obli-
gation” (CLO) was coined in 1989 (Lucas et al. 2006) when corporate
loans were first used as collateral in CDOs. However, this changed after
2001 when the US housing market started to surge and the demand for
more securitized products increased. Wall Street banks would take the
lower rated tranches (think of the BBB rated MBS) and repackage them
into new securities, namely a CDO. CDO securities would then be sold
with their own waterfall structures and the CDO market was concen-
trated among six or seven issuers. Eventually, 80 percent of the CDO
tranches would be rated triple-A despite the fact that they generally com-
prised the lower-rated tranches of MBS. Griffin and Tang (2012) inves-
tigate 916 CDOs between 1997 and 2007 and find that 91.2 percent
of AAA-rated CDOs only comply with the credit rating agency’s own
AA default rate standard. Benmelech and Dlugosz (2009a,b) examine
CDOs and the credit ratings agencies and find that the ratings were not
always accurate measures of default risk, nor were they necessarily a suf-
ficient statistic for risk.
Out of this market evolved synthetic securitized products such as the
CDO2 and CDO3. The Bank for International Settlements reports that
synthetic CDO volumes reached $673 billion in 2004 (Das et al. 2007). A
CDO2 is produced from the lower rated CDO tranches and restructured
through the securitization process again. Then the lower rated CDO2
tranches are put through the process again to produce CDO3. The height
26 B.G. BUCHANAN
of the global CDO issuance market mimics the growth in the housing
and mortgage-backed securitization bubbles. After 2008, the global CDO
issuance market plunged to historic low levels and was still struggling to
rebound in 2012.
3.9 Securitization Performance
Over the last two decades greater distance has started to be placed between
mortgage borrowers and the people who finally purchase securitized assets
(Petersen and Rajan 2002). Now it is truly global in scope. Since the 2007
financial crisis many aspects of the global securitization market such as
home equity loans and mortgages have been decimated. This is evident if
one observes Figs. 1.8, 1.9, and 1.14 which profile US securitization issu-
ances respectively during the pre- and postcrisis periods. After 2007 non-
agency CMBS declined from $229.2 billion to $4.4 billion and RMBS
also rapidly dropped from $509.5 billion to $32.4 billion. The growth
of the US MBS market is displayed in Fig. 1.8 and the growth of the US
securitization issuance market in ABS is shown in Fig. 1.9.
4000
3500
3000
2500
2000
1500
1000
500
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
MBS -Agency CMO-Agency

CMBS-Non agency Home Equity-Non agency
Resecurizaon (CMBS & RMBS)-Non agency RMBS-Non agency
Fig. 1.8 US mortgage securitization issuance 1996–2015/(USD billions).

Source: SIFMA
3,50,000.00
3,00,000.00
2,50,000.00
2,00,000.00
1,50,000.00
1,00,000.00
50,000.00
-
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Auto Credit Cards Equipment Housing-Related Other Student Loans
Fig. 1.9 US ABS issuance (USD $millions).

Source: SIFMA
In terms of more specific issuances, one observes in Fig. 1.9 that US

home equity ABS grew during 2004–2006. In 2007 this segment issued
$216.9 billion worth of securities and dropped to $3.8 billion the follow-
ing year. Since then the securitization issuance of home equity loans has
demonstrated anemic growth. Figures 1.10, 1.11 display the dominance
of agency securitized products in the aftermath of the financial crisis.
Figure 1.12 displays the most common assets that serve as a backing for
US ABS at various time periods. In 1993, 40 percent of ABS was backed
by auto loans, followed by credit cards (31 percent). Home equity loans
comprised 13 percent of the US ABS market and this figure has changed
dramatically since then, rising to 34 percent in 2001, 43 percent in 2007
(at the height of the securitization market) and declining to 2 percent
by 2012. Student loan asset-backed securities (SLABs) have comprised
between 1 percent (in 1993) to 13 percent (in 2012) of the ABS market.
Figure 1.13 shows the surge in CDO issuance prior to 2007. Gorton
(2010) states that CDO global issuance tripled between 2004 and 2006.
The decline of the CDO market was swift and as Fig. 1.13 indicates,
recovery of the market has been weak.
In 1987 the issuance of MBS in the UK marked the start of European
securitization. Italian car leasing contracts followed, followed by con-
sumer credits in France and MBS securities in other European countries
28 B.G. BUCHANAN
4,000.00
3,500.00
3,000.00
2,500.00
2,000.00
1,500.00
1,000.00
500.00
0.00
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Agency NonAgency
Fig. 1.10 American securitization issuance 1996–2014, USD bn.

Source: SIFMA
10,000.0
9,000.0
8,000.0
7,000.0
6,000.0
5,000.0
4,000.0
3,000.0
2,000.0
1,000.0
0.0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Agency Non-Agency
Fig. 1.11 American securitization outstanding, 2002–2014, USD bn.

Source: SIFMA
Panel A Panel C
Student Loans
Other 1%
Manufactured 5% Student Loans
Housing
12%
4%
Other Auto
Home Equity 9% 15%
13%
Auto
Manufactured
40%
Housing
Equipment 0% Credit Cards
6% 20%
Home Equity
Credit Cards 43%
31% Equipment
1993 2007 1%
Panel B Panel D
Student Loans
Student Loans 6%
5%
Manufactured
Housing
2% Other Other
Auto
9% 26% 10%
Housing- Auto
Related 43%
10%
Home Equity Credit Cards Equipment
34% 8%
21%
Credit Cards
23%
2001 Equipment 2014
3%
Fig. 1.12 US asset-backed securitization—Collateral type.

Source: SIFMA
600000
500000
400000
300000
200000
100000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
Fig. 1.13 Global CDO issuances (USD millions).

Source: SIFMA
30 B.G. BUCHANAN
throughout the 1990s. European securitization has enjoyed healthy

growth since 1995 as a competitor to the covered bond market. Loutkina
and Strahan (2009) report a 35 percent growth in European securitiza-
tion in recent years. The UK is the main origin of issuance and Italy is the
most important issuer of euro-denominated ABS. MBS securities play an
important role in the Netherlands and Spain. In Germany and France,
the ABS issuance remains below the potential issuance level. This is most
likely due to the fact the German market is dominated by Pfandbriefe and
the French market has a substantial proportion of “obligations foncieres”
which were introduced in 1999.
Figure 1.14 displays the rise and fall of the European securitization
markets, indicating a sharp decline after 2008. Between 2011 and 2012,
there has been another decline. Figure 1.15 illustrates the various collat-
eral types for European securitization markets between 1993 and 2012.
RMBS has consistently dominated the European securitization market
since 1993. In terms of other European ABS markets, there have been
some shifts in collateral dominance except for a small growth in the credit
card and small- and medium-sized enterprise (SME) securitization market
14,00,000.00
12,00,000.00
10,00,000.00
8,00,000.00
6,00,000.00
4,00,000.00
2,00,000.00
0.00
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Fig. 1.14 Total European securitization issuance (USD millions).

Source: SIFMA
1993 2007 Credit

Leases
Cards
Auto Consumer 0% 1%
Pubs 2% 1%
Auto 0%Other Other
17% 1% 2%
CDO
RMBS SME 10%
35% 11%
CMBS
Consumer Mixed 8%
25% 1%
CMBS
11% RMBS
63%
CDO Other Leases
3% 3% 6%
Pubs Credit Cards

Other 2001 Auto 2014
0% 1%
3% 3% Consumer
Other
SME 3% Leases 2%
7% 2%
Auto Consumer
SME 3%
13%
15% Credit Cards
Other 3%
Leases
14% 1%
CDO Other
7% 1%
RMBS CDO
38% 18% CMBS
3%
CMBS RMBS
10% 52%
Mixed
1%
Fig. 1.15 European securitization issuance (by collateral type)
during the same period. Many European banks were active securitizers,
slicing and dicing mortgages from homeowners in European countries
with Britain, Spain, and the Netherlands providing most of the loans for
the process. Figure 1.16, Panel A confirms this. In Panel B it is evident
that by 2012 that Spanish participation in the securitization market is
severely diminished due to the ongoing sovereign debt and banking crisis.
In 2012, the UK, Italy, and the Netherlands were the three main securi-
tizing markets in Europe. In 2007 alone, $690 billion (€496.7 billion)
worth of European loans became the basis for ABS, MBS, and CDOs.
Many of the loans and securities that European banks had in the securiti-
zation pipeline were stored in SIVs. When the 2007 crisis hit, European
banks had to bring them back onto their balance sheets, much in the same
way as their American counterparties did. By the end of 2009, the ECB
raised estimates of write-downs to $765 billion (€550 billion).
32 B.G. BUCHANAN
Greece
Belgium France
Germany 1%
1% 1% Ireland
3%
3%
Italy
6%
2007 United
Kingdom Mulnaonal
27% 9%
Netherlands
22%
Spain
20%
Russian
Federaon Other
Portugal PanEurope
0% 1% 5% 1%
Belgium
2%
2014
France
United Kingdom 24%
23%
Spain
Germany
12%
8%
Italy Greece
Portugal
Netherlands 9% 0%
1%
PanEurope 12% Ireland
7% Other Mulnaonal 1%
1% 0%
Fig. 1.16 European securitization issuance (by country).

Source: SIFMA
The Australian and New Zealand securitization market is displayed in

Fig. 1.17. The trend follows a familiar theme, in terms of the rapid growth
after 2000. While it is a substantially smaller market in size relative to the
USA and Europe, there has been a gradual rebound after the financial
crisis.
140,000.00
120,000.00
100,000.00
80,000.00
60,000.00
40,000.00
20,000.00
0.00
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Fig. 1.17 Securitization outstanding—Australia and New Zealand (USD millions).

Source: SIFMA
3.10
Subprime Mortgage Market and Securitization
Often borrowers were highly leveraged with little or no equity in the
home. Subprime borrowers took out “piggyback loans” of home equity or
second mortgages to cover down payments on residences. Gorton (2010)
states that subprime mortgages accounted for 20 percent of all new resi-
dential mortgages in 2006. Relatively high interest rates on subprime
mortgages made them particularly appealing candidates for securitization
and investment. In 2007, SIVs had 8.3 percent exposure to the US sub-
prime mortgage market (IMF 2008). Throughout the 2000s, subprime
mortgages contributed to an even bigger proportion of the securitization
market. In 2001, 9 percent of US mortgages issued were subprime, which
accounted for 6.5 percent of the MBS market. Four years later, 22 percent
of mortgages issued were subprime, which now accounted for 23 percent
of the MBS market.
In the case of subprime RMBS, overcollateralization and/or excess
spread was usually involved.13 What both of these devices provide is an
opportunity to transform subprime mortgages into AAA rated RMBS. The
34 B.G. BUCHANAN
smaller unrated equity tranche bears most of the risk. This shifted the risk
to investors and the lenders were now provided with funds to purchase
more mortgages.
Creating synthetic CDO products also means that if one considers the
risk exposure, the volume of risk exposure in CDOs can possibly exceed
the number of subprime mortgages actually securitized. Risk perception
was distorted by several additional factors.
One was the belief that diversification provides protection. Another
was that RMBS and CDO buyers are afforded some protection against
adverse selection if issuers with superior information could cherry-pick
mortgages, securitizing the least attractive ones for sale and retaining the
best mortgages.
Nadauld and Sherlund (2009) and Mian and Sufi (2009) examine
whether securitization leads to an increase in subprime lending. Investment
banks securitized more loans from subprime zip codes than prime zip
codes. Mian and Sufi (2009) confirmed this and note that the relationship
was particularly strong between 2002 and 2005 when private loan secu-
ritizations dominated the market. Purnanandam (2011) also finds sup-
port for this. Both groups of authors observe higher default rates between
2006 and 2007. In summary, an increase in subprime private label MBS
increases the supply of credits and increases the default rates during 2006
and 2007. Keys et al. (2010) look at credit scores. Loans above this score
are more likely to be securitized and are more likely to default than loans
below that score, most possibly reflecting declining incentives to screen
borrowers.
Other institutional investors competed heavily with the banks in the
mortgage securitization market. In the next section, I detail the events for
Carrington Capital Asset Management (CCAM).
3.10.1 Mini-Case: Carrington Capital Asset Management

Carrington Capital Asset Management was a hedge fund which special-
ized in securitizing subprime mortgages and derived significant revenue
from the unusual strategies of its servicing affiliate. CCAM’s strategy was
to stop foreclosures by repeated modifications and repeated forbearances.
By doing so, the fund could reduce losses and maintain payment streams
for the trusts and avoid selling properties at historic low market values. In
fact, one action netted the hedge fund $20 million.14
CCAM was founded by Bruce Rose, a former Salomon Brothers
employee. While at Salomon Brothers in the 1980s, Rose became familiar
with subprime lending. In 2003 Rose left Citigroup and started CCAM,
a mortgage securities hedge fund. CCAM’s mission was to “package

subprime debt into private-label securities, retaining the highest yield-
ing, lowest ranking portions of the deals for itself.”15 CCAM maintained
a relatively high degree of authority over handling distressed collateral.
Investors and ratings agencies did not appear to object to how CCAM
treated troubled collateral. CCAM would direct the servicer as to how to
dispose of the troubled collateral and sell the properties that were going
into default. Close ties were maintained with New Century Financial.
New Century Financial exchanged seed funding in exchange for a stake
in CCAM and supplied and serviced loans to CCAM. In 2007 when New
Century Financial collapsed, CCAM purchased its servicing rights and
infrastructure for $188 million and by doing so moved further into the
subprime mortgage market (when other funds were leaving the market).
This now meant that CCAM maintained absolute control of the credit
performance of New Century Financial’s originated assets. An example of
this is the CARR 2005-NC3 deal.
The CARR 2005-NC3 deal was based on a $1.7 billion mortgage pool.
The average FICO score for borrowers in the pool was 617, and nearly
half were based on the stated income. The New Century Financial origi-
nated loans were skewed towards California and Florida. In the securitized
deal, CCAM owned the credit enhancement tranche (or CE), the bottom
ranked tranche. This was a 3 percent slice of the deal created in order
to act as a buffer against losses in the more senior tranches. However, it
earned no money for the first seven months in 2007.
As the number of delinquent mortgages rose, there was the problem
of how to deal with increased foreclosures. Rose’s strategy was that loss
severities would decrease over time,16 which proved incorrect, but helped
the junior tranche investors. CCAM’s modifications, or “mods”, included:
declaring the loan to be current by adding missed payments onto the top
of the loan’s unpaid principal. Sometimes this would be coupled with a
rate reduction. In some instances, mods were made up to three times,
which allowed borrowers and CCAM a little more time. However, a 2009
Ohio lawsuit claims CCAM’s actions did not amount to a good faith effort
to keep borrowers in their houses for the long term.17
As servicer, CCAM utilized capital modifications to make loans cur-
rent, meaning that excess spread (valued in millions of dollars) could be
released to the equity tranche that CCAM owned rather than to the senior
tranches. Between September and December 2008, CCAM reworked
between $18 million and $36 million dollars of loan modifications.
During the same period, portfolio delinquencies dropped from 34 per-
36 B.G. BUCHANAN
cent to 25.6 percent and the CE tranche earned $18 million. Eventually

in 2009 and 2010, CCAM started to sell off its inventory stockpile. An
SEC investigation which finished in April 2015 resulted in no penalties or
enforcement actions.
Ghent et al. (2016) assert that securitization complexity disadvantages
senior tranches regardless of the underlying collateral quality. CCAM is an
example of this. The CCAM case also reveals that a fund having “skin in
the game” (which was a key feature of the 2010 Dodd–Frank act) does not
necessarily assume aligned incentives in servicing or quality securitizations.
3.11 The Events of 2007

Gramlich (2007) states that by 2007 more than 50,000 independent bro-
kers entered the US mortgage origination arena. These brokers were not
subject to federal supervision and were subsequently purchased by invest-
ment and commercial banks. This meant the banks now had an easier
way of accessing the subprime mortgage markets. For example, in 2006
Merrill Lynch purchased First Franklin for the purpose of converting pur-
chased mortgages into CDOs (Morgenson 2008).
Foreclosure rates on subprime mortgages started to increase in 2006
(OFHEO 2008). Between mid-2006 and mid-2007 subprime mort-
gage issuance dropped 50 percent. As subprime defaults increased,
the ratings on CDOs and RMS plummeted, which in turn exacerbated
Value at Risk (VaR) measures. New Century Financial Corporation
failed in 2007.
Approximately 80 percent of US mortgages issued to subprime bor-
rowers during this time were adjustable-rate mortgages (ARMs). In
mid-2006, home prices in the USA peaked and subsequently began a
rapid decline. Increasing interest rates were a significant contributing
factor to the house price decline. “Teaser” rates on subprime ARMs were
beginning to reset at prevailing higher interest rates. As the economy
contracted, subprime borrowers were unable to refinance their freshly
adjusted high-rate mortgages into conventional fixed-rate mortgages.
The result was an increase in delinquencies, defaults, and eventually fore-
closures. The effects of the subprime market meltdown were devastat-
ing and far-reaching. As many of the subprime mortgages were pooled
together after origination and resold as packaged securities, numerous
economic sectors—regardless of size—were adversely impacted by the
subprime fallout.
This is the case with the subprime mortgage market. Between 2001
and 2006 subprime mortgage lending had grown from $160 billion to
$600 billion (Mason 2015). Most of the subprime loans were made in
the ARMs market which accounted for 48 percent of all loans issued in
the three years prior to the collapse of the mortgage bubble. Many of the
ARMs were structured as follows. If the ARM mortgage was a 2/28 mort-
gage, for the first two years the mortgage rate was set according to a low
fixed rate, called a “teaser” rate. After the “teaser” period, the loan was
reset against a floating rate (usually LIBOR) plus a risk premium.
As long as LIBOR18 remained low, the ARM borrower faced lower
monthly payments than a fixed rate mortgage borrower. The LIBOR-
OIS spread remained low until LIBOR spiked in summer 2007. By the
end of 2007 the spread increases, and spikes again throughout 2008. US
home prices increased and borrowers who were relying on refinancing
for loan repayments could not refinance and many subprime mortgages
had ARMs. Borrowers who had expected to refinance at lower rates now
could not make payments because LIBOR was higher. This caused many
low rated tranches to default, and many better rated AAA− ones to be
downgraded as well. For those who thought that AAA− meant invest-
ment grade, or iron clad safety, this disadvantaged many investors. It also
adversely impacted institutional investors like mutual funds and pension
funds which were legally restricted to investing only in AAA securities.
Investors started to avoid many debt rated securities of all ratings. The
prices of debt rated securities kept falling because there were now fewer
investors. Firms had to mark the debt securities to cash, which required
selling more securities pressing more prices downwards, causing a “death
spiral”.
In June 2007, two Bear Sterns hedge funds failed due to investments
in subprime CDOs. Kelly and Ng (2007) state that one fund had a lever-
age ratio of 21:1. In July 2007, further downgrades occurred and German
firm IKB suffered a major loss on subprime mortgage investments. This
in turn required an emergency infusion from IKB’s shareholders and the
German government. In July 2007, the downgrade of subprime RMBS
was concentrated between Fremont General Corporation, New Century
Financial, Long Beach savings, and WHC Mortgage Corporation.
In the ABCP market issuers had increasing difficulty in locating buy-
ers for their paper. August 9, 2007, marks the start of the housing crisis
when BNP Paribas cited “evaporation of liquidity in certain segments of
the US securitization market” (Cassidy 2009). BNP Paribas had to halt
38 B.G. BUCHANAN
redemptions from three funds that could not be valued because of its
very illiquid subprime holdings. The three investment funds were holding
substantial proportions of American mortgage securities. Before the sus-
pension these three funds had a combined value of approximately US$2.2
billion (or €1.6 billion). At the time BNP Paribas had €600 billion under
management. This may at first glance seem a relatively minor fraction of
BNP’s portfolio. But after August 9, 2007, it sent stock markets around
the world plunging.
Losses quickly spread beyond the European Union. A $13 million
loss (of a $14 million investment in CDOs) was incurred by Springfield,
Massachusetts, as well as the multimillion dollar write-downs by King
County, Washington, connected with its investments in Rhinebridge
(sponsored by IKB Deutsche Industriebank, Chinn and Frieden 2011).
Countrywide Financial was one of the earliest casualties of the financial
crisis. At its peak Countrywide Financial was the nation’s largest mortgage
lender and issued 17 percent of all US mortgages. It was citing financial
difficulties after American Home Mortgage collapsed in August 2007. On
August 10, 2007, a run on Countrywide Financial started and the com-
pany quickly filed for bankruptcy. It was later bought by Bank of America
in January 2008.
Pani and Holman (2013) detail the consequences of write-downs in
securitized products in eight Norwegian municipalities. The Norwegian
municipalities had been hoping to yield a regular income stream by swap-
ping against future revenues from hydroelectric sources. None of the
eight municipalities had any immediate links to either the US subprime
mortgage market or the MBS CDO market, and even participants in
the program describe the securitized structures as being too complex to
understand and comprehend.
Bank of America and JP Morgan Chase announced that they were tak-
ing assets and liabilities onto their balance sheets. By the end of 2007,
UBS announced a US$10 billion loss largely from its AAA category of
subprime investments. Monoline insurers were also struggling with AAA
rated products. Between August 2007 and Spring 2008, the US govern-
ment provided US$1 trillion in direct and indirect support to FIs. The
specific measures are detailed in Chap. 7.
3.11.1 Mini-Case: Northern Rock

Northern Rock was one of the first casualties of the financial crisis. In
August 2007, approximately 11 percent of the British bank’s total retail
deposits were withdrawn over a three day period. Although Northern
Rock had relatively little exposure to the US subprime mortgage market,

the bank did have considerable exposure to the wholesale funding markets
in the summer of 2007.
Northern Rock had its origins in the nineteenth century as two sepa-
rate building societies—Northern Counties Permanent Building Society
(1850) and Rock Building Society (1865). In 1986 the Building Societies
Act allowed many UK building societies to become shareholder-owned
retail banks (known as “demutualization”). Northern Rock became a
bank in 1997 allowing access to the wholesale money market. For most
of its history retail deposits had funded the majority of Northern Rock’s
mortgages.19 But after 1997, the new access to the wholesale money
market allowed the bank to grow its mortgage portfolio. Between 1998
and 2006, Northern Rock had a record asset growth of approximately
23 percent per annum. Much of this growth depended on non-tradi-
tional funding sources. There were four primary funding channels at
Northern Rock: wholesale funding, securitization, covered bonds, and
retail deposits (Shin 2009). By 2007, approximately half the funding at
Northern Rock was via securitization and only approximately 20 percent
of its mortgages were being covered by retail deposits. By June 2007,
Northern Rock held 19 percent of the UK mortgage market, making
it the fifth largest lender in the nation. In 2005, Northern Rock won
the “International Financing Review Securitisation Award” (Aalbers
2008).20
Northern Rock’s securitized notes were issued over several years and
were medium to long maturity, with an average maturity of over a year.
Mortgage assets were sent to Granite Finance, which were then entered
into an agreement with special purpose entities. Compared with US
securitization, the difference is that Northern Rock’s SPEs were consoli-
dated on the balance sheet. Even though Northern Rock was not directly
exposed to the US subprime mortgage market, since securitization was a
central business strategy to the bank, it relied heavily on short-term money
market funding (such as ABCP). This also meant Northern Rock could
not securitize and sell new mortgage assets. Northern Rock then needed
to keep assets on its balance sheet that it intended to sell. The bank also
faced a sharp rise in interest rates in the money market resulting in bor-
rowing costs that exceeded the yield on mortgage assets.
Wholesale funding endured a huge decline at Northern Rock, drop-
ping from £26.7 billion in June 2007 to £11.5 billion in December 2007
as short-term notes were not renewed. At the time of its bankruptcy, the
Northern Rock had a total of £5.1 billion ($8.3 billion) of various col-
40 B.G. BUCHANAN
lateralized debt obligations (CDOs) and securitized assets. Its derivatives

book had become much bigger, to the sum of £337 billion of assets ($550
billion), as opposed to £116 billion ($188 billion) in 2007.
Despite the fact that most securitization research has focused on the
post-1970s mortgage securitization market and the 2007 financial crisis,
the process is not the relatively new phenomenon many believe it to be. In
the next chapter I discuss the history of securitization.
Notes
1. The Oxford Dictionary of Quotations, Partington, Angela (ed.),
Oxford University Press, 1992.
2. “Restoring the Economy: Strategies for Short-term and Long-
term Change”, Joint Economic Committee, February 27, 2009.
3. http://www.sifma.org/
4. Ranieri is credited with being the father of modern securitization.
5. An example of this is Bowie bonds based on music royalties of
David Bowie.
6. World Finance, July/August 2010.
7. “Morgan Stanley Pays $2.6 Billion to Settle Mortgage Claims”,
Ben McLananhan, Financial Times, Feb. 25, 2015.
8. Fannie and Freddie set for Reduced Role, Shaheen Nasiripour,
Financial Times, March 5, 2013.
9. Mortgage Daily.Com, http://www.mortgagedaily.com/
MortgageGraveyard.asp. Last accessed May 4, 2014.
10. Factbox—European, US Bank Writedowns, Credit Losses. Reuters,
February 24, 2011.
11. http://www.occ.gov/publications/publications-by-type/
comptrollers-handbook/assetsec.pdf
12. The Eurozone target is 60 percent.
13. Overcollateralization is defined as the value of assets that exceeds
liabilities. When the interest payments on the underlying mort-
gages are expected to exceed the payments offered to purchasers of
RMBS, this is defined as excess spread.
14. A Servicer’s Alleged Conflict Raises Doubts About “Skin in the
Game” reforms, Jeff Horowitz, American Banker, February 24,
2011.
2011.

2011.
2011.
18. LIBOR is used as a reference rate for financial contracts in the
lending and derivatives market. It is set each day on the basis of
inputs from major banks active in the interbank market. In
2008–2009 it became apparent that some bank personnel had
manipulated LIBOR to improve their trading positions.
19. It originated in the nineteenth century as two building societies.
20. Smith, David (2010). The Age of Instability.
Appendix 1: Securitization Framework
Loans Originator
(e.g. mortgages)
Proceeds of asset
Sell Cash flows from asset sales
pool
Special Purpose Vehicle

(SPV)
Senior tranche
(AAA) Next tranche Next tranche Last Tranche (equity
tranche)
42 B.G. BUCHANAN
Appendix 2: A MBS Waterfall Structure
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CHAPTER 2
What History Informs Us About

Securitization
February 19, 1970, is a defining moment in the history of financial inno-

vation. On this date the Government National Mortgage Association,
Ginnie Mae (GNMA), in association with the Federal National Mortgage
Association, Fannie Mae (FNMA), issued the first mortgage-backed
security. Later that year, the Federal Home Loan Mortgage Association,
Freddie Mac (FHLMC) followed suit with its issuance of mortgage-
backed securities (MBS). Hyman (2011) states that the origins of securi-
tization lie at the intersection of “turbulent global currency markets and
equally turbulent urban unrest in the late 1960s”. In the late 1960s secu-
ritization was utilized to restore stability to the American housing market.
Four decades later, after being regarded as a catalyst for the financial crisis,
securitization is once again being viewed as a solution to economic unrest
(Haldane 2009). In this chapter, I examine securitization in a global his-
torical context and argue that securitization is not the relatively new phe-
nomenon many believe it to be.
Various accounts of securitization leading up to the crisis have described
it in terms of a bubble. More specifically, Batisdon et al. (2010) discuss
securitization within the context of Kindleberger’s (2011) five-phase
model. The first stage is expansion and innovation whereby securitiza-
tions are successful and increase market confidence, leading to the sec-
ond stage—speculative frenzy. In the case of securitization this is where
the market became increasingly more complex and sophisticated (think of

DOI 10.1057/978-1-137-34287-4_2
50 B.G. BUCHANAN
CDO2 and CDO3 and the “alphabet soup”). In the third stage, termed
“paroxysm and reversal”, enthusiasm for securitized products explodes
leading to the fourth stage—pessimism and general mistrust because there
is a flight to quality and everyone tends to follow the crowd. In this case,
the securitization market becomes less liquid and in the final stage of the
crisis, there is an increased risk of insolvency and many institutions restruc-
ture their balance sheets.
There has been a plethora of “bubble” studies since the 2007 financial
crisis. The natural question in studying any financial crisis is to ask: What
happened? What can we learn? How can we prevent it from happening
again? On the first page of the Financial Crisis Inquiry Report (2011) it
states, “If we do not learn from history, we are unlikely to fully recover
from it.” This is not an isolated comment on the importance of history
in understanding the recent financial crisis. Jeffrey Garten1and Niall
Ferguson2 have also echoed these sentiments. The Economist (September
12, 2009) presses the case for looking back before forging ahead: “The
problem lies in the human tendency to be optimistic and forget lessons
of the past.” White (1990) wrote that if one means to identify common
characteristics and causes of bubbles then one should do so by historical
comparisons. He concludes the bigger the bubble, the more there is to
study and so it is not a surprise that as a result there tends to be a bubble
in “bubble studies”.
Snowden (1995) describes early attempts prior to World War II at
rebundling mortgages as tradable securities in the US market as “a fun-
damental misreading of the European experience”. The growth of the
American securitization market has been due to investments related to
mortgage-backed securities, whereas Europeans have historically tended
to trade in mortgage bonds (or covered bonds). The “covered” nature
of European mortgage bonds derives from the fact that the bonds are a
direct liability of a mortgage institution and rely solely on the creditwor-
thiness of that financial institution. Two of the most successful covered
bond markets have been in Germany and Denmark.
1 The Earliest European Experience

The first examples of crude forms of securitized transactions appear in tax
farming. Andreades (1933) argues that by the eleventh century, tax farm-
ing through the sale of public offices was an institution of classical Greek
city states and a formal institution of the Byzantine Empire. The sale of
WHAT HISTORY INFORMS US ABOUT SECURITIZATION 51
offices was a form of prudent lending to the state, made necessary by weak
public finances. Formal mechanisms provided incentives to tax collectors
to help overcome this weakness (Laiou 2002; Swart 1949).
Mortgage credit has been an important element of European finances
since the Middle Ages. In the twelfth century, European nobles were able
to obtain credit from local monasteries by pledging usage fees (or cens)
that peasants had paid instead of mortgaging the land itself. The idea
of using one’s property to generate an annual income from it (or rente)
throughout Europe started to become more entrenched. Creditors had
the right to seize property against whose income the contract had been
secured if there was a default of interest payments.
If the income was from real estate where state property was involved,
the cens could also be identified as a “compera”. The term “compera” refers
to a syndicate formed when a commune needed capital. The Genoese
compera dates back to the twelfth century (Kohn 1999; Hocquet 1995;
Munro 2003). Each compera had its own legal personality, directly man-
aged revenues, and was in turn administered by a group of trustees. If the
Genoese commune wished to borrow, it would pledge its tax revenues and
entrust its creditors to raising them (these tax purchases were known as
“comperisti”). Sieveking (1906a,b) claims that the compera membership
was at first voluntary and then compulsory. Each investor would hold one
share per 100 lire. They would then form a compera which would then be
vested with tax ownership that was specially created to pay interest and
retire the loan.
Not only did the investment yield an attractive rate of return, but pri-
vate citizens enjoyed the arrangement because of an easy cash conver-
sion feature. In the early thirteenth century public debt could also be
converted into “luoghi”. The “luogo di monte” was used to describe the
different tranches or slices of the monti capital. A luoghi had a nominal
value of 100 lire (Felloni and Guido 2004). The currency-to-luoghi ratio
was 100:1 and this was a common denominator used in order to simplify
administrators’ calculations3. Fratianni and Spinelli (2006) describe an
active secondary market in luoghi which could be used as collateral by tax
collectors, bankers, and borrowers.
The Banco San Giorgio was established in 1407 when shareholders of a
larger compera pooled their assets together4. A ledger entry in 1412 describes
one entry bundling a group of Genoese loans into a single debt pool.
Creditors could now be combined into the same ledger and savings could
be made on management expenses. The San Giorgio compera generated
52 B.G. BUCHANAN
yields of between 8 and 10 percent (Fratianni and Spinelli 2006). Among

the main risks investors faced were the fact that the San Giorgio compera and
the government’s prospects were very closely correlated with each other. As
the economy grew and contracted so did tax revenue uncertainty underly-
ing the compera contracts. The Banco San Giorgio acquired other compera
and issued shares of its own backed by the revenues vested in them. Kohn
(1999) acknowledges this as an early attempt at securitization. Debt growth
was correlated with an increase in war financing needs. For example, if there
was a period of social unrest or tax evasion and a municipality was not able to
set up a new income stream, then it could transfer control over its territories
to the Banco San Giorgio together with its tax income which would serve as
both interest and pledge for the loan.
2 Sovereign Debt

Quinn (2008) provides an account of the restructuring and securitiza-
tion of British sovereign debt in the eighteenth century involving the
Bank of England, the East India Company, and the South Sea Company.
Concessions in the form of lower rates and longer maturities were an
important aspect of the early British securitizations and helped deter
default risk. A corporation could create tranches by issuing banknotes and
bonds. After the South Sea bubble collapse in 1720 Great Britain shifted
to a more standard bond market.
3 Early Attempts at Mortgage Securitization

Plantation loans—or negotiates—were a forerunner of mortgage-backed
securities. Pioneered by the firm of Deutz and Co. in 1695, negotiates
were created when the company advanced the Austrian emperor loans
requiring the revenues from his mercury mines as collateral. The Deutz
Co. subsequently issued bonds in the Dutch capital market using the rev-
enues as security. Concerned about losing commercial competitive power
to Germany and France, Holland started to look at other financing alter-
natives. In 1753, the company applied the same process to mortgage loans
made to West Indies plantation owners. The process was based on col-
lateralized mortgages made to planters in the Dutch West Indies colonies
of Suriname, Essequebo, and Berbice. The technique organized credit
secured on plantation assets and serviced by revenues obtained from the
expanded coffee and sugar production permitted by that credit.
The Deutz Co served the twin roles of financier and commission agent.
The proceeds from the sale of bonds issued in the Dutch market were used to
provide mortgages to plantation owners. In terms of Deutz’s role of commis-
sion agent, the plantation owners were required to ship their crops back to the
firm in Holland. The plantation properties, which included slaves and equip-
ment, served as collateral for principal and interest payments. Approximately
200 plantation loans accounted for the majority of new security introductions
between 1753 and 1776 (Riley 1980). Average returns were between 5 and
6 percent per annum. These ideas were soon transplanted to British planta-
tions in the West Indies. The plantation loans promoted further foreign lend-
ing, a pattern that was increased by accelerating demand from Britain and
Austria during the Seven Years’ War (Buchanan 2014).
Credit practices became increasingly fragile in 1763, and the Dutch
market faced new challenges. One challenge was caused by overexten-
sions in British East India Company stock, encouraging developments in
London where a speculative boom had collapsed in 1772. There was also
a short-term deterioration in the West Indian trade which led to the sus-
pension of many plantation loans. These loans had been negotiated in the
1750s and 1760s on sugar and coffee speculation. The speculative boom
in the East India Company stock coincided with an expansion in credit
availability. But when stock and commodity prices both fell, this imme-
diately forced overextended firms into liquidation. In the 1760s lenders
were noticed that some planters were inflating the value of their assets and
even manufacturing fraudulent assessments that could be used to secure
loans. The loans had also become increasingly more complex and opaque.
The high yields of the plantations clearly did not reflect all the risks
involved. For instance, some contracts named specific individual planta-
tions or groups of plantations. Others were vaguer, just mentioning the
region where the capital would eventually be employed. For the latter, this
left the Deutz commission agent some flexibility and latitude in allocating
the bond proceeds. The merchant who issued the bonds could expand the
business without tying up the firm’s capital, so the securities did not pro-
vide much in the way of diversification. Because in some cases the investor
was promised payments from an unspecified portfolio of mortgages, this
left the investor without any recourse to the financier-commission agent.
The Dutch Hope Company was one of the most active investment houses
organizing foreign loans during the 1770s and 1780s. In the late 1790s
when the plantation loans defaulted, investors were forced to convert their
bonds into equity in the plantations when the plantation loans defaulted.
54 B.G. BUCHANAN
4 The Consolidated Association of Planters

of Louisiana—C.A.P.L.
The Dutch Hope Company is also mentioned in Baptist (2010, 2015). In

1833, Citizen’s Bank of Louisiana capitalized bonds that the Dutch Hope
Company agreed to market. Baptist (2010, 2015) describes events in the
late 1820s involving prospective borrowers who mortgaged slaves and
land to the Consolidated Association of Planters of Louisiana (C.A.P.L.).
The charter has its origins in an 1827 lawsuit faced by J.B. Moussier, a
Louisiana enslaver. He owed $21,000 to the Virginia-based slave-trading
partners Rogers and Harrison, for 70 men, women, and children he had
bought based on a short-term, high-interest loan. Moussier proposed
the following idea to New Orleans politician-entrepreneurs Forstall and
Lavergne: those planters could use slaves as collateral to raise capital over-
seas because Western European investors needed American cotton and
sugar. Moussier added that the capital raised could then build a lend-
ing institution controlled in America by the enslavers. That year, Forstall
and Lavergne created the charter of the Consolidated Association of the
Planters of Louisiana (C.A.P.L.) (Baptist 2015).
The process operated as follows: prospective borrowers would apply to
buy stock in the C.A.P.L. “association”. If the application was accepted,
borrowers could mortgage land and slaves to the C.A.P.L. in order to pay
for the stock. Under this scheme, the stock would entitle the borrowers
to C.A.P.L. bank notes of up to half the value of the mortgaged property.
C.A.P.L. persuaded the Louisiana legislature to back approximately $2.5
million in 15-year bank bonds at a 5 percent annual interest rate. This
backing, or guarantee, was the “faith and credit” of Louisiana (think of
it as a “faith” bond). If the loan repayments from planters failed and the
bank could not pay off the debt, the Louisiana taxpayers were now obli-
gated to pay off the debt. That is, the taxpayer was on the hook. This was
enough to convince European markets where the bonds were subsequently
marketed by Barings Bank. Barings agreed to advance C.A.P.L. $2.5 mil-
lion sterling equivalent and the bonds had a maturity of ten to fifteen
years, paying investors 5 percent per annum. The bonds were marketed in
London, Hamburg, Amsterdam, Paris, New York, and Philadelphia.
Not unlike the securitized mortgage bonds of the late 1980s to 2008,
the C.A.P.L. bonds were intended to reallocate risk—both geographic
and credit risk. In the case of the C.A.P.L. bonds, investors’ revenue was
generated from enslavers’ repayments of mortgages on enslaved people.
The C.A.P.L. model shifted risks away from both the immediate lender
(a bank) and the borrower. Baptist (2015) states that the faith bonds
shifted, or “socialized”, risks onto two groups of people, the first being
the enslaved because their work would have to repay the loans. Second,
if their owners did not pay their debts, the enslaved people themselves
would be foreclosed upon.
Baptist (2010) also describes how sometimes slaves were mortgaged
multiple times, or even with fraudulent identities. After 1832, the market
pioneered by C.A.P.L. started to proliferate across Mississippi, Alabama,
Tennessee, and the territories of Arkansas and Florida. Cotton entre-
preneurs created a number of banks much larger than C.A.P.L. and the
number of banks expanded from 4 to 16. Authorized capital grew from
$9 million to $46 million and by 1836 New Orleans had the country’s
densest concentration of banking capital—larger even than New York and
Philadelphia.
However, there were a number of agency cost problems. For example,
the roles of banker and planter started to blur. Baptist (2015) provides
an example where ten of the top eleven borrowers from the Union Bank
of Florida were members of its board of directors, or were immediate
relatives. In the C.A.P.L. case, unregulated borrowers also became heavily
leveraged and there were problems of moral hazard. This is demonstrated
by the fact that judges, politicians, and state officials controlled debt col-
lection in their states. This made it less likely that those elite borrowers
would be foreclosed, even if they fell behind on their payments. Borrowers
also used slaves bought with long-term mortgages to bluff lenders into
granting unsecured commercial loans. This fueled further problems as
borrowers kept buying more slaves on credit.
5 Dowry Funds and the “Trente demoiselles de

Genève”
Crude securitization techniques also date back to pre-Medici institutions,
namely the “bank of dowries”. These were similar to the life annuities of the
period. Fratianni and Spinelli (2006) describe the “Monte delle Doti”, or
Dowry Fund, that operated in 1425. The dowry funds permitted fathers
to make (in the names of their daughters) an investment that yielded an
attractive rate of return for a dowry, providing the girl was still living after
15 years. This proved to be a very attractive financial instrument for mer-
chants who were seeking to financially settle their daughters for life. For
56 B.G. BUCHANAN
example, a healthy young girl selected by an annuity buyer usually had a

much higher probability of surviving than the typical annuity beneficiary
(an older merchant).
A similar dowry system can be observed in eighteenth-century France
(Rajan 2010; Spang 2015). Considered by Rajan (2010) to be a “crude”
form of securitization, the dowry fund operated between Switzerland and
France. Following the expensive participation in the American War of
Independence and the Seven Years’ War, a common operating policy for
the French government was to raise short-term funds through a “rente
viagere” (or lifetime annuity). A group of Geneva bankers came up with
the following business model in the 1770s and the fund came to be known
as the “trente demoiselles de Genève” (or 30 young ladies from Geneva).
The premise of this model is that it was possible for the annuity buyer to
make payments dependent on someone else’s life. A tête, or head, was the
life specified in the contract. In order to diversify the risk of accidental
early mortality, the streams were then pooled and the Geneva bankers
then sold claims from the pool on the resulting cash flows. A pool was
typically based on 30 young Geneva women’s dowries and an annuity
purchased from the French government. The French government relied
on the “rente viagere” because it offered an attractive rate of up to 10
percent per annum. Furthermore, an investor made a lump-sum payment
to the French state and in exchange he received a certain percentage of
that amount on a semi-annual basis for as long as the name on the contract
remained alive. In order to receive the payment it had to be established
that the “head” in the contract was actually alive. If the name on the con-
tract died, payments stopped immediately. In terms of the pool, if one tête
died, 29/30th of the investment would still remain intact. Historically
rentes were a way of circumventing the usury laws (Munro 2003). Because
the French government was making neither incremental repayments nor
interest payments, the rente could not be considered a loan.
By 1789 this made up a sizeable proportion of the French state’s debt.
However, problems with credit risk and geographic risk emerged in 1789
after the French Revolution. In the aftermath of the revolution, the new
French government defaulted and fell behind on its payments. The Geneva
bankers were now being paid in a worthless currency whilst owing their
investors payment in hard Swiss currency. Many investors also defaulted
because they had borrowed to invest in annuities, considered at the time
to be a “guaranteed thing”. So we witness an early example of the lethal
combination of excessive leverage and risk.
6 Mortgage Financing—The Pfandbriefe

Germany and France were the first success stories regarding central mort-
gage facilities that were either publicly financed or sponsored and were
subject to intense regulatory scrutiny. By 1870 single centralized securiti-
zation agencies had been well established in France and Germany and the
central agencies monitored the mortgage lending operations of smaller,
regional mortgage banks in each country. This is in contrast to the early
American market that was largely privately financed and almost completely
unregulated.
The US securitization market emphasizes asset-backed securities, and
a key problem with mortgage-backed securities that is revealed by the
recent financial crisis is the non-recourse feature. What this means is that
none of the originators of the mortgages or those who create the MBS
based on them are directly liable for the repayments they promise because
the mortgage loans are moved off the balance sheet (usually to an SPV or
a trust). This is not the case with the European market, such as those seen
with the German Pfandbriefe. We see later in the book (Chap. 6) that if a
covered bond is not serviced then one can take the issuing bank to court.
In the meantime if the bank happens to go bankrupt, then the covered
bond holder can make a direct claim against the homeowner, and if the
homeowner goes bankrupt then the home can be sold to service the debt
owed. Simply stated, European mortgage-backed bonds are designed in
such a way as to make default highly unlikely. The Pfandbriefe served as
the basis for the modern covered bond.
Just as the modern securitization industry has its roots as a response to
the turbulent markets of the 1970s, the origin of the European mortgage-
backed bond market was also response to a financial crisis. The year 1763
was a watershed moment in European finance. There was the notable fail-
ure of the De Neufville bank due to its speculative activities during the
Seven Years’ War. During the Seven Years’ War credit limits had been
raised to more than 50 percent of the estate’s last sale (that is, a higher
loan-to-value ratio). There was also an increase in defaults. By 1763 the
Seven Years’ War had ended and Prussia emerged as a political and eco-
nomic power—albeit a broke one. Landowners and farmers needed access
to long-term credit at affordable rates. Where to go? Traditional sources
of financing were the Church, local merchants, and family.
Immediately after the Seven Years’ War, property in Silesia was un-
saleable. After a three-year moratorium on debt payments that was passed
58 B.G. BUCHANAN
in 1765, many estates were bankrupt. Typically the value of the estate was
worth less than the outstanding debt that could be recovered. 5In 1767,
Bühring, a Berlin merchant, presented a plan for a credit association to
Frederick the Great. Bühring had been influenced by his experience in
Amsterdam with mortgage securities and bills of exchange instruments
which had been used to finance the Dutch colonies (Wandschneider 2013).
The plan was first rejected by Finance minister von Hagen, but was later
approved on July 9, 1770 with the establishment of the Die Schlesische
Landschaft. Frederick the Great initially provided the initial capital of
200,000 talers at a rate of 2 percent for the Silesian Landschaften. Twenty
others soon followed in other Prussian states. A cornerstone of Bühring’s
plan according to Frederiksen (1894a) was:
It is the greatest financial art, which must necessarily be observed in the

state, to see that money, real property, and goods are kept at a fair and pro-
portionate value with reference to each other. Otherwise, the best arrange-
ment will fall to pieces, and one thing after another will be ruined.
Under the Landschaft structure, membership from the noble estate was
mandatory, and members were jointly liable for each other’s debts. The
association would guarantee principal and interest through this joint
liability structure. From the beginning efforts were made to make sure
the mortgages were in no way separated from other assets of the bank.
Depending on the jurisdiction, mortgage bonds were never issued for
more than 60–80 percent of the value of the collateral. It was also essen-
tial that the banks had to keep the collateral on their own balance sheet. In
other words, there was “skin in the game”. Lenders based their valuations
on average net income for the prior three to five years and were closely
scrutinized. Rather than relying on individual repayments from borrow-
ers, lenders would turn to the Landschaften. Instead of individual private
loans, the Pfandbriefe were also standardized. Consider the terms issued
by one such bank as described in Frederiksen (1894a):
The following are a few of the rules of the Prussian Hypotheken Aktienbank:
valuations shall be based on the average income from similar property; unim-
proved portions of a lot must not be included in the valuation; fixtures in
the nature of luxuries shall only be valued at the price of the corresponding
necessaries; hotels, restaurants, concert halls, school-houses, and buildings
reduced by wear are excluded; lands must be valued by a man of experience,
who shall not be a resident of the immediate locality; the reason for desiring
the loan must be stated, also whether the borrower is an experienced farmer;
buildings must be insured against fire, livestock against disease, and crops
against hail-storms.
The Raiffeisen system was created in the second half of the nineteenth
century and extended membership throughout Germany. Under this sys-
tem, every farmer would pledge an equal sum and be allowed to bid for
a loan, which all other members would guarantee. The governance struc-
ture of early associations was very closely regulated. Specifically, the gov-
ernment appointed officials who were further supervised by the Minister
of Agriculture and his representatives. Members were elected to make sure
no excessive valuations occurred.
Nor was the geographic link between the mortgage and mortgage bond
ever broken. The Landschaften was always on the hook. Transaction costs
could be reduced even further by pooling the loans, creating a deeper
group of creditors. With lowered transaction costs and standardization
came higher liquidity. The Pfandbriefe were deemed very safe, on a par
with government bonds. Eventually Pfandbriefe were listed on the Berlin
Bourse. The Landschaften helped the landed aristocracy (or Junker class)
consolidate their economic dominance (Wandschneider 2013). Access to
the Berlin market made this possible.
The Landschaften and Pfandbriefe also overcame the asymmetric prob-
lems of adverse selection and moral hazard. Under certain conditions only
poor credit risk borrowers would be attracted into the market and credi-
tors would not be willing to lend to them. This created a pool with a “lem-
ons problem”. To overcome this “lemons problem”, if all the loans come
from aristocratic estates in the same geographic region, then the joint
liability structure with its active participation had the incentive to increase
the supply of credit and improve its quality. To reinforce this, credit limit
determinations were necessary, along with correct estate assessment to
guarantee collateral. To discourage moral hazard problems associated with
too generous a land valuation assessment and collateral requirement, the
assessor was to be held personally liable for any losses.
According to Sinn (2010), not a single Pfandbrief has defaulted since
1769. This was due to the statutes that limited the associations to certain
cities or districts outside which they could not make loans. Frederiksen
(1894a) found the German credit associations formed a useful link
between the borrowers and lenders in the regional community that was
not apparent in America:
60 B.G. BUCHANAN
…so that a class of investors that would in America be afraid of invest-

ing their savings in mortgages on other than local property can do so in
Germany where the bonds of theses associations and banks are equal to the
best government bonds.
German mortgage bond yields remained remarkably stable through-

out the nineteenth century. In 1818, the Landschaften started to con-
tain provisions for debt repayments in the indenture contract. The Neue
Landschaften opened the association to small farmers in the second half of
the nineteenth century. Membership also became voluntary. Throughout
the nineteenth century additional facilities were added to the Landschaften
including savings and loans and insurance companies. In 1873, a central
Landschaft for all Prussia was established.
The German mortgage banking system became the basis for organized
mortgage banking later carried out throughout Continental Europe.
Frederiksen (1894a) doubted whether the German system, particularly
with a feature of unlimited mutual responsibility, could be successfully
imitated in the USA. The original Landschaften did not have amortiza-
tion schedules and this was viewed as a structural weakness since retiring
outstanding debt was regarded as cumbersome. Today the German cov-
ered bond market remains the largest out of 20 such European markets.
German banks began as private institutions and became joint-stock com-
panies later on (Appleby 2010).
Covered bonds became a mainstay of the European market. In
Denmark in 1795, the country established a covered bond market as a
response to the Great Copenhagen fire. Approximately 25 percent of
houses were destroyed and credit provision was extremely scarce. The city
looked to the new Pfandbriefe market operating in Germany as a guide.
In 1850 the first Mortgage Bond Act was passed in Denmark. In time this
led to the creation of a large number of “co-op” organizations, namely
savings banks, mutual insurance companies, and mortgage credit associa-
tions. There was a vast need for financing of farm workers’ land acquisi-
tions from the aristocracy. For the “middle and down-market” borrowers
there was no access to credit. Since the nation had a significant agricultural
industry there was significant event risk due to the probability of a poor
harvest. One solution was for mortgage credit institutions to pool bor-
rowers’ funds, diversifying event risk for both the lender and the investor.
The basic principles have remained almost unchanged for 150 years in
the Danish mortgage and covered bond market. During its first century,
the Danish mortgage credit sector consisted of many mortgage credit

associations, where mutuality was emphasized. Mutuality contributed to
a very restricted lending policy for Danes. The most important duty of
the mortgage credit associations was to safeguard the interests of their
members. The Danish system is a very robust one that has survived several
subsequent crises.
A Polish economist and banker, Louis François Wolowski, proposed
the Landschaft structure in France. The reasoning was almost the same
as it had been in Germany—to provide cheaper refinancing for an overin-
debted farming class. In France, the Credit Foncier (the French term for
land credit) was founded in 1852 as state chartered joint-stock monopoly
in the field of mortgage banking. The Credit Foncier was founded as a
quasi-bureaucratic management and joint-stock company. It was soon
criticized for concentrating its lending in Paris instead of in the provinces.
Its growth was nevertheless rapid and by 1893 Credit Foncier’s business
exceeded 28 New York mortgage companies (Frederiksen 1894b). In
the nineteenth century French investors preferred to send their money
overseas for more exotic investments and one popular destination was the
USA. This serves as the starting point to discuss the emergence of mort-
gage banking in the USA.
7 The Evolution of the US Securitization

Market
By 1870, single centralized securitization agencies were well established
in France and Germany and they monitored the mortgage lending oper-
ations of smaller, regional mortgage banks. A crude form of mortgage
securitization was introduced into the USA back in the nineteenth cen-
tury for essentially the same reasons as in the late twentieth century—to
facilitate interregional transfers of mortgage credit and liquidity across the
USA. Snowden (1995) describes four successive attempts in the USA to
develop private mortgage securitization, firstly in the 1870s, again in the
1880s, another with the joint-stock mortgage banks in the 1920s and last
with the issuing of private mortgage-backed securities in the 1970s. At
the time of Snowden’s writing, he states that of all four, only the last had
not ended up in collective bankruptcy. However, in 2008 Fannie Mae and
Freddie Mac were rescued by the US government during the financial
crisis.
62 B.G. BUCHANAN
There is, however, an earlier financial crisis to consider. Riddiough and

Thompson (2012) compare the 1857 panic with the 2007 crisis. They
present evidence on financial innovation during this period, namely the
railroad farm mortgage and farm mortgage-backed security. The mort-
gages were taken from the Midwest (which was a cash-poor region of the
USA at the time) and then taken east and converted into MBS-like instru-
ments, the proceeds of which were used to fund railroad construction.
Calomiris and Schweikart (1991) also discuss the panic of 1857 and
conclude that “the declining fortunes of western railroads and declines of
western land value, along with a concentration of asset risk and reserves
drain in New York city banks ultimately explain the origins of the panic”.
Riddiough and Thompson (2012) acknowledge that an initial attempt in
1850 at mortgage securitization failed, but was subsequently attempted
again in 1852 in Indiana. The next attempt was a single-asset security
based on a one-for-one match between the railroad farm mortgage and
railroad farm mortgage bond. This bears a closer resemblance to a covered
bond.
The analogous practices with the subprime crisis are no-doc loans (in
the sense that the only documentation provided was a stated warranty in
an investment circular that an appraisal had been done) with a deferred
interest payment obligation, inflated property appraisals to support high
LTV ratios, inadequate or misleading disclosure to potential investors,
improper accounting, and poor investment performance. Agency prob-
lems arose because property appraisals were made by railroad companies’
appointees.
Davis (1965) argues that in the 1870s, most savings were concentrated
in the northeast of the USA and profitable investments were located
disproportionately throughout the country, namely in the Western and
Southern regions. The evolution of the commercial paper market helped
overcome barriers to short-term capital mobility. This provided the insti-
tutional framework for a national market.
European style mortgage banking financed western city building in the
1870s. Henry Villard, who formed the Boston Mortgage Company in
1872, is credited with bringing European style mortgage banking to the
USA (Brewer 1976). Villard had studied long-term German mortgaging
and the Bankverein as a basis for his American company (Herrick and
Ingalls 1915). The end of the nineteenth century was also marked by
a reduction in legal limitations and restrictions. Late nineteenth-century
legal changes permitted a wider range of investments, and this extended
to mortgages. In 1868, life insurance companies were given authority to

invest in mortgages within a 50-mile radius of New York (Davis 1965),
and by 1875 this was extended to include adjacent states. Companies
active in this market included the Mercantile Trust Company, organized by
Equitable Insurance Company in 1874. The Mercantile Trust Company
was formed to provide an additional source of commission income for
its expanding network of policy sales agents in the Western region of
the USA. At the same time brokerage institutions were simultaneously
growing to service the investment portfolios of life insurance companies.
Mortgages were initially granted in Iowa, Minnesota, or the eastern parts
of the Great Plains states. Interregional capital mobility was enhanced by
the growth of mortgage companies that sold the Western mortgage loans
to investors in the Eastern states.
An investor drawn to this fledgling market was attracted by the com-
parably higher rate of interest offered. Western mortgages offered a much
more attractive investment alternative than US government bonds and
railroad bonds. At the time, the average rate of interest on a railroad bond
was 4.36 percent compared with the average mortgage investment, which
drew a rate of return of 6.73 percent (Frederickson 1894b). After 1873
yields in US government bonds had decreased and the railroad bond mar-
ket experienced massive defaults to the extent that by 1876 a third of all
railroad debt was in default. Mortgage instruments offered higher yield,
higher credit quality, and greater liquidity to Eastern investors, and were
therefore a more attractive investment.
Brewer (1976) actually describes two early entrants to the 1870s mar-
ket—the Mercantile Trust Company and the United States Mortgage
Company. The governance structure of these companies is noteworthy.
For example, the United States Mortgage Company had two boards of
directors—one in New York and one in Paris. The New York board had
many high-profile directors and was responsible for the assembly of mort-
gage pools and securities issuance. The European board distributed the
securities overseas which proved to be highly marketable in France. This
was due to the reputation of the American board and familiarity with the
securities process. What was unusual about the United States Mortgage
Company was that it had many overseas directors (nine out of twenty-one
sitting on the board of directors came from Europe). Eighty percent of the
company stock was owned by European investors.
The implementation of the process proved inadequate. A high
demand for these new financial instruments resulted with the European
64 B.G. BUCHANAN
board issuing bonds ahead of the loan origination back in the USA. The
New York board quickly found that loan correspondent agents were
tending to approve loans of inferior quality in order to meet demand
for the European market. The members of the US board of directors
also proved to be “time poor” because they held high-profile posi-
tions at other financial firms and the staff struggled to maintain daily
operations.
Added to this was that in 1874 the USA experienced a recession, forc-
ing a scaling back of operations. The news coverage of these events was
extremely colorful in describing this collapsing market (that also rings
true after 2007 as well). Consider the following quotes drawn from The
New York Times:
There is probably no legitimate business carried on between the two oceans

so loosely and with such an utter disregard of the ordinary precautions taken
by business men as the lending of Eastern money in the West.
Time and experience have demonstrated that a safe real estate loan is
as good a security as one can have, but to make such loans safe, and thus
remove them as far as possible from the contingency of loss and trouble, the
agent cannot sit in his comfortable office, as four out of five do, and let some
irresponsible sub-agent of questionable standing (as many of them are) do
the business for him. He must go and examine for himself or else the harvest
of delinquent loans and losses will condemn the entire system before the
years are much older.
Western Mortgages, The New York Times, August 29, 1876
As well as:
Instances are furnished us in which farms have been reported to be “well

improved” which were not really many degrees removed from the wilder-
ness, while we have others in view, were the owners in collusion with the
agent, after obtaining 40 percent of an excessive valuation, have quietly
slipped away leaving the farm a worthless piece of property in the hands of
the mortgagee.
The St Louis Journal stated, “The farmer who paid $50 an acre for land in
1872 cannot sell it for ten, or even five.”
…there is absolutely no sale for land in the West because there is no demand
Western Mortgages, The New York Times, December 13, 1877
And even:
An investor who can judge for himself as to the value of the farm and the
character of the farmer and who in the event of foreclosure can watch over
his own interest is reasonably safe. He is wholly dependent upon the integ-
rity and vigilance of others. He can have no knowledge as to the worth of
the property or the reputation and purposes of the borrower, he may be
imposed upon in the matter of valuation, and the borrower may be a scoun-
drel in league with the agent
The New York Times, September 13, 1878
Yet, this did not completely halt the growth of the mortgage market. By
the 1880s investment in mortgages anywhere in the USA was permitted.
The mortgage companies that originally acted as middlemen started to
guarantee the mortgages sold. The guarantee was then converted to a
general debenture issued against a portfolio of mortgages. In 1881, the
Iowa Loan and Trust Company (founded in 1872) became the first com-
pany to issue debenture bonds secured by mortgages. One thing that was
lacking was care in recording the name of the trustee responsible in the
assignment of mortgages underlying the debentures. In most states there
appeared to be no such examinations. So clearly a lack of recourse added a
level of opaqueness to the process.
The next development in the market was mortgage bonds issued in the
mid-1880s. During the 1870s and 1880s capital had moved from states
such as New York, Massachusetts, Maine, Vermont, New Hampshire,
Connecticut, Rhode Island, New Jersey, Pennsylvania, Delaware,
Maryland, and the District of Columbia to states such as Ohio, Indiana,
Illinois, Michigan, Wisconsin, Minnesota, Iowa, Missouri, North and
South Dakota, Nebraska, Kansas, Montana, Wyoming, Colorado, New
Mexico, and Oklahoma.
Aggressive marketing worked, because the eastern press was flooded
with pages of advertising. One advertiser, the New England Mortgage
Security Company, commonly advertised five percent ten-year bonds
which were backed by Western mortgages (Levy 2012). Due to prohibi-
tions on farmers making early prepayments, the New England Mortgage
Security Company sought to better match farmers and investors and
spread investors’ risk. In 1887, new companies were offering debentures
for as low as $50 so that small investors could join the mortgage deben-
ture market. By 1893, private eastern investors had purchased at least $93
million of mortgage debenture bonds (Levy 2012).
66 B.G. BUCHANAN
Bogue (1951) provides an account of the J.B. Watkins Company. The

Watkins Company was founded in 1870 and originally performed inter-
mediary responsibilities before starting to guarantee mortgages and then
issuing debentures. It achieved rapid growth by selling its mortgages and
bonds very quickly. Branch offices were established in New York City
in 1877 and other branches were soon established in Buffalo, Albion,
Rochester, Syracuse, Johnstown, Batavia, Wilmington, Boston, and
Ferrisburg.
In 1878, the first overseas office was established in London. Eventually
25 percent of the Watkins Land Company’s investors were English. The
rest of its investors tended to come from the mid-Atlantic and New
England States. Less than 1 percent of Watkins Land Company’s inves-
tors were institutional investors. Approximately 15 percent were minis-
ters, teachers, and doctors. Many eastern investors did not understand the
nature of agriculture in the semi-arid western parts of the Plains states.
Many land companies started to diversify their operations into other areas
such as the financial services industry. After the mid-1880s Western loan
companies found it easier to dispose of mortgages in the East. Not surpris-
ingly, in 1887 the highest number of mortgages in US history was issued
to date (Buchanan 2014).
The Lombard Investment Company of Kansas made loans and financed
ventures in 18 states and sold mortgage-backed products in the USA and
Europe. Herrick and Ingalls (1915) remark that the field was dominated
by many financial “freebooters” who preyed upon the public. Lax regula-
tory oversight, reserves and paid-in capital requirements, and questionable
and even fraudulent practices started to escalate. The bonds and deben-
tures gained the name “jaybirds6”.
In the mid-1880s an agricultural depression occurred due to a
drought. This led to declining incomes, increasing debt burdens, a
deflationary spiral, and increasing mortgage defaults. Many farms were
highly leveraged and poorly managed. With regard to the mortgage-
backed bonds, since there were multiple layers of intermediation, it was
too easy for investors and financiers to disregard the underlying mate-
rial assets. The actual assets were difficult to determine because western
farming mortgages had become so abstract and fractured. Many mort-
gage companies unable to fulfill their financial obligations collapsed.
Many of the most unsuccessful companies had been in business for
less than five years. The Watkins Land Company eventually declared
bankruptcy in the early 1890s. Levy (2012) describes attempts by

mortgage companies to turn foreclosed farmers into tenants. However,
the US Supreme Court had already blocked this and state legislatures
were hostile to this aim. The system collapsed after the 1893 panic and
almost all mortgage-backed bonds were bankrupt. What follows is a
description of coverage from The New York Times of events during that
period.
8 Newspaper Coverage of 1880s Market

An Eastern man who puts money into Western mortgages … ought to
remember that anybody who is in the business of getting money on the one
hand, and of taking mortgages with it on the other, is that the business for
his own personal advantage, and not for that of either of his clients.
The New York Times, November 28, 1889
I have seen a dozen of these land inspectors. The larger portion of them
were callow and self-sufficient youths who were fair judges of cigarettes, but
who knew nothing relative to the productive capacity of the soil or to the
climate of the country they happened to be in—but they did know that their
employers greedily desired to pocket the 10 percent commission the farmers
would have to pay to obtain the money.
Unsafe Farm Mortgages, The New York Times, December 27, 1887.
Bogue (1955) notes, “The Eastern promoter who saw investment capital
flowing westward beyond his reach, the eastern observer who distrusted
the rapidity with which land values were rising in the west and the investor
who had been unfortunate in his choice of a western agent were all willing
and eager to stress the danger of western mortgages.”
Levy (2012), “The investor in mortgages securities was like a man who
bought a horse ‘without the examination as to whether the animal was
blind, halt or lame.’”
The Western land boom turned to bust in 1893. By 1897 only 7 out
of 74 mortgage companies were still operating in New York. This sec-
ond generation of American mortgage banks had violated two central
principles of European mortgage banking, namely that: (1) mortgage
securities should be fully secured by high-quality loans and (2) organizers
of the mortgage bank should pledge their own capital as additional secu-
rity against default. For the next few decades it became very difficult to
attract US eastern financing into western mortgages.
68 B.G. BUCHANAN
9 US Mortgage Banking Moves into

the Twentieth Century
During the 1920s, two financial innovations dominated the American real
estate market. The first was the GMPC, or guaranteed mortgage partici-
pation certificate. GMPCs represented pools of residential mortgage cash
flows from a basket of cities across the USA. The other innovation was the
real estate bond, which was issued against a single commercial mortgage.
A departure from the European style of mortgage banking, the US real
estate bond was a liability of the borrower. Simon Straus is credited with
originating this style of real estate bond in 1909. This is coincidentally the
same year Moody’s was founded so the ratings industry was still relatively
non-existent.
Straus had emigrated from Prussia in 1852, the same year the Credit
Foncier was founded in France. By this time the Prussian mortgage market
had also been well established. The real estate bond Straus designed was
a security with a senior claim on a building, and these were sold to inves-
tors in small denominations and at high rates of interest. A Straus bond
yielded 6 percent and was twice the rate paid on a commercial bank savings
deposit. It was also more than 2 percentage points higher than the rate
offered by savings banks. Straus bonds also competed with foreign govern-
ment bonds that flowed to the American market during the 1920s. These
single-property real estate bonds were used to finance the construction
of very large commercial buildings in the nation’s largest urban centers,
especially in New York and Chicago. Gradually, Straus became a lead-
ing financier of skyscrapers that were increasingly forming the New York
skyline (Goetzmann and Newman 2009). Straus’ advertisements were
also considered to be quite appealing and distinctive. The advertisements
claimed that not a single customer had lost a cent in a Straus investment
since 1882. In 1912 one advertisement claimed, “thirty-five years without
loss to any investor”.
In 1916 the US Congress established the Federal Land Bank System, a
successful system of central mortgage banking enjoying a federal guaran-
tee. However, more extensive regulation and centralization was still absent
from the securitization wave of the 1920s. Overly optimistic speculation
contributed to overbuilding. Goetzmann and Newman (2009) chart the
extent of the real estate mortgage bond market during the 1920s. The real
estate bond issuance business eventually accounted for approximately 23
percent of all corporate debt issuance by 1925.
Mortgage pooling collapsed in the early 1930s as real estate prices col-
lapsed nationwide during the Great Depression. In the aftermath of the
collapse of the market, real estate bond issuance accounted for 0.14 per-
cent of all corporate debt issuance by 1934. The New York Real Estate
Securities Exchange was established in 1928 but very few transactions
subsequently took place. Johnson (1936a,b) found that 61 percent of real
estate bonds failed to meet their contractual obligations.
According to Ross (1989), the Equipment Trust Certificate (ETC) is
the financial instrument that inspired the modern mortgage-backed secu-
rity. As previous historical examples show, the ETC was not the first collat-
eralized debt instrument, but it certainly moved well beyond just pledging
payment streams. The ETC represented a relatively homogeneous pool
of business equipment, which, during its working life, produced steady
income to service its own debt. It was quite a simple financial instrument
because any physical damage could be insured. Failing to meet expecta-
tions was the major risk involved, but the ETC proved to be a success-
ful instrument in industrial equipment financing. The concept behind the
ETC was then applied to home mortgages in the late 1960s.
10 Beyond the Great Depression

The scale of the Great Depression overshadowed the development of
many financial institutions for the following decades. The Federal Housing
Authority and Veterans Housing Authority insurance were available by the
late 1930s to encourage private mortgage companies to secure mortgage
purchase commitments from long-term lenders on a small scale before the
primary lending companies originated the loans. Fannie Mae (FNMA)
is a result of the 1930s New Deal and was established to buy and sell
government-insured mortgages. Under this arrangement it was an admin-
istrative burden for an investor to track payments and file the necessary
paperwork.
The mid-1960s was characterized by a credit squeeze in which US
homebuyers could not tap access to mortgage borrowing. There was
demand for mortgage credit, but in a rather unbalanced regional pattern
(Snowden 1995). The late 1960s also witnessed urban unrest in the USA,
not to mention volatile currency markets. The global dollar supply clashed
with Regulation Q. In 1966 Regulation Q was at its ceiling rate of 5.5
percent. Historically, in periods of high inflation, the US Federal Reserve
would increase the ceiling, but not this time. Banks responded by trying
70 B.G. BUCHANAN
to sell their muni investments all at once, but that only led to massive price
declines. Money flowed out of depository institutions into the securities
market. Because Regulation Q continued to stay locked in at 5.25 percent,
savings and loan institutions could not raise their interest rates. In 1968
interest rates on US bank deposits were facing liquidity and low capital-
ization problems. The mortgage-backed securities market development
in the 1970s can be attributed to structural problems in the US banking
system. Another view is that it is the result of a federal policy to solve a
political problem7. Higher interest rates continued to have the effect of
choking off the US home mortgage supply to consumers. The Fed wanted
to increase the US money supply but the 1960s credit crunch was a very
fresh memory. Savings and loans institutions could no longer be depended
upon to provide mortgage capital to the US economy.
Under the new 1968 U.S. Housing Act, FNMA was divided into two
new agencies: the Government National Mortgage Association (Ginnie
Mae or GNMA) and a newly privatized FNMA. Whilst GNMA was
responsible for social programs, FNMA served as the market-making pro-
gram. The same year, Ginnie Mae (GNMA) announced that it would be
issuing RMBS. Dealing with prepayment risk was a major issue, because
any unexpected repayments would end up being invested at too low a rate.
The “pass-through” concept came out of this and was adopted from its
use at the time in the savings and loans industry. Since the new mortgage-
backed security aggregated mortgage revenue and repackaged it to resem-
ble a coupon-paying bond, it was a much easier security to administrate.
GNMA announced that it would offer these new MBS in August 1969.
Initially two types of mortgage-backed securities were offered:
(i) A bond-like structure that contained regular interest and principal

payments. These MBS were based on enormous pools of mort-
gages, averaging $200 million.
(ii) A pass-through-like structure, which also offered principal and

interest payments but was based on smaller mortgage pools averag-
ing $2 million.8
Four features characterized the GNMA model: (1) to ensure timely

and precise payment to investors, issuers offered performance guarantees;
(2) a high degree of protection against both credit losses and physical
damage to the properties that were collateralized; (3) a pool of financial
assets that was diversified yet possessed predictable yield and scheduled
principal amortization; and (4) flexibility in maturity promises. The
GNMA- guaranteed security system was undoubtedly successful for a

number of reasons. Apart from the “full faith and credit” backing of the
US government, there were substantial exemptions in paperwork require-
ments and, to the regulated investors, preferential investment eligibility.
These new MBS were not unlike the mortgage guarantee bonds of the
late 1800s. GNMA, in association with FNMA, offered the first MBS on
February 19, 1970. Associated Mortgage Companies issued $2 million
of pass-through MBS to three New Jersey public sector union pension
funds. Three months later, GNMA sold $400 million of MBS to investors.
Within a few years GNMA stopped offering the bond-like MBS.
Many banks quickly found that asset securitization was an effective
way to manage prepayment and interest rate risk. Asset-backed securities
issued after the 1970s were also designed to repackage reinvestment risk.
New investor markets were also being aggressively pursued, specifically
pension funds. Like insurance companies, pension funds shared an inter-
est in investment grade bonds, but pension funds could not participate in
mortgage buying. The new mortgage-backed security circumvented all
of that, and the investor’s connection with the underlying asset was not
anonymous and secondhand.
The 1970 Emergency Home Finance Act resulted in the creation of
the Federal Home Loan Mortgage Corporation (FHLMC), or more
colloquially ‘Freddie Mac’. FHLMC not only promoted trading in
conventional home mortgages, but also stimulated secondary market
activities among participating thrift institutions of FHLMC. FHLMC
established credit evaluation, appraisals, loan documents, and mort-
gage issuance procedures to be in place by 1972. Both FHLMC and
FNMA proceeded to develop uniform mortgage loan documents, pur-
chasing and underwriting standards, and the development of conven-
tional loan supporting documents. From the savings and loans industry
perspective, this helped accelerate buying and selling of mortgages
on a national scale. The other advantage for savings and loans to buy
MBS was that it allowed banks to evade geographic and state bound-
ary restrictions on lending. By 1973, Freddie Mac had purchased three
times as many conventional mortgages as federally insured mortgages
and was the third largest debt issuer in US capital markets. The inter-
regional allocation of mortgage credit improved substantially after the
1970s. Due to their relatively high yield compared to US Treasury
securities, MBS soon became of interest to global investors. In terms of
the US capital account, it received a boost due to this new-found flow
of foreign investment.
72 B.G. BUCHANAN
To stimulate market growth, the government guarantee was the key to

securitizing mortgages. GNMA guaranteed Federal Housing Authority-
insured mortgages and Veterans Association-guaranteed mortgages. The
first financial futures contract had a GNMA certificate as the underlying
security.9 GNMA certificates also found an extra use as collateral for short-
term borrowings in the form of repurchase agreements (repos), and these
were repackaged for smaller investors through specialized mutual funds.
This found great appeal among institutional investors.
Fannie Mae and Freddie Mac asset-backed securities were backed
by bricks and mortar and carried an implicit government guarantee.
Mortgages had to be conforming and were limited to a maximum amount
of $417,000. If the loan-to-value ratio was in excess of 80 percent, then
additional insurance had to be purchased. Being able to trade conven-
tional mortgages at a distance was regarded as a huge feat in mortgage
market development. In 1978, FHLMC was permitted to include mort-
gage bankers and non-federal chartered savings and loans institutions.
Lewis Ranieri is credited with being the father of modern securitiza-
tion when he worked at Salomon Brothers. In 1977, traders at Salomon
Brothers and Bank of America starting pooling thousands of mortgages
and passing homeowners’ payments on to global investors. In 1977 when
Ranieri led the movement to securitize mortgages, only 15 states recog-
nized mortgage-backed securities as legal investments. Through extensive
lobbying Ranieri won a battle to remove legal and tax barriers and this
launched the private mortgage securitization market. In 2003, regulators
forced Fannie Mae and Freddie Mac to scale back and private sector pro-
viders quickly filled the gap in the securitization market with more relaxed
lending terms.
In 1975, FHLMC issued the “Guaranteed Mortgage Certificate” to
address the asset–liability mismatch problem. This meant that a minimum
amount of principal was guaranteed each year. If amortization of the
mortgage pool exceeded the scheduled redemptions, then more principal
could be repaid for the certificate. Against this backdrop escalating interest
rates proved problematic for savings and loans institutions because they
had to fund long-term mortgages with short-term deposits. By 1978, it
was possible to receive a credit rating for pass-through securities.
FNMA and Freddie Mac combined accounted for half of all single-
family mortgages purchased (Frame and White 2005). Yet GSEs could
only offer mortgages below a certain threshold. FNMA created the first
“stripped mortgage security”. This meant that securitized products could
be based on either an interest-only payment pool or principal-only pool

of payments. In 1983, FHLMC introduced the collateralized mortgage
obligation (CMO), which was regarded as a major financial innovation
because it separated investors by maturity classes. If a CMO holder elected
early, or priority, redemption then he would usually accept a lower rate of
interest. For tax and accounting purposes, straight pass-through securi-
ties depended on the equal treatment of all security holders. The range of
securitization products widened after this hold between CMOs and pass-
through securities was eradicated.
In the 1980s, securitization became a dominating source of funds
instead of relying on savings and loans and commercial banks for mort-
gage loan funding (Gerardi et al. 2010). The market extended into other
areas such as leasing receivables, car loans, credit card receivables, and
consumer credit. European securitization started in 1987 with the issu-
ance of MBS in the UK. Italian car leasing contracts followed, and then
consumer credits in France and MBS securities in other European coun-
tries throughout the 1990s.
In 1984, SMMEA (the Secondary Mortgage Market Enhancement
Act) was passed by the US Congress and as a result almost any investor
could hold mortgage-backed securities. This was followed by the 1986
Tax Reform Act, which created a more tax-friendly environment by intro-
ducing REMIC (Real Estate Mortgage Investment Conduits). After these
two acts were passed, there was a significant increase in loan liquidity and
flow of capital into the securitization market (Loutskina 2011).
As the 1980s progressed, other payment rights, such as auto loans and
credit cards, were being repackaged into securitized products. In 1986,
General Motors Acceptance Corporation sold $4.2 billion in auto loan
receivables into asset-backed securities. In the next chapter, I discuss fur-
ther innovations in securitization that have emerged since the 1980s.
Notes
1. “A Return to Reality” by Tricia Bisoux (BizEd May/June 2009)
Garten said, “For all the discussion of the need for long-term think-
ing, we have markets that are very short-term oriented… If I could
devise a curriculum, it would be heavily geared toward history. I bet
very few CEOs had an education in financial history.”
2. Guardian (May 25, 2009). Ferguson stated, “Economists with their
more mathematical approach to social science conspicuously failed
74 B.G. BUCHANAN
to anticipate this crisis, whereas a sense of history made it clear that

we were vulnerable to a liquidity shock because of the extent of
leverage, of debt that had emerged in the system.”
3. For example, a “compera” with a nominal value of 50,000 lire con-
sists of 500 luoghi. A profit of 6 lire on each luoghi realized a 6
percent profit.
4. Compera were usually named after a saint for divine protection.
5. The equivalent of the “underwater mortgage” in the recent financial
crisis.
6. They gained this name after similarity in color, tone, and character
to the flashy and raucous Kansas bird.
7. Hyman, Louis (2011).
8. Hyman, Louis (2011).
9. Boser et al.
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CHAPTER 3
Beyond Mortgage-Backed Securities
1 Introduction
The Government National Mortgage Association (GNMA, or Ginnie
Mae) started the modern securitization era in 1970 with the creation of
US government guaranteed pass-through mortgages. Freddie Mac issued
its first pass-through security in 1971, followed by Fannie Mae in 1981.
In 1983 Freddie Mac issued its first collateralized mortgage obligation
(CMO). A competing private label securitization market emerged in
1977 when Bank of America issued residential mortgage-backed securities
(RMBS). Fidelity Mutual Life followed with one of the first commercial
mortgage-backed securities (CMBS) in 1983 (IMF 2013).
Bleckley (1985) quotes William Benedetto of Dean Witter Reynolds
remarking “The mind boggles at the number of things you can do”. In the
same article securitization is described as the “hot new game in creative
financing”. 1985 was a banner year for the emerging ABS market. In
March 1985, Sperry Lease Financial Corporation borrowed $192 mil-
lion of debt backed by computer leases in order to pay down company
debt. In May 1985 the first private car loan ABS was issued by Chrysler
Financial. Several banks quickly followed suit, continuing to service the
car loans they originated, while passing principal and interest payments
onto investors. Later that year Marine Midland cited a desire to expand
the company’s nationwide presence when it securitized $60 million of
car loan receivables. Two years later, Imperial Savings Association issued

DOI 10.1057/978-1-137-34287-4_3
78 B.G. BUCHANAN
the first collateralized debt obligation (CDO). In 1987 the first credit
card backed ABS was issued (IMF 2013). After 1985 RMBS became
more widespread in the UK and then internationally (IMF 2013). Auto
loan-backed ABS were first issued in the UK in 1990 and ABS deals first
emerged in Continental Europe the same year.
After its successful foray into the securitization market in the 1970s,
Salomon Brothers did not take long to find other products to securitize.
By the mid-1980s, Lewis Ranieri and his Salomon Brothers team raised
approximately $1 billion through CMBS, mainly office buildings, apart-
ments, and shopping malls. Salomon's first CMBS deal was relatively
small, where the bank sold $25 million in mortgages. By the mid-1980s
the group had raised nearly $1 billion through a CMBS transaction for
Olympia & York (one of the largest developers in the world at the time).1
At the same time a number of industry insiders were approaching the
growth of the securitization market with a degree of caution due to the
potential complexity and lack of historical information behind securitized
products.
Former Salomon Brothers trader Andy Stone took the securitization
market in another direction during the 1990s. The Resolution Trust
Corporation (RTC) was established by the US government in the after-
math of the Savings and Loan crisis, and was responsible for assuming the
toxic loans from failed thrift institutions. Stone2 bought mobile home and
apartment loans from the RTC for pennies on the dollar, then bundled the
loans and securitized them and sold them at a handsome profit.
By the 1990s the SEC recognized that asset securitization was becom-
ing one of the dominant methods of producing capital in the USA.3 New
securitization products continued to emerge throughout the 1990s, includ-
ing collateralized loan obligations (CLO) and the first subprime backed
RMBS. The first synthetic CDO was issued in 1997, followed by ABS-backed
CDOs in 1999. Securitization developed along three broadly defined asset
classes: fixed income assets, tangible assets, and firms. Edmunds (1996)4
viewed the outlook for securitization very optimistically by saying “…the
potential gain from securitization is over half a year’s income for every per-
son on earth and more than the increase in income achieved during the past
decade”. The SEC also established a new office to oversee securitization
transactions in 1997.5 A watershed moment was reached in 2005 when the
US private label securitization mortgage-backed securities (MBS) market
exceeded the government MBS market (Fig. 3.1).
BEYOND MORTGAGE-BACKED SECURITIES 79
3,000.0
2,500.0
2,000.0
USD Billions
1,500.0
1,000.0
500.0
0.0
Agency Total Non Agency Total
Fig. 3.1 US mortgage securities issuance.

Source: SIFMA. Agency securitizers include the Federal National Mortgage
Association, the Government Housing Loan Mortgage Association, and GNMA.
Agency MBS
By 2006, at the height of the securitization bubble, there was a wide

range of securitized products that came to be known as “alphabet soup”.
Apart from CMO (where all the tranches drew their payouts from the
same pool of mortgages) and CLO, CSO [collateralized synthetic obliga-
tions (consists of a synthetic asset pool)], CFO (a CDO-like structure that
acquires investments in hedge funds or private equity funds), CCO (col-
lateralized commodity obligation—this acquires exposures in commodity
derivatives) and CXO (acquires exposures in exchange rate derivatives)
were now being created.
During the run-up to the 2007 financial crisis more esoteric securitiza-
tions, such as those based on microfinance loans, solar leases, gold, and
comic book leases emerged. For example, GLD is the SPDR Gold Trust
ETF and was introduced in November 2004; GLD represents the securi-
tization of gold and provides traders with a convenient and cost-effective
80 B.G. BUCHANAN
way to invest in gold. Zhang (2015) shows that the securitization of com-
modities can have a negative effect on commodity company stocks if the
new securities attract investors away from the stocks. A sample list of secu-
ritized asset classes is displayed in Table 3.1.
In this chapter, I discuss the evolution of asset-backed securitiza-
tions beyond the more familiar MBS market. I will include examples
such as accounts receivables securitization market and student loan
asset backed (or SLABs) market. The SLABs market has received closer
attention in the last few years, as US student debt now exceeds $1.2
trillion dollars and the student debt mountain has been compared to
the mortgage bubble. Intellectual property securitization accelerated
after 1997 with Bowie Bonds, which are discussed at length along
with film rights and brand name securitization. Finally, the chapter
concludes with a short mini-case-based discussion on sovereign debt
securitization, specifically that of Greece in the run-up to the 2010
Eurozone debt crisis.
Table 3.1 Examples of securitized asset classes
Aircraft leases Motorcycle loans

Auto loans (both prime and subprime) Music royalties
Brand names Movie royalties
Commercial real estate Manufactured housing loans
Computer leases Mortgages (prime, Alt-A, subprime)
Comic book leases RV loans
Consumer loans Small business loans
Credit card receivables Solar leases
Equipment leases Sovereign debt
Equipment loans Student loans
Franchise loans Trade receivables
Future flow receivables Time share loans
Gold Tax liens
Healthcare receivables Taxi medallion loans
Health club receivables Whole business loans
Home equity loans Worker remittances
Intellectual property cash flows
Insurance receivables
Life insurance
Microfinance loans
2 Accounts Receivables Securitization

The cash flow cycle, represented by the conversion of cash into inventories,
accounts receivables, and back into cash is the lifeblood of any company
(Higgins 2007). Accounts receivables is possibly the biggest component
of incoming cash flow at most companies and one of the most significant
assets on a firm’s balance sheet, comprising of on average, 21 percent of
a manufacturing firm’s assets (Mian and Smith 1992). But what if there
is a slowing down of accounts receivables collected by a company? The
company is faced with the following alternatives: delay the payment of its
own bills, or borrow more to finance the firm’s working capital, or both.
This also has to be simultaneously balanced against maintaining a quality
debt rating for the company.
In terms of asset-backed securitizations, receivables securitization
enjoyed steady growth after the 1970s. Considered to be an excellent
source of short-term cash and self-liquidating (Schwarcz 1999) receiv-
ables securitization has been a viable alternative to receivables factoring.
Under factoring, a company can sell their accounts receivable at a dis-
count to finance companies termed “factors”. The risk of non-payment of
accounts (with the exception of the account debtor’s inability to pay) is
assumed by the factor.
Receivables securitization works like most other ABS structurings: the
firm pools its accounts receivables and sells receivables rights to an special
purpose vehicle (SPV). The SPV uses the proceeds from the subsequent
securities issuance to pay for the receivables. The SPV decomposes the
cash flows into tranches and sells off the less risky (higher credit quality)
tranches while retaining the riskier ones. While the tranches are essen-
tially being backed by the same pool of assets, they usually have differ-
ent risk, duration, and other characteristics (Arnold and Buchanan 2009,
2010). Usually, the ABS are over-collateralized, such that the firm actually
retains the equity portion in the SPV. This provides credit enhancement,
or a margin of safety, to the investor. Accounts receivables securitization
also addresses the moral hazard issue (Palia and Sopranzetti 2004). Like
other securitized products, investors have increasingly depended on rat-
ings agencies to perform ongoing monitoring of the underlying pool of
receivables. Receivables collection is used to repay investors who base their
decision to buy the ABS on its credit rating. An outline of the process is
provided in Fig. 3.2.
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Buy furniture
Department store
Customers
Make a loan Sell Accounts Receivable Pay

Cash
Master Trust
Sell asset backed securities
Investors
Cash
Fig. 3.2 Accounts receivable securitization
Can the investment decision be made without concern for the com-
pany’s financial condition? Sure, because the company and SPV no longer
own the receivables. So one of the benefits for the issuing company is
that it can now obtain a lower cost of financing, even if it had previously
been in a weakened financial condition. What about concern over future
receivables? Yes, definitely, and this depends on the assignment of future
receivables such as franchise or license fees.
By 1996 receivables securitization was one of the most rapidly grow-
ing segments of the US credit markets (LoPucki 1996). One reason for
the popularity of transferring relatively illiquid receivables to a bankruptcy
remote entity is that once these assets are legally separate from the com-
pany and its creditors, these repackaged securities typically carry higher
ratings than the company’s own debt issues.
Financially troubled companies also benefit from receivables securitiza-

tion by receiving payments on their receivables more quickly. In addition,
the company can also reduce its debt-to-equity ratio and consequently
boost its borrowing power because the receivables have been sold to a
trust rather than a loan of these assets.
However, there is a potential downside to the securitization of accounts
receivables. In order for a company to grow, the company has to create
more sales and one way of doing this is through creating a higher volume.
And since securitization means the company does not have to borrow, it
just needs to securitize more assets (i.e., generate more accounts receiv-
ables). Instead of producing more actual product, the process creates an
incentive—or conduit—to sell credit. The sale of new credit becomes a
new inventory for the firm. This is best illustrated by the case of Heilig–
Meyers (Arnold and Buchanan 2009, 2010) and is further discussed in
Chap. 4.
3 Student Loan Asset-Backed Securitization
3.1
Overview of US Student Loan Market
In 2015, despite an improvement in US labor market conditions, student
loan borrowers were still experiencing high debt distress levels. One in
four US student loan borrowers was considered to be delinquent or was in
default on other obligations.6 In 2015 average student debt was $29,0007
and this represents a 20 percent increase from 2010. US student debt
balances have tripled over the past decade8 and are currently estimated
to be close to $1.3 trillion, higher than credit card borrowing.9 By 2015,
student loans were the second largest source of consumer debt in the US,
and comprised a larger portion of household debt than auto or credit
card loans.10 The federal loans student balance doubled from $516 bil-
lion to $1.2 trillion between 2007 and 2015.11 An additional $150 billion
in loans from banks and private lenders was also owned by students and
parents.12
In 2008, two thirds of bachelor degree graduates had student debt
compared to less than 50 percent in 1993. Concern has started to focus
on the increase in one-year default rates among student loan borrowers.
For every borrower who defaulted, there were at least another two bor-
84 B.G. BUCHANAN
rowers who fell behind in their payments (Lewin 2011b). As many states
are poised for further tuition increases, this will place more pressure on the
student loan market.
Throughout the financial crisis comparisons were made between the
student loan market and mortgage market, with references being made to
the formation of a higher education “bubble” (Lieber 2010, Surowiecki
2011, and Abraham and Macchiarola 2010). It also focused attention on
the Sallie Mae and the SLABs market. “Sallie Mae” was formed in 1972 as
a federally chartered government sponsored enterprise called the Student
Loan Marketing Association. It currently represents the largest private
source of funding, delivery, and servicing of student loans in the USA. It
is also the largest issuer of SLABs in the nation.
3.2 The Rise of Sallie Mae

Sallie Mae was formed in 1972 as a federally chartered government spon-
sored enterprise called the Student Loan Marketing Association. The
purpose of Sallie Mae was to create a secondary market for securitizing
student loans (Fried and Breheny 2005). By securitizing the loans, origi-
nators had the ability to issue more loans. Sallie Mae’s role expanded as
loan eligibility expanded through the 1980s. Sallie Mae’s assets grew from
$1.6 billion in 1979 to $26.8 billion in 1988 (Dillon 2007).
By 1992, the federal government decided to start a new loan program
that had funds go directly from the federal government to the schools in an
effort to prevent fraud and to lower the cost of student loans (i.e., cut out
intermediaries like Sallie Mae and guaranty agencies). The new program
was called the Federal Direct Lending Program (FDLP) and it competed
directly with Sallie Mae and lenders in the Federal Family Education Loan
Program (FFELP). Sallie Mae responded by going “private” in 1996 and
expanding into all aspects of student loans from origination to collection
In 1997, Sallie Mae began privatizing its operation. In 2004, Congress ter-
minated its federal charter and it became a private company. In that time, its
stock price increased by nearly 2000 percent. The company is the country’s
largest originator of federally-insured student loans and provides debt man-
agement services and technical and business products to colleges, universi-
ties, and loan management guarantors. Sallie Mae has the ability to control
the entire loan process—making loans, guaranteeing them and collecting on
them. (Simmons 2008: 34)
Sallie Mae began to expand further into the private student loan arena
(i.e., loans made when government sponsored loans are not adequate for
the total cost of education) which generally caters to middle and upper-
class families and into the loan consolidation arena (i.e., bundling all loans
into one loan). Loan consolidation becomes a particularly curious venture
because student loans can only be consolidated once. In essence, there
is only one opportunity to refinance student loans unlike other forms of
credit.
A great deal has changed at Sallie Mae since 1972. Currently known
as SLM Corporation, Sallie Mae is a for-profit publicly traded enterprise
worth approximately five billion dollars in market value (SLM Corporation
2010 annual report). According to its 2008 annual report, Sallie Mae
expected 90 percent of the company’s needs to be funded through secu-
ritization. The company has also entered into other areas of consumer
finance such as auto loans, debt collection, guarantor servicing, and more
recently, in 2010, retail banking.
Basically, the securitization of student loans is the mechanism that
allows Sallie Mae to keep growing. The demand for student loans increases
with ever-increasing college tuition and the existence of student loans cre-
ates more demand for college enrollment. To accommodate student loan
demand, the loans are originated and securitized so that originators can
then generate more loans to meet the growing demand. Both systems feed
into each other generating an ever-increasing student loan business.
The securitization of loans is certainly not unique to student loans and
even though many student loans carry a guarantee, other types of securi-
tized loans also have insured payouts as well. However, what makes stu-
dent loans different is that student loans cannot be discharged through
a personal bankruptcy making the risk taken by the guarantor well miti-
gated and the guarantor’s position very profitable. New measures make
repayment more feasible for borrowers, but this feature of not being able
to discharge a student loan through bankruptcy is still very prominent.
Consequently, from a default liability perspective, student loans are a very
attractive investment for the originator, the guarantor, and the investor in
the securitized loan (Arnold et al. 2012).
Because of the close ties between origination, servicing, guaranty,
and collection inside Sallie Mae, conflicts of interests begin to emerge.
Providing students or the federal government with the best value may not
be the best value for the shareholder. It was noted that having a borrower
default became more lucrative than working with a borrower to maintain
86 B.G. BUCHANAN
an existing loan. Further, by creating/maintaining “preferred lender list”

status, financial aid offices may blind students to possibly better rates from
lenders not on the preferred lender list. In these instances, regulation and
oversight become critical and by the mid-2000s, such oversight was found
to be lacking (Surowiecki 2007).
On April 30, 2014, Sallie Mae completed a plan to legally separate a com-
pany spin-off into two distinct publicly traded entities—an education loan
management, servicing, and asset recovery business: Navient Corporation
(“Navient”), and a consumer banking business: SLM Corporation.
3.3 Student Loan Asset-Backed Securities (SLABs) Market

The SLABs market rose from $44.7 billion outstanding in 2000 to $240
billion outstanding in 2010.13 The last ten years has also witnessed a surge
in the issuance of SLABs. Figure 3.3 indicates there has been a leveling
off of SLABs outstanding after the financial crisis. Figure 3.4 details the
issuance of SLABs and reveals an even starker picture. Due to low interest
rates and easier credit availability, the issuance of SLABs seems to mimic
a pattern witnessed in the US mortgage market. The peak of the SLABs
300.0
250.0
200.0
USD Billions
150.0
100.0
50.0
0.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Fig. 3.3 Student loans ABS—Outstanding

80,000.00
70,000.00
60,000.00
50,000.00
USD Millions
40,000.00
30,000.00
20,000.00
10,000.00
0.00
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Fig. 3.4 US student loans—Securitization issuance.
Source: SIFMA
issuance market was reached in 2006, and Fig. 3.4 reveals a sharp decline
of SLABs issued between 2007 of $61.4 million to $28.2 million in 2008.
SLABs have been considered to be appealing to investors because they
usually carry high credit quality, low spread volatility, and credit stability.
Both government loans (guaranteed loans or directly funded by the US
government) and private loans typically serve as the pools for SLABs. SLM
Corporation used securitization as part of its privatization plans in order
to refinance its assets.
SLABs payments are typically made on a quarterly basis and are backed
by future interest and principal payments from the student loan borrow-
ers. Like many other ABS, a multi-tranche structure can be issued with
tranches typically organized with weighted average lives varying from one
to more than eight years. The shorter-lived tranches tend to receive the
senior principal distributions first.
Most SLABs are indexed against the London Interbank Offer Rate
(LIBOR). The three-month T-bill rate may be used in other SLABs issues.
Since a short-term T-bill or commercial paper is used to determine stu-
dent loan interest, lenders such as Sallie Mae will attempt to manage the
88 B.G. BUCHANAN
basis risk with derivatives. In terms of other risk considerations, there is

also uncertainty regarding future cash flows. For example, a period of
low interest rates is more conducive to refinancing, so if more borrowers
choose to refinance their loans, then the higher prepayments will result in
an increase in principal cash flow. On the other hand, the principal distri-
butions will decrease if the proportion of the pool’s underlying loans in
forbearance or deferment increases.
In an overview of the SLABs market, Fried and Breheny (2005) observe
that the SLABs market tends to have a global investor base, especially with
European investors. Like many other ABS, SLABs have to be assigned
ratings. Prior to 2007, many senior tranches tended to carry investment
grade ratings. It is also worth noting the ratings changes in the SLABs
market after 2007, the downgrades, upgrades, and total ratings by the
three main ratings agencies: Moody’s, Standard and Poor’s (S&P), and
Fitch. In 2007, Fitch and S&P assigned more downgrades than upgrades.
Between 2008 and 2011 downgrades outweighed upgrades by all three
ratings agencies. In early 2012 there has been a slight increase in upgraded
ratings by Fitch.
The SLABs market addresses two important informational asymmetric
problems—the “market for lemons” and “capture theory”.
3.4 The Lemons Problem and Capture Theory in Student Loans

Akerlof (1970) noted that in some markets, a seller has an incentive to sell
poorer quality merchandise at the price level of a higher quality product.
This occurs because the buyer does not have the ability to recognize that
a product is of poor quality (i.e., a “lemon”). The situation is a result of
the asymmetric information that the seller possesses which is unavailable
to the buyer.
Student loans carry this “lemon” feature in that the student (i.e., the
borrower) to a large degree determines the quality of the loan through
their personal choices and the realization of the quality of the loan will
take some time to materialize. A loan to a student who performs well
in classes and gets hired into a lucrative profession after graduation is a
higher quality loan than a loan to a student who does not finish their
education or finishes it with a skill set that is not in high demand in the
workforce. Determining the quality of the student loan is difficult at best
when the student first applies for a loan because of the lack of collateral
and uncertain future earnings. Even when a degree is earned, the quality
of the loan may still be in question. Further, a student’s education is not

readily transferable to the lender in the case of a default. Consequently,
“lemons” in this market have an incentive to default, particularly, if per-
sonal bankruptcy can eliminate the loan.
The federal government understood the “lemons” problem with stu-
dent loans from the outset of starting federally funded student loans in
1965. The federal government offered subsidies and incentives for states
to create guaranty agencies for the loans and the government created a
temporary guaranty agency (the Federal Insured Student Loan Program)
while the state agencies were being established.
As eligibility for student loans is expanded to include riskier parties,
a large guaranty agency becomes overwhelmed with default primar-
ily from loans made to students attending “for-profit” institutions of
higher education. In the late 1980s, the Higher Education Assistance
Foundation (HEAF), a guaranty agency based in Minnesota had pur-
sued these risky loans aggressively and was facing default rates as high
as 35 percent (see Dillon 2007). The federal government would “bail
out” HEAF by assuming its liabilities (in fact, Sallie Mae was contracted
to help unwind HEAF, Stanton 2007) and by the late 1990s, the fed-
eral government virtually assumed the function of guaranteeing federally
sponsored student loans.
The guaranty agencies still existed in a more passive capacity relative
to guaranteeing loans. However, the agencies still continued operations
related to servicing loans, providing borrowers’ assistance for loans, and
the collection of defaulted loans. Although for many years student loans
had been exempt from being discharged in personal bankruptcy over a
particular period of time after coming due, in the late 1990s, it became
law that student loans could not ever be discharged in a personal bank-
ruptcy. Such legislation certainly addressed the “lemons problem” per-
taining to student loans; however, it created a new problem.
Based on the incentive structure, it became more profitable to put a
student loan into forbearance (i.e., allowed to accumulate interest without
requiring repayment) and then into eventual default with additional fees
rather than providing loan assistance (Miller 2009).
The “lemons problem” also arises in the SLABs market. A lender spe-
cialized in lending to universities and is likely to demonstrate an informa-
tion advantage over the investors regarding the quality of the student loan
pool. The slices, or tranches, in a SLABs securitization can efficiently solve
the “lemons problem” because the less informed investors are supplied
90 B.G. BUCHANAN
with the senior and safer tranches that have very low default probabili-
ties. This should hold as long as the originator holds the riskiest tranche,
meaning that the SLABs originator will be the first to suffer any losses of
the lower quality student loans.
This solution to the “lemons” problem with student loans and its con-
sequences play a large role in what Sallie Mae would eventually come to
be. In 2000, Sallie Mae would purchase USA Group and assume most of
its activities except for USA Funds (the largest guarantee agency in the
country). USA Funds would enter into an exclusive agreement with Sallie
Mae to contract all of its guarantee services to Sallie Mae.
3.4.1 The Capture Theory

In 1971, George Stigler developed a theory that essentially states: when
regulators come from within the industry that is to be regulated, the indus-
try can effectively “capture” the regulators. It certainly appears to be logi-
cal that regulators need to be familiar with the industry being regulated
and part of that familiarity can be from having participated in the industry.
However, if the industry has significant influence over the regulator due to
the regulator’s past experience in the industry (or future prospects within
the industry), the regulator may become compromised as to who should
benefit from the regulatory process.
By 2007, allegations emerged that college financial aid offices and
administrators were being improperly induced by lenders to shepherd stu-
dents toward particular loan products and/or to have lenders be on a
schools’ preferred lender list. Two reports in 2007 from Senator Edward
Kennedy, Chairman of the Health, Education, Labor, and Pension
Committee, chronicled these activities. Sallie Mae and a number of other
lenders became the target of an investigation by the New York Attorney
General, Andrew Cuomo, about such abuses and eventually reached
negotiated settlements. With the settlements, lenders agreed to follow a
new code of conduct that prevented similar practices in the future and to
donate funds to educate college-bound students in regard to student loan
options.
Similar allegations of predatory lending and impropriety would emerge
again in the financial sector after the meltdown of the mortgage market in
2008. Although it appeared new at the time, it actually was not. The dif-
ference with the student loan industry was that the lenders did not need
to be “bailed out”. However, Stigler’s “capture theory” becomes well
illustrated in both instances (Arnold et al. 2012).
3.5 The Current Student Loan Landscape and Sallie Mae

As a response to the financial crisis in 2008, the Federal Reserve announced
the formation of the Term Auction Loan Facility (TALF) to encourage
liquidity and issuance of ABS, including SLABs. If a SLABs issued after
January 2009 carried an AAA rating, then the SLABs would be eligible as
TALF collateral. In addition, the Smart Option Student Loans Program
was started in 2009 which requires that interest payments be made while
the student is in school as opposed to most other student loans where pay-
ments are deferred until the student graduates.
In 2010, the FFELP program was discontinued in favor of promoting the
direct loan program FDLP which assumed all forms of federal student loans
(see Santo and Rall 2010). Income-Based Repayment (IBR) plans emerge
that cap monthly loan repayment to 15 percent of monthly discretionary
income with loan forgiveness after 25 years. Congress passed a more aggres-
sive IBR plan with monthly loan repayment set at 10 percent monthly discre-
tionary income and debt forgiveness after 20 years to take effect in 2014. The
Obama administration desired to have this program start sooner than 2014.
Despite the ending of FFELP lending in 2010, Sallie Mae still had a size-
able FFELP portfolio of $148.6 billion when the program ended (2010
Annual Report). Sallie Mae still has a large business with private student
loans and with the acquisition of Upromise in 2006, Sallie Mae is also a
significant player in 529 college savings plans. Cross-selling opportunities
also expanded as Sallie Mae even started piloting a consumer credit card
in 2011. SLM Corporation also started to expand its deposit base through
its retail bank in Utah to fund its private loan origination. In 2010, SLM’s
charge-offs as a percentage of average loans in repayment and forbearance
increased from 3.8 percent in 2008 to 7.2 percent in 2009 (quoted on
GAAP basis, pg 69, SLM Corporation 2010 10K report).
Although there have been changes to help borrowers, student loans
still cannot be discharged through personal bankruptcy and IBR programs
are not available to all. Student loans and defaults are growing (Cauchon,
October 18, 2011, and Lewin, September 12, 2011). With regard to the
“hardship” standard, in 2008 only 0.04 percent of student loan recipients
who filed for bankruptcy were successful in getting their college loans
dismissed (Dell 2011).
This behavior is another facet of the “lemons problem” discussed
earlier in that the availability of student loans is so ubiquitous that cer-
tain schools simply recruit students to take classes for the purpose of
92 B.G. BUCHANAN
generating “loan income” for the school. Actually retaining a student

throughout a program does not appear to be a high priority according
to the report.
In addition, as college students graduate with increasing levels of
debt, their choices, such as starting a business, buying a home, pursuing
graduate education may be quite different. The treatment of student loan
defaults is different to other loan defaults in that the student loans can-
not be discharged in the event of bankruptcy. Under such an event, the
government can garnish up to 15 percent of take-home pay, and seize tax
refunds or social security payments to recover any student loan money
owed. It can also result in difficulty for the borrower getting a job if a
credit report is checked.
4 Intellectual Property Securitization

Three types of securitizations have dominated the securitization landscape
since the 1970s: mortgaged-backed securitizations; asset-backed securi-
tizations; and IP-backed securitizations (IPS). In 1997 a major turning
point in modern securitization occurred. Up until then both MBS and
ABS were based on a pool of revenue streams currently flowing from exist-
ing mortgage loans, car loans, student loans, etc. Specifically, MBS are
created based on a pool of revenue streams currently flowing from real
estate loans. ABS are based on a pool of currently flowing revenue streams
from auto loans, student loans, credit card debt, etc. In both cases, the
rights to the revenue streams are sold to a third party. In the case of intel-
lectual property (IP) securitization, the main idea is the securitized prod-
uct is based on a pool of sold rights to unknown future flows of revenues.
The revenues are derived from IP includes assets such as trademarks,
brand names, movie libraries, book publishing, patents, sports contracts,
and royalties. IP securitizations are also known as future flow securitiza-
tions (FFS). IP securitization principles are also applicable to small and
medium-sized enterprises (SMEs) (Beck and Demirguc-Kunt 2006). The
first major investment bank to complete a securitization deal with an IP
component was Morgan Stanley Dean Witter which raised $1.4 billion in
a securitization deal for the Formula One racing body (Brandman 1999).
By the end of the 1990s, the potential size of the IP securitization was
estimated to be worth US$1 trillion (Brandman 1999).
The support IP securitizations have found positive support includ-
ing: (1) an effective way for non-investment grade companies to obtain
investment grade financing, (2) it is a useful way for a company to raise

funds without diluting company equity ownership, and (3) it is borderless,
not just limited to large company use. Yet it remains that many global IP
securitizations are non-recourse with no postsecuritization liability for the
issuing firm. In a postcrisis era, where there is a call for issuers to be “on
the hook” or have some recourse, this can also be perceived as a disadvan-
tage for IP securitization. The risk of IP securitizations is that it also tends
to be perceived as more speculative than ABS and MBS. The expectation
that future sales may not eventuate is what makes an IP securitization
riskier, adversely impacting investors (Taylor et al. 2009).
4.1 How IP Securitization of Royalties Works

An IP securitization of royalties provides a large sum of money efficiently,
quickly and often with favorable tax consequences. In this framework, the
artist is able to convert future royal streams into an upfront lump-sum
cash payment. One reason an artist may borrow against the royalty stream
is that the lump-sum cash payment may allow the artist to secure a future
distribution or recording contract.
For an IP securitization that is royalty-based, the entertainers assign
their rights to an SPV in order to receive future royalty payments. For
example, music royalty payments may be generated from fees relating to a
song’s use in the movies, on the radio or in advertising. The bonds that are
issued by the SPV constitute a debt obligation and are repaid over a fixed
number of years based upon the revenue generated by the royalty fees.
After the maturity date, the royalty payments revert back to the enter-
tainer as does the security interest in the copyright.
IP securitization allows artists to fully capitalize on their royalty income
compared with a loan against the royalty stream. This may yield 70–80
percent of what banks think the royalty stream is worth (Fairfax 1999). In
the earlier days of the royalty securitization industry, an entertainer could
be provided with a tax deferral because he did not have to pay income tax.
This is because from a tax perspective the securitization is viewed as a loan,
particularly if the funds are used for a business purpose.
In an IP royalty securitization, the entertainer is not required to sell
their property rights, which is viewed as “selling a birthright” by many
estates and by many entertainers. In an IP securitization, the copyright
serves as collateral, which is released back to the artist when the bond is
paid off.
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4.2 Mini-Case—Bowie Bonds
The securitization industry changed markedly in February 1997 when
David Bowie securitized his music royalties. Bowie’s financing team
found that more money could be raised through a securitization deal than
through the usual royalty distribution networks. Why did Bowie need the
cash? To satisfy UK residency tax concerns and to buy out his manager
who owned some of the rights to Bowie’s songs. The resultant “Bowie
Bonds” had no associated underlying existing loans, but was based on
the rights (for approximately ten years) to the future income stream of 25
of his albums that had been released between 1969 and 1990. This was
equivalent to future royalty payments generated from the sale and use of
more than 250 songs (including Space Oddity, Changes and Heroes) in
Bowie’s recording catalogue. The bonds were issued in a $55 million pri-
vate placement deal. The $55 million lump-sum payment allowed Bowie
to borrow more money upfront rather than get a steady stream of income
from royalty revenue in his back catalogue. Copyright ownership was cru-
cial to the deal, as Bowie owned the rights to all his songs at the time.
Bowie assigned payment of his royalties to an SPV which then issued the
bonds at an interest rate of 7.9 percent, an average life of 10 years and
maturity of 15 years. The bonds were non-recourse but carried a guaran-
tee by EMI Music. In addition, the underlying pool was overcollateralized
which ensures that the bonds receive a high credit rating from the ratings
agencies. Moody’s initially rated the Bowie bonds as an A-3 rating.
Fahnestock and Company were underwriters for the Bowie bond issue.
Fahnestock’s Managing Director, David Pullman, later established the
Pullman Structured Asset Sales Group which specialized in securitizing
celebrity royalties. After the Bowie Bond issue, securitized music royal-
ties became known as “Pullman Bonds”. In August 1998, the Pullman
Group completed a $30 million private offering with the securitization of
Motown music royalties. Later in the year the group completed an $11
million securitization for Ashford and Simpson’s royalties. In May 1999,
750 of James Brown’s songs were securitized earning the entertainer
between $35 and $55 million. Global Entertainment Capital LLC con-
ducted a $30 million securitization for the heavy metal band Iron Maiden,
with a longer maturity of 20 years. Other IP securitizations at the end of
the 1990s included the music royalties of Dusty Springfield, Rod Stewart
(who raised $15 million through securitization), Bob Dylan, and Michael
Jackson.
Fairfax (1999) recognizes the difficulties that the entertainment world

has in replicating the success of the Bowie Bonds. First, the growth of
IP securitization faces limitations because well compensated entertainers
may have less of a need for cash; the difficulty of predicting future music
royalties could make IPS less appealing. One response could be to pool
royalties based on many artists and then conduct a securitization based
on pooled royalties. For example, movie libraries could be securitized by
pooling together large groups of films and revenue generated by long-
term licenses by major film studios (Brandman 1999).
It is certainly not a “one size fits all” template, as few artists are as
able to match a royalty income stream as high as David Bowie. Audience
tastes also change over time which makes the royalty streams more vul-
nerable, especially if we are looking at ten-year payment streams. It also
makes risk evaluation more complex and intricate. Other influential fac-
tors determining whether an IP royalty securitization may be successful
are: (1) establishing ownership of copyright and (2) if the copyright is
jointly owned, the value of the securitization may be diminished if both
parties do not participate in the transaction. Litigation costs involving
copyright can diminish the advantages of IP securitization for investors.
For example, Tupac Shakur’s family-sued Death Row Records claiming
the company did not own the copyright and therefore a securitization
should not be pursued (Fairfax 1999).
Copyright legislation was disrupted after 1999 by the arrival of Napster
and peer-to-peer (P2P) music sharing platforms.14 The rise in online music
and an increase in CD piracy, made it much more difficult for artists to
derive income streams, negatively impacting Pullman bonds. For example,
the price of Bowie bonds declined in 2004 when the bonds were down-
graded to BBB+, a notch above junk status.
4.3 Film Securitizations
Since 1997, other artists and companies who have utilized IP securiti-
zation include: Iron Maiden, Rod Stewart, Dreamworks, Calvin Klein,
Arbys’ Restaurant Group, Quiznos, BCBG Max Azria Group and Sears.
Securitization deals started to gain more traction in Hollywood after
the turn of the century. Universal Studios employed securitization tech-
niques in the late 1990s (Sear 2006) and Dreamworks used them in
2002. Dreamworks was acquired by Viacom Paramount Studios and in
96 B.G. BUCHANAN
2006 the studio announced a securitization deal of the recently acquired

Dreamworks library to an investment group owned by George Soros.
The 59-title deal was valued at $900 million and included films such as
Gladiator and American Beauty (Sear 2006). In early 2006 the Weinstein
Brothers (Miramax Studios) entered into a $500 million AAA-rated secu-
ritization facility to finance their films over a five-year period. Studios (such
as the Disney and Touchstone labels) worked with investment partners
such as Credit Suisse First Boston and hedge funds to complete securitiza-
tion deals (Sear 2006). By 2005, 15 major film securitizations had been
completed, totaling over $10 billion (Eisbruck 2005).
In a traditional film financing framework, the risk of cost overruns is
often high. Most film securitizations focus on securitizing future cash
flows of films that have already been produced or are part of a studio’s
established film library. Future film portfolio transactions are also called
slate financings. Over the period 1995–2005 period more performance
risk started to be shifted to investors (Eisbruck 2005) because of the
greater availability of historical data and success of earlier transactions.
A film securitization pool can include both recently released films as
well as future films that can be added for funding periods ranging from
three to five years. In earlier versions of film securitizations rights are sold
to a portion or all of the film’s future cash flows from future films in
exchange for the costs of film production. The funds sold in the bond
offering are held in an account and advanced to the studio prior to the
film’s release on a per-film basis. Just like in traditional film financing,
securitized cash flows generated by films allow the recovery of other costs
such as those for printing and advertising.
The cash flows of each film are typically sold under a true transfer
to an SPV. In turn the SPV licenses enough rights to the film studio so
that the studio can arrange third party distribution or to distribute the
film rights itself. The licensed rights include distribution agreements and
gross receipts. The sponsoring bank issues highly rated commercial paper
through an off-balance sheet conduit that is then used by the conduit to
make short-term loans to the SPV backed by the purchased film rights.
Surety bond coverage can be used to provide first loss protection against
defaults on SPV loans up to a limited amount.
Revenues pledged to the securitization will typically include domestic
and international theatrical rentals, home video, and pay and free televi-
sion. In the mid-2000s revenues increased from the DVD sales market
(Eisbruck 2005). Future film securitization proved to be a means of help-
ing accelerate reimbursement of a slate’s production costs. It also serves

as a capital raising tool that reduces dependence on the corporate parent.
The 2002 Dreamworks securitization deal was an example of a film
revenue advance transaction. A film revenue advance transaction is differ-
ent to future film portfolio securitizations because the advances are usually
made two months after a film’s domestic release (as opposed to just prior
to future film deals). The film’s projected revenues are the more impor-
tant determinant than productions costs. According to Eisbruck (2005)
when Moody’s is assigning a rating the agency finds a film that has been in
domestic release for two months as more predictable revenue, and there-
fore a lower performance risk.
4.4 Brand Name Securitization
4.4.1 Mini-Case Sears

The idea of massive unlocked capital potential in IP securitization lasted
well into the 2000s. Guess? Quiznos, Arbys, and Dunking Donuts carried
out deals around trademark and franchise fees. In April 2007, Business
Week reported that Sears was planning a $1.8 billion IP securitization
based on the brand names Kenmore, Craftsman, and DieHard—con-
sidered to be Sears’ “crown jewels” (Berner 2007). Touted as the big-
gest IP securitization in business history (Berner 2007), the Sears deal
involved transferring brand ownership to an off-balance sheet entity,
KCD, which Sears then paid for the right to use the brands. Sears then
held the bonds in a Bermuda based insurance subsidiary, where they
serve as protection against any future loss. This is also performed at a
relatively cheaper cost than Sears could obtain externally. In effect KCD
charges royalty fees to license the three brands and uses royalties to pay
interest on the bonds it issued. The resulting bonds had a higher rating
(Baa2) than Sears regular bonds (Ba1) (Berner 2007). In the event of
bankruptcy, the three core brands that had been securitized would be
out of reach of Sears’ bondholders. The bondholders would then have
to talk to the insurers. Sears owns every component along the way. What
makes the Sears securitization different to ones previously mentioned
is that it did not involve preexisting royalty payments. Effectively Sears
created payments in order to issue the bonds and so the payments netted
out to zero. However, if Sears were to sell the bonds to external inves-
tors, then investors would be holding the bonds and Sears would be
holding $1.8 billion in cash.
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A criticism coming out of the recent financial crisis is a focus on short-

termism; especially short-term debt and profits. This same criticism could
also be made of IP securitization (Taylor et al. 2009) identifies the follow-
ing IP/brand securitizations risks: liquidity risk, event risk, moral hazard
risk, and brand risk. In the last case, Taylor et al. (2009) compare brand
securitization with the recent subprime bubble. If a brand has been secu-
ritized there may be very little incentive to monitor the brand or protect
it. In the high-risk subprime mortgage bubble, originators became lax at
verifying borrowers’ true credit and income background and once the
subprime loans were securitized, the originator was no longer on the hook
for the poor loan. Another example of FFS that has shown great potential,
particularly in emerging markets, is remittance securitizations. This is pro-
vided in more detail in Chap. 6.
5 Solar Securitization

Each year, the solar industry contributes approximately $15 billion to
the US economy.15 Solar securitization is a relatively new asset class that
incorporates the key benefits of securitization including credit enhance-
ment, portfolio diversification, liquidity, time and risk-tranches securities,
liquidity, and bankruptcy remote SPVs. As a social dividend solar securi-
tization offers an efficient long-term and liquid source of capital. Since
2008, solar energy use has become less novel, more predictable, and is
up 1200 percent. Over the same period, the market for commercial solar
securitization has increased from less than $1 billion to approximately $15
billion. The potential for securitization exists in both the residential and
commercial solar markets. Solar City has led the residential solar securiti-
zation market and Tioga Energy with the commercial solar securitization
market (Joshi 2012).
The solar lease has spurred the “green” movement in securitization,
although the market is still relatively young. Solar leasing helps homeown-
ers and businesses install rooftop systems without having to deposit tens
of thousands of dollars upfront. Major installers, such as Solar City or
SunRun lease solar panels, and the homeowner signs (typically) a 20-year
lease and then makes regular payments out of the savings on their electric
bills. The 20-year lease resembles a mortgage, auto loan, and many other
products with a cash flow structure that is now being securitized. The
securitized product is known as solar energy backed securities (or hereafter
SEBS).
There are a number of potential benefits of solar securitization. Firstly,

it could potentially scale up the solar industry and allow developers to
obtain financing at a lower cost than corporate debt or tax equity. Given
that institutional investors such as pension and mutual funds are big inves-
tors in securitized products, solar securitization offers a new asset class
to investors who were previously hesitant about investing in renewable
energy.
There are also a number of potential impediments to the solar securiti-
zation market. Firstly, due to the relatively youth of the market there is a
lack of standardized contracts. This is also a function of the dominance of
small and medium-sized enterprises in the commercial solar leasing mar-
ket. Secondly, a long-term 20-year contract puts the investor at a greater
risk of being renegotiated especially if the retail price falls. Finally, while
solar leases are being accumulated, there is the difficulty of warehousing
the assets. Other risks to SEBS include: counterparty risk; servicer/spon-
sor risk; credit risk; lease transfer risk; insurance risk; grid electricity prices;
structural risk; insolation risk; and technology risk.
The solar sector has depended on tax-equity investors for much of its
history, thus placing a constraint on its growth. The availability of tax
equity credits that allowed continued growth of the solar sector during
the financial crisis (Joshi 2013). Federal tax credits to the solar sector are
scheduled for sunset by 2017 from their current level of 30 percent to 10
percent. In the next couple of years it will be necessary to attract public
sector investors if interest from tax-equity investors declines.
6 Sovereign Debt Securitization—Greece

and the Eurozone
International concern over Greece’s deficit and debt levels followed the
country’s October 2009 election. Newly elected PM George Papandreou
promised to address nationwide corruption as well as welfare and state
reform issues. After the election, a closer examination of the government
coffers caused the new Socialist government to revise its reported budget
deficit of 6 percent of GDP upwards to 13 percent of GDP, then to 15
percent of GDP (well above the Eurozone limits). The Greek current
account deficit was in excess of 10 percent of GDP, triggering further
concerns about Greece’s ability to cope with its existing debt obligations.
Additionally, widespread tax evasion was exposed meaning that Greece
had to spend more on benefits and receive less in taxes.
100 B.G. BUCHANAN
Greek Bonds German Bunds
40
35
30
25
20
15
10
Fig. 3.5 Spread between Greek bonds and German bunds. Source: Bloomberg
On December 8, 2009, Greece’s long-term sovereign debt was down-

graded from A− to BBB+—the first time in a decade that Greece had not
receive an A- rating. As a consequence, Greece’s cost of borrowing started
to escalate. In early 2010, when S&P downgraded its debt rating again,
market confidence was shattered and Greek bond yields started to rise,
reaching as high as 35 percent. Spreads between German bunds and Greek
gilts grew even wider in the following months as evidenced in Fig. 3.5.
Attention extended to the Greek derivatives markets and the nation’s
accounting rules. Specifically, banks such as Goldman Sachs, Deutsche
Bank, Morgan Stanley, and Citi received closer scrutiny over their role
regarding derivatives contracts with the Greek government. For exam-
ple, there is the currency swap arrangements Greece entered into with
Goldman Sachs. To raise capital outside of Europe the Greek govern-
ment issued debt in US dollars and Japanese yen. The swap, which had a
notional value of $10 billion, did not use the prevailing exchange rate but
instead the historical implied foreign exchange rate. This rate was based
on a weaker Euro which meant that Greece could exchange its dollars and
yen for a greater number of euros. This created an upfront payment by
Goldman to Greece at the swap’s inception (of approximately $1billion)

and an increased stream of cash flows to Greece during the swap’s lifetime.
From Goldman’s perspective, it would recover these cash flows in the form
of a balloon payment at maturity. And because European accounting rules
did not require Greece to report this as a credit, so it resembled a loan to
Greece and the government could remove the $1 billion off its balance
sheet.16 At the time under the existing Eurostat rules this was a perfectly
legitimate transaction, and other European nations had followed a similar
path with derivatives and sovereign debt. Eurostat treated an upfront pay-
ment as interest and this could reduce the leverage profile of the country
involved. If it could reduce the leverage profile of the country, it would
mean that a country’s debt ratio stayed under the Eurozone limits.
6.1 The Greek Securitization Market

Between 1999 and 2002, Greece launched seven securitizations worth
more than €5.2 bn ($4.7 bn), which at the time was approximately equiv-
alent to 4.1 percent of GDP, the highest in the eurozone at the time. In
2000, Greece was viewed as having the potential to be one of the fastest
growing ABS sectors in Europe. A chronology of Greek securitization
deals is provided in Appendix 1. This was largely due to a securitization
of deposits into a government owned bank (the Consignment Deposits
and Loans Fund—CDLF) and a €650 million securitization deal named
Ariadne, which was the first European securitization of lottery receiv-
ables. However, the IMF commented that Greece’s use of off-balance
sheet accounting methods “impedes efforts to achieve a sustainable rapid
decline of the public debt.”17 In 2001, both Greece and Portugal passed
legislation to make securitization simpler.
Many of the securitization issues were made using different SPV. Many
were named after characters from Greek mythology. For example, an
SPV named Aeolos (after the Greek god of winds) raised €355m in 2001
backed by revenues owed to the Greek state by international airlines using
Greek airspace and paying landing fees at domestic airports. Another,
Ariadne (after the princess who found her way through the labyrinth at
Knossos in Crete) was an issue backed by revenues from OPAP, the state
lottery organizations. An SPV named Atlas, orchestrated the biggest secu-
ritization deal in 2001 when it raised €2bn backed by grants the finance
ministry expected to receive from European Union structural funds over
the next seven years.
102 B.G. BUCHANAN
ABS structures were set up in order to tap capital markets in countries

where the foreign currency debt ceiling, lack of investor awareness, and
financial volatility had earlier prevented such possibilities. Global invest-
ment banks assisted the Greek government in securitizing future flows of
income such as lotteries and highway tolls. In 2001, the Greek govern-
ment raised €2.35 bn through two deals carried out through Luxembourg-
based SPVs: a €2bn issue backed by future income from a package of
EU structural funds, and a €355m issue backed by future revenues from
Eurocontrol to the Greek civil aviation authority for air traffic control
services.
For many years one of the biggest problems confronting the Greek
government was its expected pension outlay, regarded to be the highest
in the Eurozone, (approximately 12 percent of GDP). Unfunded pension
liabilities were estimated at over 200 percent of Greek GDP. Historically,
Greece operated under the pay-as-you-go system and shortly after join-
ing the Eurozone, the nation’s pension deficit amounted to about 4.5
per cent of GDP, which was financed from the budget. The IKA plan in
2002 faced difficulties in gaining EU approval because the refinancing
deal involved a securitization arrangement to avoid increasing the budget
deficit. Eurostat had already questioned using securitization as a practice
to reduce the public debt and at the time Greece had already secured
funds equivalent to 4.4 percent of GDP.
The first securitization of Greek residential mortgages was carried out
in November 2003, by Apsis Bank (assisted by lead managers ABN Amro
and National Bank of Greece). The total issue was valued at €250 million
of which €225million were triple A securities.
Other banks followed suit and sought to securitize mortgages as well
as other loan classes, such as consumer loans (including car-financing pay-
ment schedules). The 2004 Olympic Games held in Greece was considered
to have favourable prospects regarding securitization. Municipalities such
as Amarousion, where many Olympic events took place expressed interest
in securitzation participation. There were also suggestions for securitizing
the proceeds from the country's first wave of concession projects, such as
the Attiki Odos highway and the Gefyra suspension bridge. An executive
at one of Greece’s top construction groups commented,
It is too early to contemplate securitization of the existing concessions. But

the amounts are substantial and their income stream very sound. It is more
realistic to anticipate securitization of proceeds from the second wave of
concessions, such as new toll roads.18
In 2005 the Greek government announced a securitization deal worth

€2bn (or income equivalent of 1.5 percent of GDP) intended to pro-
vide a buffer for a tax revenue shortfall. The securitization transaction was
planned to be backed by tax arrears revenue and it was estimated that at
least €10bn out of €17bn in delinquent tax claims could be collected.19
The securitization deal had the potential to provide income equivalent to
1.5 percent of Greece’s GDP.20 The issue was targeted to overseas investors
and Citigroup advised the government on managing the transaction and
setting up a SPV. At the time the privately placed tranches were expected
to receive an AAA rating from the ratings agencies relative to Greece’s BB
sovereign rating. In late 2005 Greece abandoned plans for the €1.5bil-
lion securitization deal (backed by government tax arrears21) because of
European Commission opposition to such a “one-off” measure to reduce
the budget deficit.22 In October 2005, it also came to light that interna-
tional investment banks were assisting governments finance their national
debt by arranging securitization programs. Twelve of the twenty-five EU
member countries were running official deficits at or above the 3 percent
of GDP limit. It had already been revealed in 2004 that Greece had been
providing false deficit figures every year since 1998.
At the start of the Eurozone debt crisis in early 2010, a number of
Greek structured deals and securitizations either saw their ratings cut by
the ratings agencies or were placed on review.23 As the Eurozone debt
crisis continued to unfold it also drew attention to securitization and
the Eurostat rules that had been established within the previous decade
(Figs. 3.6 and 3.7).
6.2 What Are the Eurostat Rules for Securitization?

Eurostat is designated to handle how sovereign securitizations are treated
in the Eurozone. From a government’s point of view, the key appeal of
securitization deals is that the process allows governments to secure fund-
ing without raising their official debt burden. Until July 2002 the ESA
95 rule book had been unclear on what securitization structures were
legal. In July 2002, Eurostat ruled that revenues from securitization issues
could not be used to write down a country’s public debt. Greece stopped
whereas Italy continued and it seems that Italy did not guarantee the
performance of its securitizations (whereas Greece) did. This meant that
Italy was passing the credit risk down the line. Greece’s stated surplus
of 1.8 percent of GDP was revised to a 1.1 percent deficit. Relative to
USD Millions USD Millions
104
0
5000
10000
15000
20000
25000
30000
35000
10,000.00
20,000.00
30,000.00
40,000.00
50,000.00
60,000.00
70,000.00
0.00
1985
1986
Source: SIFMA
Source: SIFMA
1993
1987
1994 1988
1995 1989
B.G. BUCHANAN
1996 1990
1991
1997 1992
1998 1993
1999 1994
1995
2000
1996
2001 1997
2002 1998
Fig. 3.6 Greece—Securitization issuances.

1999
2003
Fig. 3.7 Greece—Securitization outstanding.

2000
2004 2001
2005 2002
2003
2006
2004
2007 2005
2008 2006
2009 2007
2008
2010 2009
2011 2010
2012 2011
2012
2013
2013
2014 2014
other eurozone members, Greece had raised smaller amounts, but the
securitization issues as a percent of GDP was higher than other member
countries. After the Eurostat ruling, Greece’s public debt rose from 99.8
percent to 107.6 percent of GDP, the third highest after Belgium and
Italy.24 Those countries affected by the Eurostat ruling suffered a sharp
deterioration of public finances as capital transfers, essentially subsidies to
state-controlled corporations, were reclassified as expenditures, increasing
the budget deficit. Proceeds from securitization, convertible bonds and
privatization certificates were added to the public debt.
Additionally, another problem Eurostat statisticians had was how to
treat future-flow ABS deals from the Italian and Greek governments.
In future these would be regarded as pure government borrowing.
Unsurprisingly these types of trades immediately disappeared from the
landscape. The Four Eurostat Principles for securitization created in 2002
are listed as follows:
1. Future receivables securitization not corresponding to actual assets

on the sovereign balance sheet should be recorded as debt, not as a
sale.
Under this principle, Eurostat has the power to enforce policy choices
upon governments. For example, consider the licences granted for lot-
tery tickets and the licence fees generated. The licence fees can be used to
reduce national debt. Yet if the licence fee receivables from government
owned lotteries are securitized this is treated as borrowing and cannot be
used to reduce the national debt.
2. If the securitization is supported by an effective guarantee of the

cashflows, then it must be recorded as debt.
3. If the assets are sold at more than a 15 percent discount from their
market price, then the transaction should be recorded as debt, not
as a sale.
4. In the event where the sale price is not received up front, the balance
should be recorded only at the time of its receipt.
6.3 The Eurozone Crisis and Beyond

In July 2010, Greek banks started to unwind securitization deals in order
to maintain access to central bank funding. Many of the ratings being
assigned fell below the ECB’s minimum standards (an A3 floor or A-) for
106 B.G. BUCHANAN
use as loan collateral. If the bank falls below this floor, it means the spon-
soring bank needs to pump in cash to boost the rating or unwind the deal.
Moody’s had already reviewed 27 securitization deals.
As the debt crisis unfolded in early 2010, debate emerged over whether
the Bank of England would accept ABS as collateral. The Bank of
England’s discount window only accepted sovereign credit of G10 coun-
tries with credit ratings of at least AA-, which is four notches higher than
Greece's BBB+ credit rating (rated by Standard and Poor’s). Moody’s
estimated that the deals were worth €54bn ($73bn) in total of which €27
bn was rated AAA, and started to request credit enhancement to maintain
its ratings. For example, residential mortgage-backed deals would require
an enhancement between 25 and 45 percent of the outstanding notes, up
from between 15 and 20 percent.
After the ECB shut off repo facilities using bonds issued or guaranteed
by the Greek government, Greek banks face ever-diminishing options for
financing. Since the ECB announced its ABS purchasing program (ABSPP)
in late 2014, there has been a significant improvement in spreads. Yet
there are still concerns about the return of redenomination risk.25 What
if Greece defaults and has to leave the Eurozone? This means that the
country would have to return to the drachma and this represents a huge
downside risk to the sector. For Greek RMBS, these would be denomi-
nated in euros as they were issued by non-Greek issuers. The mortgages
themselves are likely to be converted to drachmas, because every loan in
the securitization is linked to the country of origin. This leaves a mismatch
in cash flows. And even if this were not the case, the collateral backing the
loans would fall in value given the expected decline in the drachma relative
to the euro and this would place further stress on the ability of borrowers
to make interest payments.
A new government, led by Alexis Tsipras, was elected in January 2015.
Old fears of sovereign deafult were rekindled. The Tsipras led govern-
ment promised to renegotiate Greece’s bailout from the Eurozone. In
early 2015 Greece’s unemployment was 20 percent and the Greek econ-
omy had contracted 25 percent since its debt crisis had started. The
country had improved its national budget deficit by raising taxes, spend-
ing cuts, and structural reforms. After a “no” vote in a national refer-
endum in June 2015 Greece defaulted. This led to bank closures and
enforcement of capital controls. Tsipras finally capitulated in July 2015
and a new bailout agreement was reached, including similar austerity
measures as before.
In 2015, the Greek securitization market once again found itself in

turbulent times, despite a significant improvement in spreads since the
European Central Bank announced its ABS purchasing program in late
2014. Investors were once again worried about the return of redenomina-
tion risk. After the ECB shut off access to its repo facilities using bonds
issued or guaranteed by the Greek government, Greek banks found them-
selves with fewer options. However, Greek banks could still access emer-
gency liquidity assistance (ELA), under which collateral would remain on
the balance sheet of Greece’s central bank (not the ECB’s). Greek banks
requested 10 billion euros, but the ELA provided a lower amount—3.3
billion euros.
Notes
1. Lewis Ranieri and the Road to Hell. Crains’ New Business, June
27, 2010.
2. Lewis Ranieri and the Road to Hell. Crains’ New Business, June
27, 2010
3. Investment Company Act Release No. 19, 105 [1992 Transfer
Binder] Fed. Sec. L. Rep.
4. Edmunds, J. C. (1996), Securities: The New World Wealth
Machine, Foreign Policy, Fall Issue No. 104, pp. 118–134.
5. SEC Creates new group to handle ABS, new products, Steve
Goldstein, Corporate Financing Week, December 15, 1997.
6. A Student Loan System Stacked Against the Borrower, Gretchen
Morgenson, NY Times, October 9, 2015.
7. Hufington Post.
8. America’s Student Debt Pain Threatening a Corner of Bond
Market, Bloomberg, April 29, 2015.
9. The Indebted Ones, The Economist, October 29, 2011.
10. We’re Frightenly in the Dark about Student Debt, Susan Dynarski,
NY Times, March 20, 2015.
11. The Student Debt Collection Mess, Natalie Kitroeff, Bloomberg
Magazine, June 8, 2015.
12. IBID.
13. SIFMA.
14. “Bowie Bonds” blazed a trail through capital markets, Peter

Campbell, January 11, 2016.
108 B.G. BUCHANAN
15. Wall Street Goes Green. Why Solar is Booming, Michael Grunwald,
Time. August 28, 2014.
16. Dunbar, Nick. Revealed: Goldman Sachs’ mega-deal for Greece,
Risk Magazine, July 1, 2003.
17. Securitisation plans on hold in Greece, Kerin Hope, Financial
Times, April 30, 2002.
18. Market Opens up to financial sector securitizations, Euromoney, 2003.
19. Sovereign ABS: Greece puts together tax deal, Euromoney,

September 2005.
20. Greece faces up to taxing times, Kerin Hope FTimes, October 2005.
21. Portugal actually pioneered the securitization of tax arrears deals.
22. Greeks drop Euros 1.5 bn securitization plan for budget, Kerin
Hope, FTimes, December 16, 2005.
23. Investors should watch out for the sovereign effect, Jennifer

Hughers, FTimes, February 20, 2010.
24. Moves to balance budget and reduce debt ratio, Kerin Hope,

FTimes, November 12, 2002.
25. Progonati, Evis. Securitization Offers Funding Lifeline to Greek
Banks but Redenomination Risk Remains, Forbes Business, February
19, 2015.
Appendix 1: Timeline of Greek Securitization
2001–2004 Greece raises more than EUR4 billion ($5.44 billion) from a series
of securitizations.
March 2002 Eurostat announces four principles for sovereign securitization.
April 4, 2002 Greece announces a Euros 9.6 bn (Dollars 8.4 bn, Pounds 5.9 bn)
refinancing plan for its biggest state pension fund, IKA.
April 30, 2002 The government also plans to securitize a second tranche of income
from OPAP, the state lottery.
Greece announces it is freezing all securitization plans until
Eurostat conclusions are released.
November 2003 Apsis Bank carries out the first securitization of Greek residential
mortgages.
December 2003 Greece securitizes €2 billion of future revenues from the Third
Community Support Framework.
September 2005 Greece plans to securitize delinquent tax receiavbles. An €11 billion
pool of delinquent taxes stood ready to back the transactions.
October 2005 Greece announces plans to use a €2 bn securitization deal to offset a
projected shortfall in tax revenue.
December 2005 Greece drops plans of securitization deal due to Eurostat opposition.
February 2010 Greek securitization and structured deals either have their ratings
cut or are placed on review for a downgrade.
March 2010 Greece is carrying a BBB+ rating by S&P. Moody’s signal more
downgrades are imminent.
July 2010 Greek banks start to unwind securitization deals to main access to
central bank funding, including EFG Eurobank ERGAS IAS,
Greece’s second largest bank.
August 2012 Greek government announces that it is planning to launch
Chinese-style “economic zones” with special tax and regulatory
breaks in a desperate bid to attract foreign investment.
June 2014 Greece’s Alpha Bank announces plans to securotize $1.36 billion of
shipping loans.
Source: Lexis-Nexis: Proquest
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CHAPTER 4
Securitization and Risk Transfer
The role that financial institutions and corporations should play in the
global economic and political framework has been widely debated since
the financial crisis. In 2009, at a meeting of UK bankers and clergy, Mark
Costa, Chairman of Lazard International, stated, “Capitalism has slipped
its moral moorings.”1 Five years later, Mark Carney, the Governor of
the Bank of England, stated, “…just as any revolution eats its children,
unchecked market fundamentalism can devour the social capital essen-
tial for the long-term dynamism of capitalism itself” (Longley 2014). An
examination of ethical lapses is inevitable in the aftermath of any finan-
cial crisis. Aspects of the 2007 financial crisis may be characterized by
greed, recklessness, and dishonesty, but it may also be described as the
result of good intentions gone amiss (Tett 2009; FCIC Report 2011).
Scalet and Kelly (2012), Donaldson (2012), and Graafland and van de
Ven (2011) have examined moral and ethical issues that emerged from the
recent credit crisis. Securitization has been attributed to be one channel
that facilitated the amplification of systemic risk by increasing excessive
leverage and risk concentration across the financial sector.
A study of the securitization industry in ethical terms is not just impor-
tant because of the complex ethical relationships that exist between origi-
nators, special purpose vehicles (SPVs), ratings agencies, investors, and
regulators but also because of the role it plays in the global financial sys-
tem. When assessing securitization and the financial crisis a less explored
aspect of the literature is the ethics of risk transfer. In this chapter we
explore the ethics of risk transfer and securitization.

DOI 10.1057/978-1-137-34287-4_4
112 B.G. BUCHANAN
Originally, securitization was intended to be a cheaper, efficient form

of financing that could reallocate risk to less risk-averse investors. Apart
from risk transfer, the securitization process could be used for capital
relief purposes. In the early 1980s, when private market mortgage secu-
ritization was relatively new at Salomon Brothers, Lewis Ranieri claimed
that securitization reduced the average cost of mortgages by 200 basis
points. In 2010, he headed Ranieri Asset Management and claimed,
“Securitization is not the villain. Abuses in securitization are to blame.”2
Ranieri went on to say, “If Fannie Mae and Freddie Mac had stayed
with their strict underwriting standards, and never broadened to toler-
ate Alt-A or subprime lending, the market would never have supported
the more risky lending that became so prevalent in 2005–2008.” James
Rokakis (FCIC Report 2011) told the commission that securitization
“…freed up a lot of capital. If it had been done responsibly, it would
have been a wondrous thing because nothing is more stable, there’s
nothing safer, than the American mortgage market. It worked for years.
But then people realized they could scam it.”
The growth in securitization which fueled the credit boom, in fact, did
not lead to a diverse distribution of risk across the system. In theory, due
to securitization some assets could potentially be worth more off-balance
sheet as securitized products than on the balance sheet. An important
lesson gleaned from the financial crisis is that the securitization structure
itself represented a major source of risk. It became impossible for investors
to ascertain cash flow patterns and disruptions to the mechanism because
of complex and opaque structures.
Solomon (2012) argues that the decision-making process became dis-
torted because the originator could externalize the default risk onto credi-
tors, and hence securitization became the preferred choice of financing.
As we have seen in Chap. 1, certain kinds of loans and products were
securitized on a massive scale prior to 2007. There was a huge demand
for securitized products especially by institutional investors (mutual funds
and pension funds could only invest in AAA products). One benefit is that
it increased the volume of available loans but an unintended consequence
was a fueling of both predatory lending and the amplification and disper-
sion of risks arising from bad loans. We also saw that for a number of finan-
cial institutions which utilized securitization, much of the risk stayed on
balance sheets. This could be in a number of forms: (i) The banks holding
on to retained tranches (the riskiest tranche); (ii) trading books held large
SECURITIZATION AND RISK TRANSFER 113
portfolios of asset-backed securities (ABS); (iii) hedges against monoline

insurers in the form of negative basis trade portfolios; and (iv) off balance
sheet exposures via the banks support for SIVs or asset-backed commercial
paper (ABCP) conduits.
The risks arising in a securitization transaction include, but are not lim-
ited to: credit risk; liquidity risk; market risk; prepayment risk; agency risk
between the various participants in the securitization process; interest rate
risk; currency risk; sovereign risk; legal and governance risks; counterparty
risks; servicing risks; and risks of an operational nature. Additionally, vari-
ous risk estimation issues are associated with securitization—especially the
underestimation of the correlation of the performance of lower-rated resi-
dential mortgage-backed securities (RMBS) tranches underlying CDOs
along with the overestimation of the quality of loans. Various risk man-
agement techniques for ABS included: credit enhancement; sovereign
protection; cash flow reallocation; liquidity support; cash reserves overcol-
lateralization; and interest/currency hedges.
Kolb (2011) explores the distributive justice aspects of risk manage-
ment and finds the business sector generally fails to consider the important
normative dimension of who bears the risk and how that risk is transferred.
There are five types of social risk management that Kolb (2011) considers:
mitigation; diversification; voluntary transfer of risk to others; involuntary
transfer through deceit; and involuntary transfer through the excessive
use of power. No special ethical problems are posed through either the
mitigation or the diversification of risk. Nor should there be any special
ethical problems posed through the voluntary transfer of risk since both
counterparties should have a full understanding and knowledge of the
risks being exchanged and transferred. However, there are ethical prob-
lems posed when there is an involuntary transfer thorough deceit and/
or excessive use of power (Boatright 2010; Buchanan 2015b) document
that because financial innovation is often inherently opaque, the dangers
and risks are difficult to perceive. Due to the opaque nature of the secu-
ritization process, investors were often unaware of the risk shifting taking
place. Gabaix et al. (2006) describe such a strategic misrepresentation to
the purchaser as “shrouded attributes” and this may well apply in the case
of securitization ethics. Former US Treasury Secretary and chairman of
investment bank Goldman Sachs, Henry Paulson, states that securitization
contributed to the overleveraging that led to the crisis because it “sepa-
rated originators from the risk of the products they originated.”
114 B.G. BUCHANAN
1 Risk Management and Securitization
This crisis is no exception in the sense that in the aftermath an examina-

tion of flawed incentives an ethical lapses is inevitable (Scalet and Kelly
2012; Donaldson 2012; Kolb 2011; Graafland and van de Ven 2011;
Boatright 2010; Buchanan 2014, 2015b). Boatright (2010) argues that
because financial innovation is often inherently opaque, the risks are dif-
ficult to perceive. At the height of the securitization bubble in 2006 there
was a wide range of securitized products, or what came to be known as
the “alphabet soup”. The structured products could be created according
to different risk tiers.
How the alphabet soup could be manufactured after 2001 became
increasingly more complex. For example, tranches from one mortgage
pool could be combined with tranches from other mortgage pools, thus
creating a collateralized mortgage obligation (CMO).3 Or a collateralized
loan obligation (CLO) could be produced by combining tranches from
completely different types of pools, based on commercial mortgages, auto
loans, student loans, credit card receivables, small business loans, and even
corporate loans. Collateralized debt obligations (CDO) ended up being
highly heterogeneous debt securities produced by combining the tranches
of the CDOs with other CDO tranches. This resulted in CDO2.
Two of the most common mistakes examined in the securitization liter-
ature include (1) investors underestimated the probability of defaults and
(2) the correlation of these defaults. In a healthy economy, default cor-
relations tend to be very low but in a recession they will increase, making
the assessment of idiosyncratic risk less reliable. During the securitization
boom, financial engineers came up with more elaborate and complicated
ways of exploiting correlation structures designed to address the prob-
lem, how likely is it that one default would trigger others? The Gaussian
copula function (Li 2000) measures the degrees of dependencies of dif-
ferent kinds among a group of variables. Many financial institutions soon
adopted this model to develop “correlation trading” despite Li’s warn-
ing against a one-size-fits-all template. This introduced new risks into
the financial system. Because the correlation trading models have been
designed in a similar manner, many of them contained the same default
triggers leading to simultaneous defaults after 2007.
Another example is the securitization of non-standardized mortgages
and risk amplification. Consider the pay-option adjustable rate mortgage
(or pay-option ARM). This is a very highly leveraged mortgage i nstrument.
The borrower can choose how fast to amortize the principal and thus
interest rate risk is shifted to the borrower. If the borrower exercises the
option to defer part of the interest then that deferred interest is added to
the borrower’s outstanding balance. The loan has become riskier, and the
borrower’s leverage has increased. But what if these mortgages are then
bought by a SPV which funds the securitization process with senior, sub-
ordinate, and residual securities? The subordinate class is not only lever-
aged but also funds a disproportionate part of the pool’s credit risk. Since
the pay-option ARM negatively amortizes, the credit risk increases over
time, adding more risk to the financial system.
The huge volume in available loans prior to 2007 fueled predatory
lending and the amplification and dispersion of risks arising from bad
loans. Consider the collateralized debt obligation (CDO). Originally this
market had been based on junk bonds in the late 1980s. However, after
2001 the demand for securitized products escalated. Low investment
grade tranches [think of BBB mortgage-backed securities (MBS)] were
repackaged into a new CDO—a resecuritized product. Despite the fact
600000
500000
U
S
D 400000
M
i
300000
l
l
i
200000
o
n
s
100000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
Fig. 4.1 Global CDO issuance

116 B.G. BUCHANAN
that the CDO was based on lower rated tranches of MBS, 80 percent of
the CDO market received a triple A rating (FCIC Report 2011). The
growth of the CDO issuance market is displayed in Fig. 4.1.
As the CDO market approached its peak volume in 2006, the US cur-
rent account deficit approached 6.25 percent of GDP. To finance this
debt, the US needed to attract 70 percent of the world’s capital flows
(Rajan 2010). With US interest rates at historical lows, these higher yield-
ing (and riskier) CDO instruments became more attractive. After 2004,
demand for CDOs surged and gave rise to synthetic securitized products,
namely CDO2 and CDO3. Effectively the CDO boom “created the inves-
tor” (FCIC Report 2011).
2 Ethics of Risk Transfer: Originate-to-

Distribute Model
Ethical problems emerge when the transfer of risk involves asymmetric
information, deception, or the exercise of power. Consider the shift from
the Originate-to-Hold (OTH) to Originate-to-Distribute (OTD) model.
Under the OTH model, the creditworthiness of potential borrowers
was verified by issuers who had the incentive and responsibility to do so
because the issuers held the loans on their books and subsequently bore
the full risk of default. There was a shift in risk responsibility under the
OTD model. Now the originator and security packager were often the
same entity. The originating financial institution is now incentivized to
boost return on equity by turning over its balance sheet more frequently.
This is achieved by moving more loans off its balance sheet and securitiz-
ing those loans. The institution that initially made the loan no longer has
to care whether or not the borrower can repay the loan and only bears
the risk for the amount of time between making the initial loan and the
moment it sells the security. In the resulting securitization the financial
institution may have only borne the risk for a number of days (Lanchester
2014).
Under the OTD model the financial institution has no real interest
in the financial condition of the borrower. The risk responsibility now
shifts to the ratings agencies and ultimate investors around the globe.
Securitization transactions are believed to have created moral hazard
problems because originators did not have to live with the credit conse-
quences of their loans. The increase in volume of originated loans would
lead inevitably to an increase in fees generated. When employees were paid
for booking loans there was an incentive to boost the volume of loans. The
ratings agencies also had skewed incentives (Scalet and Kelly 2012) due
to the information and servicing payments supplied by the securitization
originators.
The OTD model tended to present a false sense of confidence that
risks were understood and being effectively managed. Tett (2009) quotes
Charles Pardue:
I don’t think we should kid ourselves that everything being sold is fair value.
I have been to dealer events where bankers are selling this stuff, and the sim-
plicity of the explanation about how it works scares me … there are people
investing in stuff they don’t understand, who really seem to believe the
models, and when models change, it will be a very scary thing.
The OTD model transformed the incentives for securitization participants,

particularly lenders. It did so by undermining accountability and respon-
sibility for the long-term viability of MBS and continued to exacerbate
the poor quality of loans. In this crisis, investors also did not seem to real-
ize the responsibility for understanding and assessing the risk of subprime
mortgages was now in their hands. Mian and Sufi (2009) note a negatively
correlated relationship between credit growth and income growth. They
determine that the rate of securitization is much stronger in subprime ZIP
codes where the default patterns are subsequently quite high.
Furthermore, a combination of herd mentality and complacency also
explained the lowering of investing standards. Cheng et al. (2014) study
the individual purchase behavior of mid-level Wall Street managers who
worked directly in the mortgage securitization business. They find that
securitization mid-level agents neither managed to time the market nor
did they exhibit cautiousness in their home transactions. The results apply
especially for those agents living in the “bubblier” areas of the USA and
the agents may have been rather susceptible to the potential source of
belief distortion. This could include job environments that encourage
group thinking, cognitive dissonance, and other sources of overoptimism.
It also raises the crucial question: What happens when you break the link
between originator and lender? (Soros 2008) claims that securitization became
a “mania” around 2005: “Securitization was meant to reduce risks through
risk-tiering and geographic diversification. As it turned out, they increased the
risks by transferring ownership of mortgages from bankers who knew their
customers to investors who did not.” In summary, not all the conditions for
transferring and managing risk were met, creating ethical problems.
118 B.G. BUCHANAN
3 The CDO Market and the Ethics of Risk

Transfer
So where do CDOs fit into the ethics of risk transfer story? Problems of
distributive justice in risk transfer are also well illustrated in the manufac-
ture of CDOs and synthetic instruments such as CDO2 and CDO3. In the
late 1980s, Drexel Burnham Lambert assembled CDOs out of various
companies’ junk bonds and investors then picked their preferred level of
risk and return from the tradable securities. In 2001, American Express
announced a $26 million loss from CDO-related investments. American
Express had been carrying out these resecuritizations since 1997 but the
company head admitted the firm did not fully comprehend the risk of
the CDO investments.4 Moody’s then went on to announce that 58 per-
cent of synthetic CDOs had exposure to Enron, Global Crossing, and
WorldCom. Despite this when the housing market began to surge after
2001, the demand for securitized products accelerated and CDOs were
no exception (Tett 2009; Boatright 2010).
Since 2001, the securitization structure of the CDO market had
become increasingly complex and opaque. For example, recall the earlier
discussion of how CDOs could be constructed from mixing together dif-
ferent tranches. Each time the tranches are mixed together with other
tranches in a new pool, the securities become more complex. For example,
assume a hypothetical CDO2 held 100 CLOs, each holding 300 corporate
loans, and then we would need information on 30,000 underlying loans
to determine the value of the security. However, assume that CDO2 holds
100 CDOs and each of those holds 100 RMBS comprising 5000 mort-
gages. The number now rises to 50 million mortgages.
Thus, issues could now create CDOs of ABS from mezzanine tranches
which were bundled up and resecuritized. Wall Street bankers would take
the low investment grade tranches (think of the BBB MBS) and repackage
them into new securities, namely a CDO. So it really became a securiti-
zation of a securitization. Eventually, 80 percent of the CDO tranches
would be rated triple-A despite the fact that they generally comprised the
lower-rated tranches of MBS (FCIC Report 2011). CDO securities would
then be sold with their own waterfall structures. The CDO market was
controlled by six or seven issuers. Out of this market came the synthetic
securitized products namely the CDO2 and CDO3. A CDO2 is produced
from the low investment grade CDO tranches and put through the secu-
ritization process again. Then the low investment grade CDO2 tranches
are put through the process again to produce CDO3. The rise and fall of
the global CDO market is displayed in Fig 4.1, and it is clearly evident this
segment is struggling to rebound. From the above description it quickly
emerges that with the creation of synthetic CDOs the securitization pro-
cess started to achieve quite bizarre levels of complexity. Therefore it is not
surprising that the securitized products came to be thought of colloquially
as an “alphabet soup”.
MBS and CDOs created further leverage because they were initially
financed with debt. The original mortgage creates leverage particularly
when the loan is low on down payments and a high loan-to-value ratio.
With synthetic securitized products, CDOs purchased as collateral in cre-
ating other CDOs creates another round of leverage. The CDO backed
by MBS that in turn was backed by mortgages creates another level of
leverage. Credit default swaps (CDSs) applied to securitized products in
the 1990s played a central role to the securitization market, especially to
investors. A firm wishing to reimburse its credit risk gets a counterparty to
take on that risk, the risk of default, and effectively pays a premium to it
to do so. The counterparty buys a CDS from another firm (AIG was the
most famous example (Tett 2009)). The default risk does not necessarily
stay with the original seller because these products can be freely traded.
What emerges out of the CDO market prior to the crisis is opaqueness
and complexity, making risk assessment extremely difficult. If the risk is
properly priced by the market and the market remains liquid then it is
sound, otherwise it indicates unethical factors may be present and this was
the case with CDOs.
Another way of considering the complexity of CDO related products is
to calculate the number of pages of documentation for a prospective inves-
tor. Haldane (2009) considers a diligent investor attempting to understand
securitized products. Table 4.1 provides data on the level of documentation
Table 4.1 Climbing the securitization complexity tree—Typical contract

details
[1] Pages in CDO2 prospectus 300

[2] Pages in ABS CDO prospectus 300
[3] Pages in RMBS prospectus 200
[4] Number of ABS CDO tranches in CDO2 125
[5] Number of RMBS in a typical CDO 150
[6] Number of mortgages in a typical RMBS 5000
Source: Haldane (2009)

120 B.G. BUCHANAN
for a prospective RMBS investor, which is relatively straightforward, approxi-

mately 200 pages (assuming there are 5000 mortgages in a typical RMBS).
However, the complexity of documentation quickly escalates for a prospec-
tive CDO2 investor.
Using the sample data in Table 4.1, the approximate number of pages
to read for a CDO2 investor equals:
Pages in CDO2 prospectus + [(pages in RMBS prospectus) * (no. of

RMBS in CDO) * (pages in ABS CDO prospectus) * (no. of ABS CDO
tranches in CDO2)]
= [1] + [3]*[5]*[2]*[4]
= 300 + [200*150*300*125] pages
= 1,125,000,300 pages.
So to truly comprehend the components of a CDO2 in this case, the inves-

tor would need to read in excess of one billion pages.
After August 2007, many securitized products were extremely difficult to

price as trading was drying up and write-downs were being declared.
There was a lack of market prices on products such as CDOs and CDO2
and so valuation on the books of banks became doubtful and coun-
terparties became reluctant to deal with each other. However, if one
considers the following example from the WSJ, it is not surprising that
the securitized products were difficult to price and that trading dried
up due to so much product complexity and uncertainty about future
performance.
A 2009 WSJ article5 examines the details of several CDOs using

SecondMarket data.6 The authors provide an example of a $1 billion
CDO2 created by a large bank in 2005. The CDO2 had 173 invest-
ments in tranches issued by other pools, specifically 130 CDOs and
43 CLOs each composed of hundreds of corporate loans. There were
numerous tranches in the issue—$975 million of four AAA tranches
and three subordinate tranches priced at $55 million. The AAA tranches
were bought by banks and the subordinate tranches mostly by hedge
funds. Two of the 173 investments held by this CDO2 issue were in
tranches from another billion-dollar CDO that had been created by
another bank earlier in 2005. The earlier issue was composed of 155
MBS tranches and 40 CDOs. Two of these 155 MBS tranches were
from a $1 billion RMBS pool created in 2004 by a large investment
bank, composed of almost 7000 mortgage loans (of which 90 percent
were subprime loans). In this RMBS issue there were $865 million of
AAA notes, about half of which were purchased by the Federal National
Mortgage Association, Fannie Mae (FNMA) and the Federal Home
Loan Mortgage Association, Freddie Mac (FHLMC) and the rest by
a variety of banks, insurance companies, pension funds, and money
managers. As of the WSJ writing in 2009, 1800 of the 7000 mort-
gages remained in the pool, with a delinquency rate of approximately
20 percent.
One of the disadvantages about securitization mentioned before is that

default correlations that are low in a healthy economy may become very
high during a recession and this means that the attempt to diversify
idiosyncratic risk becomes less reliable. During the housing and securiti-
zation boom financial engineers were attempting to come up with more
innovative ways of exploiting correlation structures. That is, how likely
is it that one default would trigger others? The most famous example
was the increasing use of the Gaussian copula model. Li (2000) mea-
sured the degrees of dependencies of different kinds among a group
of variables but warned against a one-size-fits-all model. Despite this
warning, many banks adopted the Gaussian copula model as a template
and soon developed “correlation trading” and this in turn introduced
new risks into the financial system. The main problem this presented
was that all structures were now being designed in a similar manner and
contained the same default triggers. So this meant if there was a trigger
event, then many financial institutions would simultaneously default.
And relatively recent historical episodes tell us that this is not the first time
that such correlation trading has gone awry. At the turn of the century
multi-sector CDOs were constructed based on loans that were assumed
to have low correlations with respect to each other. Yet in 2002 after the
dot.com bust, 9/11, and large defaults in the mobile home loan mar-
ket, the multi-sector CDO market experienced write-downs. Backed by
mortgages, mobile home loans, aircraft leases, and mutual fund fees and
defaults in these markets happened simultaneously, causing losses in the
multi-sector CDO market.
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4 Securitization Déjà Vu

In terms of shifting risk responsibility, is this time different? Not really.
Buchanan (2014) states that this shifting of risk responsibility has
occurred before in early attempts to introduce a mortgage bond mar-
ket to the nineteenth-century US financial market. While securitization
can potentially provide a low-cost form of efficient financing, some of the
risk and unsustainability issues we have observed during this crisis have
occurred before. For example, in 1994 the Askin hedge fund had a $2
billion CMOs position.7 The Federal Reserve raised interest rates half a
percent in the same year, reducing the value of fixed income assets. Askin
was forced to sell some of the fund’s investments but discovered there
was little demand and the CMO market ground to a halt as market prices
plunged lower. Final total losses in the CMO failure were approximately
$55 billion (or approximately 5 percent of a trillion dollar market at the
time) (Morris 2008). In the aftermath, allegations were made regard-
ing valuation difficulties surrounding the toxic waste associated with the
CMOs. Kidder Peabody was a major participant in the CMO market at
this time and incurred massive losses. The market started to recover in
1996 and the initial response was the creation of a more conservatively
structured RMBS market.
In 2001, American Express announced a $26 million loss from CDO
related investments. American Express had been carrying out these rese-
curitizations since 1997 but the company head admitted the firm did not
fully comprehend the CDO’s risk.8 Moody’s then went on to announce
that 58 percent of the synthetic CDOs had exposure to Enron, Global
Crossing, and WorldCom. The events at Enron challenged regulators
to reexamine the role of off-balance sheet vehicles in hiding Enron's
liabilities.
Earlier in the chapter I stated a reason provided for undertaking
securitization is to exploit correlation properties between asset classes.
Yet attempts to diversify idiosyncratic risk may become rather illusory
in nature if the default correlations that are low in a healthy economy
become very high during a recession. This problem was revealed in
2002 in the multi-sector CDO market which experienced write-downs
after the dot.com bust, 9/11, and large defaults in the mobile home
loan market. The CDOs were backed by mortgages, mobile home loans,
aircraft leases, and mutual fund fees and defaults in these markets hap-
pened simultaneously, causing losses in the multi-sector CDOs. These
asset classes were assumed to have relatively lower correlations but they
spiked during the 2002 recession. Despite this the CDO market contin-
ued to prosper until 2007.
The recent financial crisis is not the first time controversy over cash
CDOs versus synthetic CDOs has occurred. In 2002, the Head of the
UK Financial Services Authority, Howard Davies, described synthetic
CDOs as “the most toxic element of the financial markets today.”9 Cash
CDOs have collateral of bonds or loans whereas synthetic CDOs contain
credit derivatives such as CDSs. In 2004, the UK bank, Barclays, was fac-
ing legal proceedings from one of its CDO investors, HSH Nordbank. A
German Landesbank, HSH Nordbank, was seeking compensation over
losses it claimed it suffered regarding a $151 million investment in syn-
thetic CDOs arranged and managed by Barclays Capital. The losses were
incurred as a result of investment in aircraft leases. HSH Nordbank and
Barclays eventually settled out of court in 2005.
The LTV Steel case represents an extremely powerful challenge to the
notion of a “true sale” to a SPV in the securitization market (Fabozzi
2005). The issue of “true sale” is very important in the event that the
originator of the SPV’s assets goes bankrupt. If the arrangement is not
deemed a “true sale” then it is termed a secured lending arrangement.
With a true sale, the originator shifts all the risks to the SPV. A secured
loan usually suggests that if investors have any recourse against the origi-
nator or if he risk shifts from the SPV to the originator. If the seller ever
files for bankruptcy, then “bankruptcy remoteness” means that the col-
lateral is removed from its bankruptcy estate. At the time of the LTV Steel
case there did not appear to be any case law directly addressing whether a
contested securitization transaction is a sale or secure financing. The LTV
Steel case challenged the bankruptcy remoteness concept and indeed chal-
lenged the legal foundation of the ABS industry (Strak 2002).
Prior to its Chapter 11 filing, LTV Steel was one of the US’ largest steel
companies. As of September 30, 2000, LTV Steel had $5.8 billion in assets
and $4.7 billion in liabilities. In addition to this the company had a work-
force of 17,500 people, 100,000 retirees who depended on LTV Steel
for its medical benefits, and the company made a profound impact on the
economy of northern Ohio. Regarding its securitization arrangements,
LTV Steel established two structured financing arrangements. The first
was set up in 1994 when LTV Steel created a wholly owned corporation;
LTV Sales Finance Co. to serve as the SPV. LTV Sales Finance Co. securi-
tized all the accounts receivable for LTV Steel. The issue received an AAA
rating and UK bank, Abbey National, was a major investor.
124 B.G. BUCHANAN
In 1998 a second structured finance arrangement was established.

The SPV was called LTV Steel Products and LTV Steel sold its inven-
tory (including raw materials to be manufactured into saleable goods) to
this SPV. The issue received a BBB rating from Fitch Rating, suggesting
a riskier investment. A consortium of banks led by Chase Manhattan was
the major investor.
The company filed for bankruptcy on December 29, 2000, and dur-
ing the legal proceedings the bankruptcy remoteness concept was chal-
lenged. Here is the dilemma LTV Steel faced: If it declared Chapter 11
bankruptcy protection and if it no longer owned its inventory and receiv-
ables, then how could the company restructure its liabilities and obtain
new financing? The company needed cash. Nor could it compel the SPVs
to seek Chapter 11 protection. Neither of the SPVs filed for bankruptcy
protection. LTV Steel argued that the securitizations did not represent
true sales and therefore the company was entitled to the cash flows that
had been transferred to the SPVs.
On the first day of the LTV Steel case, the bankruptcy court disassem-
bled the ABS structure, and exerted authority over the assets that purport-
edly belonged to the SPVs and permitted the debtors to use the assets on a
postpetition basis. Abbey National disputed the ruling by arguing that the
bankruptcy court lacked the jurisdiction over both SPVs had overstepped
its boundaries by allowing debtors to use the SPV’s property. The bank-
ruptcy court denied the motion.
This was the first time an ABS structure was tested in a bankruptcy
context. It is also an unusual case because LTV Steel had placed all of its
assets that could readily be converted into cash into the SPVs. This left
only large illiquid assets such as aging machinery and mills, which are not
the preferred assets a bank wants to take as collateral. Also, if the court
resolved the case in Abbey National and the bank consortium’s favor, then
this would have massive socio-economic consequences. The mills would
cease operations, thousands would become unemployed, thousands of
retirees would lose their medical benefits, and there would also possibly
be an increase in bankruptcy filings in northern Ohio, since many other
businesses depended on LTV Steel.
The survival of LTV Steel depended on the true sales argument.
Eventually, the parties settled prior to the final court decision. Although
LTV Steel could use the cash flows, there was a summary finding that the
securitizations did represent true sales to the SPV (Fabozzi 2005).
Additional concerns over litigation risk were also raised when Conseco
Finance Corporation (a major originator of manufactured housing loans)
declared bankruptcy in December 2002. This was the third largest bank-
ruptcy filling in US corporate history (after Enron and WorldCom). At the
time of its bankruptcy Conseco had been servicing its securitizations for a
50 basis point servicing fee. The controversies centered on the cash flow
waterfall, which the bankruptcy court altered without consent (a trust-by-
trust basis is required of all the note holders) and the servicing contracts.
The court ruled that a 50 basis point servicing fee was inadequate and
ordered the fee be increased to 115 basis points. Additionally, by chang-
ing the waterfall cash flow structure the bankruptcy court avoided the
documenting and legal protections that were assumed to apply to ABS
investors.
Asset-backed security returns depend on whether borrowers will be
able to service their loans. Arnold and Buchanan (2009, 2010) reinforce
this danger of breaking the link between the originator and lender in
their analysis of Heilig-Meyers’s securitization of accounts receivables.
Once the largest furniture retailer in the USA, Heilig-Meyers had been
experiencing cash flow problems prior to 1998 and in order to acceler-
ate cash flow, Heilig-Meyers decided to securitize its accounts receiv-
able. The company held the riskiest tranche of a financial product that
was securitized with low-quality loans, or what is termed toxic waste.
In 2000 a sudden downgrading in ratings was the result of significant
portfolio deterioration following a controversial servicing transfer. The
servicing transfer became controversial because borrowers were usually
assessed on individual store credit scoring models and made payments
at individual retail locations. Problems arose when Heilig-Meyers shut
its doors during bankruptcy proceedings. The accounts receivable cer-
tificates defaulted once stores began closing. Even if borrowers wanted
to repay their debt, there was no store open to make a payment.
Consequently, in 2001, Heilig-Meyers became the first company in
which the senior notes of ABS suffered a principal loss. In addition, by
2000, an estimated one out of nine bankrupt Americans owed money
to Heilig-Meyers. In 2003, Union Bank and Bank of America were
accused of misreporting the credit quality of Heilig-Meyers’s ABSs.
First Union settled out of court and in late 2008 the plaintiffs (includ-
ing AIG) were awarded $141 million in damages from the Bank of
America case.
126 B.G. BUCHANAN
5 Is Every Asset a Suitable Candidate

for Securitization?
Securitization of more esoteric sources, such as cash flows from solar pan-
els and home rental income have picked up since the financial crisis. Yet it
raises the question, is every asset necessarily a suitable candidate for secu-
ritization? To satisfy these criteria, the assets must be sufficiently strong to
support a high credit rating without the backing of the originating lender.
More specifically, the prospective asset pool should have a stable history
of rate, delinquencies, prepayments, and default data. To facilitate such a
statistical analysis, the asset volume should be sufficiently large and homo-
geneous. The prospective asset also needs to be unencumbered and trans-
ferable. The asset pool also should be sufficiently diversified in terms of
geography and socio-economic characteristics in order to reduce exposure
to economic stresses. In the next two sections, I discuss the securitization
of life insurance settlements and future flow securitizations.
6 Life Insurance Settlements

A senior life settlement is a contract that provides a way for the very old,
or terminally ill, holder of a life insurance policy to liquidate it and obtain
cash prior to death. In the aftermath of the financial crisis a 2009 New
York Times article described a growing life insurance settlements securi-
tization market.10 The article detailed how Wall Street investment banks
were planning to buy life settlements then securitize thousands of policies
together into bonds. The bonds would then be resold to investors such as
pension funds and other big investors. Life insurance companies use the
securitized bonds to hedge their portfolios provided to individuals against
the risk of premature death. The securitized bonds would then generate
an income stream from the insurance payouts that come due when the
original policyholders die. The Wall Street bank would profit from fees for
creating the bonds, reselling them, and subsequently trading them.
Senior life insurance policies were first securitized in 2004 (Stone and
Zissu 2006). Whereas MBS are primarily affected by prepayment rates, life
insurance settlement securitizations are impacted by death rates. In this
case, the key risk to quantify is “longevity risk,” the risk that an insured
person will live longer than their actual expected life span. The earlier
the original policyholder dies, the bigger the return on the securitized
bond. Yet if a life settler lives longer than expected (according to actuarial
c alculations) then the value of a securitized portfolio decreases, so inves-

tors could potentially lose money. With $26 trillion worth of life insurance
policies in the USA at the time, the 2009 New York Times article drew
comparisons with the overzealous securitization of subprime mortgages
(Hamilton 2010). The New York Times article subsequently generated
an unusually high number of reader comments,11 which criticized greed
and the misaligned incentives created by the process. It also raised impor-
tant questions about rational decision making and ethics. Nurnberg and
Lackey (2010) warn of the ethical dimensions of securitizing life insurance
settlements. Hamilton (2010) summarizes life insurance securitization as
“…it appears that large-scale securitizations of viatical settlements are at
best a modest profit endeavor and at worst a profit mirage analogous to
the mortgage market meltdown”.
7 Future Flow Securitizations

In 1997 a major turning point in modern securitization occurred. Up until
then both MBS and ABS were based on a pool of revenue streams cur-
rently flowing from existing mortgage loans, car loans, and student loans,
etc. In 1997, intellectual property (IP) securitization changed the indus-
try—most famously when David Bowie securitized his rights (for approxi-
mately 10 years) to the future income stream of 25 of his albums. The
intention behind this was to raise acquisition capital the singer required.
The resultant “Bowie Bonds” had no associated underlying existing loans
(as opposed to ABS and MBS, which are based on a verifiable income
stream from existing receivables or loans). Other artists and companies
who have utilized IP securitization include: Iron Maiden, Rod Stewart,
Dreamworks, Calvin Klein, and Sears.
IP securitizations are also known as future flow securitizations (FFS).
IP securitization principles are also applicable to small and medium-sized
enterprises (SMEs) (Beck and Demirguc-Kunt 2006). The support the IP
securitizations have found include: (1) it is a good way for non-investment
grade companies to obtain investment grade financing, (2) it is a useful
way for a company to raise funds without diluting company equity owner-
ship, and (3) it is borderless, not just limited to large company use. Yet
it remains that many global IP securitizations are non-recourse with no
postsecuritization liability for the issuing firm. In a postcrisis era, where
there is a call for issuers to be “on the hook” or have some recourse, this
can also be perceived as a disadvantage of IP securitization. The risk of IP
128 B.G. BUCHANAN
securitizations is that it also tends to be more speculative than ABS and

MBS. The expectation the future sales may not eventuate is what makes an
IP securitization riskier, adversely impacting investors.
A criticism coming out of the recent financial crisis is a focus on short-
termism; especially short-term debt and profits. This same criticism could
also be made of IP securitization. Taylor et al. (2009) identify the follow-
ing IP/brand securitizations risks: liquidity risk, event risk, moral hazard
risk, and brand risk. In the last case, Taylor et al. (2009) compare brand
securitization with the recent subprime bubble. If a brand has been secu-
ritized there may be very little incentive to monitor the brand or protect
it. In the high-risk subprime mortgage bubble, originators became lax at
verifying borrowers’ true credit and income background and once the
subprime loans were securitized, the originator was no longer on the hook
for the poor loan. Another example of FFS that has shown great potential,
particularly in emerging markets is remittance securitizations.
The long-term sustainability of securitization requires further examina-
tion from a number of perspectives. As extensive global reform of secu-
ritization markets is implemented a better understanding of risk transfer
in necessary. At its height in 2006, securitization did not so much involve
diversifying risk as its wholesale transfer. Because the technology was so
opaque (Pasquale 2015), counterparties could not fully comprehend what
they were buying and secondly there was the transfer of “toxic rules”
(aided with excessive leverage) through the financial system. While secu-
ritization can potentially provide a low-cost form of efficient financing,
some of the risk-related problems we have observed in this crisis have
occurred before.
As extensive global reform of securitization markets is implemented a
better understanding of risk transfer is necessary. At its height in 2006,
securitization did not so much involve diversifying risk as its wholesale
transfer. Because the technology was so opaque (Pasquale 2015), counter-
parties could not fully comprehend what they were buying and secondly
there was the transfer of “toxic rules” (aided with excessive leverage)
through the financial system.
Jacobs (2009) distinguishes between risk sharing and risk shifting. He
describes risk sharing to be the combining of risk exposures in such a way
that the components offset each other in some way. Risk shifting oper-
ates by moving risk from one party to another party. In the OTH model,
if there was a decline in home value, the risk shifted from the borrower
to the mortgage lender. While securitization was originally intended to

increase funds available for prime mortgages and to reduce risk, it also
became a technique for mortgage lenders to shift risk. And this became
more prevalent with the rise of the subprime mortgage market after the
1990s. Subprime securities carried higher interest rates which made them
particularly appealing candidates for securitization and resale. Borrowers
also tended to take out second mortgages, or piggyback loans, to cover
down payments and so this additional leverage (with little or no equity in
the home) heightened the risk, especially as it was shifted off the mortgage
lender’s balance sheet and through the global financial system.
8 Mini-Case from the Global Financial Crisis
8.1 GSAMP Trust 2006-S3

The GSAMP Trust 2006-S3 was a $494 million product issued by Goldman
Sachs and represents a fraction of the more than half-a-trillion dollars of
MBS issued in 2006.12 GSAMP was just one of 83 mortgage-backed issues
totaling $44.5 billion that Goldman sold during 2006. GSAMP origi-
nally stood for Goldman Sachs Alternative Mortgage Products but quickly
became synonymous with the junk mortgages that became infamous early
on in the financial crisis.
In 2006, Goldman Sachs assembled 8274 second-mortgage loans origi-
nated by Fremont Investment & Loan, Long Beach Mortgage Co., and
other mortgage lenders. More than a third of the loans were in California, a
market of high price appreciation at the time. At first glance GSAMP 2006-
S3 appeared to be a fairly straightforward deal, one of the 916 residen-
tial mortgage-backed issues totaling $592 billion that were sold in 2006.
However, closer inspection of the GSAMP issue reveals that the average
equity that the second-mortgage borrowers had in their homes was 0.71
percent. This means that average loan-to-value of the issue's borrowers was
99.29 percent. Furthermore, approximately 58 percent of the pool was
based on loans that were either no-documentation or low-documentation.
It was also unclear whether borrowers' incomes or assets bore any serious
relationship to what was declared to the mortgage lenders. Owner-occupier
loans are considered less risky than loans to speculators and 98 percent of
the GSAMP borrowers said they were occupying the homes they were bor-
rowing on, but no one knows if that was actually true.
130 B.G. BUCHANAN
Goldman acquired second-mortgage loans and assembled them

together as GSAMP Trust 2006-S3. When it came to making the secu-
ritized assets sellable, Goldman sliced and diced the $494 million of sec-
ond mortgages into 13 separate tranches. The top tranches, named A-1,
A-2, and A-3, carried the lowest interest rates and the least risk, and was
valued at a total of $336 million. Next in line to get paid, and carrying
progressively higher interest rates, was the $123 million of intermediate
tranches—M (for mezzanine) 1 through 7. Finally, Goldman sold two
non-investment-grade tranches. The B-1 tranche (priced at $13 million),
went to the Luxembourg-based Absolute Return fund. Aimed at non-US
investors, this GSAMP tranche spread GSAMP's problems beyond US
borders. The second non-investment grade tranche, B-2 (priced at $8 mil-
lion), went to the Morgan Keegan Select High Income fund. Goldman
appears to have kept the 13th slice, the X tranche, which had a face value
of $14 million as its fee for assembling and completing the deal.
Despite the fact that the individual loans in GSAMP looked like
financial junk or “toxic waste”, 68 percent of the issue, or $336 million,
ended up being rated AAA by the credit ratings agencies. This meant it
was perceived to be as safe and secure as US Treasury bonds. A further
$123 million, 25 percent of the issue, was rated investment grade, at
levels from AA to BBB−. Thus, a total of 93 percent of the GSAMP
issue was rated investment grade. Just recall, that is despite the fact
that this issue was backed mainly by dubious quality second mortgages
on homes in which the borrowers (of whom most made income and
financial assertions that were low or no documentation) had less than 1
percent equity.
Less than 18 months after the GSAMP2006-S3 issue was floated, a
sixth of the borrowers had already defaulted on their loans. Investors who
had paid face value for these securities suffered heavy losses. This is due
to the fact their GSAMP securities had either defaulted (for a 100 percent
loss) or had been downgraded by credit rating agencies, further depress-
ing the securities' market prices.
By February 2007, Moody’s and S&P were already downgrading the
GSAMP issue. Both agencies dropped the top-rated tranches all the way
to BBB from their original AAA, depressing the securities’ market price
substantially. In March 2007, less than a year after the issue was sold,
GSAMP began defaulting on its obligations. By the end of September
2007, 18 percent of the loans had defaulted. As a result, the X tranche,
both B tranches, and the four bottom M tranches had already been
wiped out,
9 The Financial Crisis and CDO Lawsuits

Of course, many wonder if some securitized instruments were too com-
plex for investors to fully understand their downside risks. In numerous
media and regulatory accounts, synthetic CDOs are credited with con-
tributing to the downturn by magnifying losses. Consider the Goldman
Sachs ABACUS 2007-AC1 deal which was completed in April 2007.13 In
its promotional literature prior to 2007 Goldman Sachs had stated:
“The ability to structure and execute complicated transactions to meet mul-

tiple clients’ needs and objectives is key to our franchise” and “executing this
transaction [that is, ABACUS] and others like it helps position Goldman to
compete more aggressively in the growing market for synthetics written on
structured products.”
ABACUS refers to a series of synthetic CDOs whose performances were

tied to RMBS. Actually, the deal was structured around three primary
instruments: RMBS, synthetic CDOs and CDS. Synthetic CDOs do not
own the underlying assets and unlike traditional cash CDOs, synthetic
CDOs do not contain actual tranches of MBS, or even tranches of other
CDOs. Instead, synthetic CDOs simply reference mortgage securities (in
the ABACUS case, RMBS) and are thus bets on whether borrowers will
pay their mortgages. Or in other words, a bet on whether or not there will
be a credit event. Substituting for the real mortgage assets, CDSs were
part of the structured package but they did not finance a single home
purchase. Compared with other structured finance products, synthetic
CDOs were cheaper and easier to create than traditional CDOs especially
as the momentum in the housing market was beginning to slow. Creating
synthetic CDOs took a fraction of the time because there were no mort-
gage assets to collect and finance. Synthetic CDOS were also easier to
customize, because CDO managers and underwriters could reference any
mortgage-backed security.
During the period 2004–2006, Goldman Sachs issued 318 mortgage
securitizations totaling $184 billion (of which a quarter were subprime),
and 63 CDOs totaling $32 billion; Goldman also issued 22 synthetic
or hybrid CDOs with a face value of $35 billion.14 In April 2010, the
Securities and Exchange Commission (SEC) charged Goldman, Sachs &
Co. for defrauding investors by misstating and omitting key facts about its
synthetic CDOs which were tied to subprime mortgages in a deal com-
pleted as the US housing market was beginning to falter.
132 B.G. BUCHANAN
At the heart of the SEC filing (dated April 16, 2010) were allegations
that Paulson and Co., a large hedge fund, had taken a prominent role
in the ABACUS 2007-AC1 deal. According to the SEC filing, Goldman
Sachs told investors that the RMBS were selected by an objective and
independent third party, ACA Management LLC (ACA), which special-
ized in credit risk analysis. ACA served in the role as “portfolio selection
agent”. Paulson and Co. played a significant role in the portfolio selec-
tion of RMBS. Paulson’s selection criteria tended to favor relatively lower
FICO scores, a high percentage of ARMs, and a high concentration of
mortgages in states that had been experiencing substantial price appre-
ciation (such as Arizona, Nevada, Florida, and California). This was not
known to investors such as IKB, nor was it included in the Goldman Sachs
marketing materials. After participating in the RMBS selection, Paulson
and Co. effectively shorted the portfolio by entering into a CDS to buy
protection on its investment. The CDS also references the RMBS perfor-
mance in a portfolio. By taking the short position, Paulson and Co. was
economically incentivized to select RMBS that had a higher likelihood of
a credit event in the near future.
The SEC charged Goldman Sachs Vice President Fabrice Tourre for
defrauding investors. The SEC complaint details how Tourre, who was in
charge of structuring the synthetic CDO transactions, also communicated
directly with investors and prepared the marketing materials. According to
the charges, Tourre also misled ACA into believing Paulson and Co. had
taken a $200 million long position, a sharp contrast to what the hedge
fund was actually doing.
The ABACUS 2007-AC1 deal closed on April 26, 2007. By October
24, 2007, 83 percent of the ABACUS 2007-AC1 RMBS had been down-
graded and 17 percent was on negative watch. By January 2008, 98
percent of the portfolio had been downgraded.15 The Goldman Sachs syn-
thetic CDOs ultimately failed as a result of the subprime market meltdown
in 2007. The final losses from the failure of the ABACUS 2007-AC1 are
staggering. Whereas John Paulson netted approximately $1 billion, IKB
lost approximately $150 million, ACA Capital lost approximately $900
million, and Goldman Sachs lost approximately $100 million (which was
only partially offset by the $15 million fee it received from Paulson &
Co.). Goldman and the SEC reached a settlement in July 2010. Tourre
decided not to settle with the government and his trial went ahead in
2013. The trial largely depended on email evidence in which the SEC
claims that Tourre knew he was selling compromised investments to inves-
tors. A timeline charts these events in the Appendix 1.
One of the major victims of the failed ABACUS 2007-AC1 warrants

further attention. IKB Deutsche Industriebank AG (IKB) is headquar-
tered in Dusseldorf, Germany, and specialized in making loans to SMEs.
Prior to the 2007 crisis, IKB had been a valuable Goldman Sachs cus-
tomer. Beginning around 2002, IKB was involved in the purchase of secu-
ritized assets for itself as well as in the role of an advisor. The securitized
assets consisted of, or referenced, consumer credit risk including mid- and
subprime mortgages which formed the basis for RMBS CDOs. Through
a subsidiary, IKB Credit Asset Management GmbH, IKB provided invest-
ment advisory services participating in a commercial paper conduit called
Rhineland Program Conduit. In 2006, IKB had stared to demand third
party assessments of securitization deals and so Goldman Sachs brought
ACA into the ABACUS 2007 deal. SEC filings assert that IKB was on
the wrong side of the Goldman Abacus 2007-AC1 deal. In August 2007,
IKB was bailed out due to its massive losses from the subprime market
meltdown. IKB’s ABCP was held by many American investors including:
the city of Oakland, California; Montana Board of Investments and the
Robbinsdale Area School District in Minneapolis.16 Chinn and Frieden
(2011) detail the impact of the Rhinebridge SIV failure on King County,
Washington. King County had a $4 billion portfolio which made invest-
ments on behalf of the county’s fire departments, library system, school
districts, and other agencies. The country invested approximately $207
million in SIVs after Rhinebridge was founded in June 2007. Rhinebridge
issued commercial paper which it sold to investors (like King County)
and invested the proceeds in US RMBS. By October 2007 Rhinebridge
could not meet its obligations to its investors because of the slowing US
mortgage market and increase in defaults. This meant Rhinebridge was
receiving less in mortgage payments and therefore could not meet its obli-
gations to its investors like King County.
10 Goldman Sachs—The Timberwolf and Point

Pleasant CDOs
In 2010 Goldman also faced another CDO related lawsuit. This time
the lawsuit was brought by Basis Yield Alpha Fund, an Australian hedge
fund and Goldman client that claimed to have invested $11.25 mil-
lion in Goldman’s Timberwolf CDO. Timberwolf became a symbol of
the financial crisis when an e-mail by former Goldman Sachs executive
Thomas Montag describing it as “one shi--y deal”, was released by US
Senate lawmakers investigating the bank in April 2010.17 Basis Yield Alpha
134 B.G. BUCHANAN
Fund alleged that Goldman designed Timberwolf to quickly fail so that

Goldman could offload low-quality assets and profit from betting against
the CDO. Basis Yield Alpha Fund alleged that Goldman Sachs was formal-
izing its Timberwolf deal with the hedge fund during the same week that
Montag sent the e-mail describing the Timberwolf investment.
Basis Yield Alpha Fund alleged that Goldman Sachs marketed new
CDO investments in early 2007, after the company had determined that
the value of securities in that market “would likely go into sharp decline
in the near future”, and then used the new CDOs as a vehicle to short the
market. Furthermore, the lawsuit further detailed how Goldman began
making margin calls on the deal within two weeks of the fund’s invest-
ment. By the end of July 2007, Goldman Sachs demanded more than $35
million and the Basis Yield Alpha Fund alleged that Goldman’s demands
forced it into bankruptcy in August 2007. The 2010 lawsuit claimed that
Goldman received about $40 million from the liquidation of Basis Yield
Alpha Fund. Goldman CEO Lloyd Blankfein quickly dismissed Basis Yield
Alpha Fund’s claims that Goldman misled investors. “I will tell you, we
only dealt with people who knew what they were buying. And of course
when you look after the fact, someone’s going to come along and say they
really didn’t know.”18
In 2010 US District Judge Barbara Jones threw out the lawsuit. Judge
Jones ruled Basis Yield Alpha Fund, being an Australian fund, could
not use US securities laws to pursue its claims. In October 2011, Basis
Capital filed another lawsuit in the New York State Supreme Court. The
suit relates to Timberwolf and Point Pleasant. Point Pleasant was a CDO
based on subprime residential home mortgages, and two CDSs that ref-
erenced securities from the Timberwolf CDO. In the 2011 lawsuit Basis
Yield Alpha Fund accused Goldman Sachs of making false and misleading
statements on the sale of the Timberwolf and Point Pleasant securities.
Basis Yield Alpha Fund sought to recover more than $67 million it said it
lost in the CDO deal and $1 billion in punitive damages.
In January 2014 a New York state appeals court ruled that Goldman
Sachs must face fraud claims in a $1.07 billion lawsuit filed by Basis Yield
Alpha Fund. A five-judge panel at the New York State appeals court upheld
state Supreme Court Justice Shirley Werner Kornreich’s October 2012
denial of Goldman Sachs’s motion to dismiss the fraud claims. In its rul-
ing, the appeals panel said the lower court had rightly declined to dismiss
the fraud claims. They rejected Goldman’s view that the claims should
be thrown out because of disclosures and risk disclaimers in its offer-
ing circulars. Four of the judges concluded that if the Basis Yield Alpha
Fund’s allegations were true, then this revealed a picture of a “‘vast gap
between the speculative picture Goldman presented to investors and the
events Goldman knew had already occurred in 2007.”19 The fifth judge
on the appeals panel concurred with different reasoning. However, the
2014 New York appeals court ruling was modified to throw out claims of
negligent misrepresentation, unjust enrichment, and rescission. The court
refused to allow the case to go into arbitration, which had been requested
by Goldman Sachs.
In 2012 Justice Kornreich had declined to dismiss the fraud claims
because the disclaimers and disclosures in the offering circulars did not
preclude Basis Yield’s claim that it relied on Goldman Sachs’s misrepresen-
tations and omissions. So what the subsequent trial had to determine was
whether Goldman’s misrepresentations and omissions were the reasons
Basic Yield Alpha Fund invested in Point Pleasant CDOs and Timberwolf
CDSs, or whether Basic Yield Alpha Fund simply entered into a bad deal.
The structures of the GSAMP2007-FM1, ABACUS and Timberwolf
deals are summarized in Table 4.2.
11 What Is in a Name?

The name “Timberwolf” evokes an aggressive and fearsome name. In fact
it was not uncommon prior to 2007 for many securitization programs
to have over the top and exuberant names. According to the Wall Street
Journal,20 a selection of CDO deals carried names including: Corona
Borealis CDO Ltd (meaning Northern Crown in Latin); Coriolanus (the
Shakespeare character who was killed for his betrayal); Timberwolf and
Table 4.2 Selected CDO Deals

GSAMP 2007-FM1 ABACUS Timberwolf
2007-AC1
Type Subprime RMBS Synthetic CDO Synthetic CDO2

Size $707 million $2 billion $307 million
AAA rated (%) 77.5 19.2 70.2
Initial rating date 2/9/2007 5/31/2007 3/27/2007
First downgrade 12/4/2007 11/1/2007 11/7/2007
Highest current rating Baa2 Ca Caa3
Source: Permanent Subcommittee on Investigations

136 B.G. BUCHANAN
Tourmaline (named after a gem with variable hues because the stones
passed over a rainbow on their journey from the center of the Earth). In
the case of Greek sovereign debt securitizations, SPVs commonly carried
names from Greek mythology such as Aeolos (the god of wind); Ariadne
(who found her way through the Knossos labyrinth) and Atlas (who held
the world on his shoulders).21
In 2013, CDO dealmakers were choosing more neutral, longer-lasting
names that were able to buffer various economic cycles. A sampling of
names includes: Marathon CLO, Symphony CLO Ltd., Arbor Realty
Collateralized Loan Obligation Ltd, and Jamestown CLO II. The last one
is named after the first permanent English settlement in the US and the
Jamestown CLO II was meant to evoke a connection between the USA
and Europe as well as longevity and stability.
This optimistic redubbing also applies to the former subprime MBS. A
September 2015 Financial Times report22 details two deals for a bond
based on “non-prime mortgages”. This term is used to describe mort-
gages that do not meet government standards. Again after the financial
crisis “ability to repay” rules to raise lending standards and to insulate
against credit being extended to borrowers unable to make good on a
loan.
Notes
1. Faith and Finance: Of Greed and Creed. Patrick Jenkins. FTimes.
December 23, 2009.
2. Securitization Founder Defends MBS. Total Securitization and
Credit Investment, SEC News, July 23, 2010.
3. “Why Toxic Assets are so Hard to Cleanup”, Kenneth Scott and
John B Taylor, WSJ, July 2009.
4. “Instruments of Destruction”, Frank Partnoy, NYTimes, Room
for Debate, April 27, 2010.
5. “Why Toxic Assets are so Hard to Cleanup”, Kenneth Scott and
John B Taylor, WSJ, July 2009.
6. SecondMarket is a firm which specializes in illiquid assets.
7. A CMO is issued as a debt obligation not a sale in which the issuer
can actively manage the cash flow of the underlying collateral.
8. “Instruments of Destruction”, Frank Partnoy, NYTimes, Room
for Debate, April 27, 2010.
9. “Complex, opaque and risk—yet popular. Collateralized Debt

Obligations”, Alex Skorecki, Financial Times, November 29,
2004.
10. Wall Street Pursues Profit in Bundles of Life Insurance, Jenny
Anderson, New York Times, September 5, 2009.
11. It generated 635 reader comments.
12. “Junk Mortgages Under the Microscope”, Alan Sloan, Fortune,
October 16, 2007.
13. “SEC Charges Goldman Sachs with Fraud in Structuring and

Marketing of CDO Tied to Subprime Mortgages”, SEC Release,
April 16, 2010.
14. FCIC Report.
15. SEC filing: SEC Plaintiff versus Goldman Sachs and Fabrice

Tourre, April 16, 2010.
16. FCIC Report (2011).
17. “Goldman Sachs Must Face Fraud Claims in Timberwolf Suit”,
Bloomberg Business, January 30, 2014.
18. FCIC Report (2011).
19. “Goldman Sachs Must Face Fraud Claims in Timberwolf Suit”,
Bloomberg Business, January 30, 2014.
20. These CDO Names Don’t Cry wolf, Jeanette Neumann, Wall
Street Journal, June 10, 2013.
21. Securitisations set sights on Greek ruins, Financial Times, February
16, 2010.
22. Riskier Mortgages are Back—but don’t call them subprime, Joe
Rennison, Anna Nicoloau, Financial Times, September 7, 2015.
Appendix 1: Timeline of Events Surrounding

Goldman Sachs ABACUS 2007-AC1
2004 Goldman Sachs launches Abacus 2004-1, a deal worth $2 billion. This is
Goldman’s first major synthetic CDO issue.
Mid- John Paulson, a hedge fund manager, creates the Paulson Credit Opportunity
2006 Fund. This fund is set up with a target of making bearish bets on the mortgage
market.
Dec. Goldman begins to go short the U.S. housing market.
2006
138 B.G. BUCHANAN
Early Paulson & Co.’s joint head of “credit opportunity,” Paolo Pellegrini, asks
2007 Goldman salesmen and Wall Street bankers to create a synthetic CDO. The
purpose is so that the firm can short.
Early Goldman Vice President, Fabrice Tourre, contacts portfolio selection agent
2007 ACA Management, a firm that oversees CDO portfolios.
Feb. Paulson and Tourre discuss the portfolio with ACA. The portfolio becomes a
2007 CDO called Abacus 2007-AC1.
Feb. The US subprime mortgage market weakens but it soon recovers some of its
2007 strength. This makes it easier to get the Abacus 2007-AC1 deal done.
March The SEC forms a working group that focuses on mortgages securitized by Wall
2007 Street—especially CDOs sold during 2006 and 2007.
April The Abacus 2007-AC1 deal closes. Goldman gets paid $15 million in fees.
2007
Early The SEC requests information from Paulson and his team about the ABACUS
2008 2007-AC1 deal.
Aug. Goldman is subpoenaed by the SEC.
2008
Late Paulson & Co. executives meet with the SEC and share details of the Abacus
2008 deal.
July The SEC informs Goldman Sachs that it is being served with a Wells notice.
2009 This is a formal warning that civil fraud charges could be forthcoming.
Sept. Goldman Sachs meets with the SEC to discuss the Wells notice.
2009
April The SEC convenes a meeting to vote on the Goldman charges on April 14. On
2010 April 16, 2010, the SEC announces the suit against Goldman Sachs. Goldman
Sachs shares drop 12 percent. Fabrice Tourre is also placed on paid leave by
Goldman Sachs.
April Tourre testifies at a Senate subcommittee and denies the SEC’s charges against
2010 him. Tourre also argues that all of the investors involved in the deal were
sophisticated investors and should have been aware of the inherent risks in the
deal. He also claims that he never told ACA Capital Management that Paulson
was an equity investor in the Abacus CDO.
July Goldman and the SEC announce a settlement. Tourre decides not to settle and
2010 he is scheduled for a later trial. Goldman pays $550 million to settle the charges,
a record at the time. Approximately $300 million is allocated to SEC fines and
the rest is intended to compensate those who lost money on the investment. As
part of the settlement, Goldman acknowledges it should have revealed Paulson
& Co.’s role in the ABACUS deal.
Dec. Tourre leaves Goldman. He later enrolls as a doctoral student in economics at
2012 the University of Chicago.
May ACA’s fraud claims against Goldman Sachs are dismissed by the New York state
2013 appeals court. The court’s verdict is that as a “highly sophisticated commercial
entity,” ACA should have realized something was amiss with the ABACUS
offering.
July Fabrice Tourre’s trial commences.
2013
Aug. Tourre is found guilty of six counts of securities fraud.

2013
Dec. SEC announces it will seek $910,000 in fines against Fabrice Tourre. In
2013 addition, the government announces it will seek the forfeiture of $175,463 in
ill-gotten gains, along with $62,858.03 in interest.
Source: Factiva, Wall Street Journal
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CHAPTER 5
Securitization in Emerging Markets
In this chapter, I examine the history and development of emerging mar-

kets securitization. While the US securitization market developed as a
means to accelerate liquidity, much of the emerging market securitization
was initially established to deal with non-performing loans (NPLs). I trace
the development of Latin American and Asian securitization. Additionally,
I provide a mini case of the Chinese securitization market which became
the largest Asian securitization market in 2014. I trace the evolution of the
Chinese market from its pilot securitization program in 2005 to the pres-
ent. The mini case makes it clear that at first glance, it may appear that the
surging CLO market in China has a sense of déjà vu about it, especially if
we recall the CLO product track record in US markets during the financial
crisis. However, CLOs were introduced into the USA and China for very
different reasons.
Securitization has played a vital role in emerging market economies
since the late 1980s. Many companies in emerging markets do not always
have access to global capital markets and securitization offers an oppor-
tunity to tap long-term, low-cost financing. In the early days of emerging
markets securitization foreign bank financing was extremely expensive to
obtain. International bond financing rates of 17 percent were quite com-
mon and US Treasury securities of similar maturity were 8 percent (Hill
1998). However, at the time a securitized instrument could be issued at a
rate of 13 percent.

DOI 10.1057/978-1-137-34287-4_5
142 B.G. BUCHANAN
While not a “true” securitization (Kendall and Fishman 2000), the earli-
est application in emerging markets is the Brady Plan (1989–1992/1994),
or Brady Bonds. Brady Bonds are bonds issued by emerging market coun-
tries but are credit enhanced by US Treasuries. Named after former US
Treasury Secretary Nicholas Brady, investors are at least assured of pro-
tecting their principal from default risk because US Treasury zero coupon
bonds serve as the collateral. They are not a “true” securitization because
it is a transaction that has merely converted syndicated debt into securities.
In fact, in the early years of emerging market securitization, many of the
funds that moved through emerging bond markets rather than through
bank loans did not qualify as securitized products. Nevertheless, this credit
enhancement program for troubled emerging market assets proved suc-
cessful and there have been many analogies made with the recent financial
crisis and Brady Bonds (Gumbrau-Brisa and Hann 2009).
The utilization of securitization technology in times of economic cri-
sis has been a common theme across emerging markets. This is best
demonstrated with the securitization of NPLs in Latin America dur-
ing the 1994 Mexican Peso Crisis and the 1997–1998 Asian Financial
Crisis. Non-performing loans are a major problem in the banking sys-
tem of many emerging market countries. The legal infrastructure and
recovery systems are attributed to the accumulation of NPLs (Kothari
2006; Gyntelberg and Remolona 2006) and often bad loans remain on
a bank’s balance sheet well after a financial crisis. For example, in 1997
Japanese banks’ balance sheets had US$1 trillion in non-performing
assets (Kothari 2006). The 1997 Asian financial crisis was the impetus
for a number of Asian countries to implement securitization as a means
of recycling NPLs. The Asian Bond Markets Initiative (ABMI) included
securitization as a proposal to introduce more sophisticated bond mar-
kets to the Asian region in the aftermath of the 1997 Asian Financial
Crisis (Sekine et al. 2009).
Koth et al. (1998) discuss the problems Eastern European firms face
when trying to raise capital in international financial markets during the
1990s. Due to significant losses sustained on NPLs, commercial banks
had been hesitant to provide funding for Eastern Europe’s debt problems.
Koth et al. (1998) suggest securitization as a partial solution to the NPL
problem. They focus on how Eastern European loan portfolios of large
commercial banks might be packaged for securitization in international
capital markets.
Securitization has also proved to be an effective tool in mitigating sov-
ereign risk. Even if a firm carries a good credit rating, domestic firms can
SECURITIZATION IN EMERGING MARKETS 143
face historical constraints in financing themselves due to low sovereign

ratings and poorly perceived political risk.
Securitization in emerging markets brings a number of benefits to
stakeholders. For the originators, the benefits include:
1. A lower cost of funds can be obtained if the quality and ratings of

the assets exceed that of the originator’s.
2. Access to longer-term funding.
3. Improved asset-liability management.
4. Improved regulatory capital management.
5. The ability to raise funds based on asset risk rather than corporate
risk.
6. Access to a broader investor base, not just the domestic market.
7. Improved credit risk management.
For investors, the benefits include:
1. Emerging market mortgage-backed securities (MBS)/ asset-backed

securities (ABS) can potentially allow investors to create a more
diversified portfolio.
2. The senior MBS/ABS tranches offer higher returns than equally
rated government and corporate debt.
3. For high yield funds the subordinated tranches potentially provide
an attractive investment opportunity.
Research indicates that banks in developing economies are hesitant to

make mortgage loans due to the associated risks of liquidity, interest rate,
and credit risk.1 The transition process away from emerging market status
focuses on the following three key processes: (1) economic stabilization
and liberalization; (2) privatization; and (3) financial sector development.
Galal and Razzaz (2001) contend that property rights in institutional
reforms are important for reducing information asymmetry, improving
contract performance, and for capital markets to provide affordable hous-
ing. They are supportive of a secondary market in which standards for
collateral and credit evaluation can potentially increase the market for new
mortgage originations.
Arner (2002) states, “the promotion of ABSs, especially MBS, can have
a significant impact on financial development and stability, in turn sup-
porting economic development.” MBS are being promoted as a way for
banks to transfer the risk of loans to investors in the products. Mortgage,
144 B.G. BUCHANAN
or indeed many other types of asset securitization is not possible without

the following in place: (1) a market for real estate-based finance; (2) capi-
tal markets; and (3) infrastructure to support securitization, especially the
inclusion of special purpose vehicles (SPVs). Certainly, what are needed
are mortgages of predictable or standardized quality. Jaffee and Renaud
(1996) maintain that securitization and secondary mortgage markets con-
fer two main benefits: (1) the ability of banks to shed risks associated with
holding mortgages; and (2) the creation of standards of credit evalua-
tion and collateral procedures that directly increase the efficiency of the
primary market for mortgage origination. Schwarcz (2009) recognizes
securitization’s potential in emerging markets and examines how receiv-
ables financing in the context of cross-border transactions can be made
more cost efficient. Faleris (2005) focuses on transnational cross-border
securitization, specifically the packaging and rebundling of state-owned
securities.
As mentioned in Chap. 3, future flows securitization (FFS) has demon-
strated a lot of potential since the late 1990s because (1) it is a good way
for non-investment grade companies to obtain investment grade financ-
ing, (2) it is a useful way for a company to raise funds without diluting
company equity ownership, and (3) it is borderless, not just limited to
large company use. It is also a technique that is proving useful in emerging
markets. Under a true sale FFS, it was possible to obtain a rating at the
sovereign level or above, especially if the corporate rating was weaker. One
example of a FFS involves the originator for future flow currency receiv-
ables to be transferred to an offshore account held by a SPV outside the
originator’s jurisdiction. The offshore SPV consequently makes it difficult
for the government to confiscate or interfere with the assets, thus mitigat-
ing political risk. The FFS can contain a credit enhancement, such as bond
insurance and/or the pool can be overcollateralized. Another example of
FFS that has shown great potential, particularly in emerging markets is
remittance securitization.
1 WORKERS’ REMITTANCES SECURITIZATION

These flows are a major driver of financialization in emerging markets
(Hudson 2008). It represents a means of the unbanked being banked—
and can act as an incentive for financial institutions to encourage remit-
tance senders and receivers to use formal banking systems. Worker
remittances are currently a dominant source of foreign exchange for many
developing countries. Worker remittances are defined to be financial flows

that migrants send to their family back home, and are the sum of workers’
remittances, compensation of employees, and migrants’ transfers. In this
case, the emphasis is on diversified payment rights which are the right, but
not the obligation, that a bank has in the payment orders that it receives
to pay funds to beneficiaries. Remittances do not just have to be cash;
they can be social, technical, and political resources and can include wire
transfers, check payments and credit card payments.
Remittance securitization was first carried out in Mexico in 1994 as
a response to the country’s currency and stock market crisis. Investor
confidence had fallen and the country had to find innovative ways of
securing longer-term financing. Since then remittance securitization has
been encouraged by the World Bank and has taken off in other emerg-
ing markets. A remittance securitization can be described as follows: the
originator is the bank seeking to raise capital, the SPV is the issuer of the
debt instruments, and the investors are the parties who purchase the debt
instruments from the SPV. The originator pledges its future remittances
to an offshore SPV. Short-term debt is then issued to the SPV. Worker
remittance flows are then collected by an offshore SPV and payments are
made to the investors and the remainder is sent to the bank. The SPV
has the first right to receive migrant workers’ transfer payments and cash
from the remittances and this builds up in the trustee maintained account.
The account is maintained until the next principal and interest payment
to investors is due. The trustee then sends the excess cash through to the
originating bank (Hudson 2008). This structure avoids the international
capital markets’ concern about sovereign risk. If the structure is success-
fully implemented, the originating company can receive a rating that is
better than the sovereign rating of the country in which the originator
operates (Hughes 2011). The ratings analysis emphasizes the strength of
the originator, not the isolation of future flow from the liabilities of the
originators. However, remittance securitization can possibly generate new
risks because fee structures are often opaque (such as hidden charges and
poor foreign exchange rates).
2 MICROFINANCE SECURITIZATION
Schwarcz (2009) and Hartig (2011) propose that securitization techniques
can be applied to microfinance to disintermediate the need for commer-
cial banks. Microfinance refers to the provision of sustainable small loans
146 B.G. BUCHANAN
and other proportionally scaled financial services (such as credit, savings

accounts, and insurance) to low-income individuals and the poor, in order
to enable them to start or expand small businesses (United Nations 2005).
The role of microfinance institutions (MFIs) is to provide these finan-
cial services and most MFIs operate on a non-commercial basis. Schwarcz
(2009) estimates that outstanding microfinance loans of between $20 and
$60 billion are being made internationally every year. For many years the
demand for microfinance lending vastly exceeded the supply of funds that
could be raised from charitable donors. Additionally, less than 7 percent of
those eligible for microfinance loans (approximately a 100 million people)
actually receive them (Schwarcz 2009). Commercial banks have become
funding sources for microfinance loans in many emerging market coun-
tries. However, the main drawback is that many of these commercial banks
are charging staggering rates of interest, with some charging interest rates
of 5000 percent per annum (Bystrӧm 2008).2 Schwarcz (2009) warns of
the potential dangers of securitizing risky microfinance loans to facilitate
financing to the impoverished if the negative aspects of securitization are
not addressed.
Bystrӧm (2008) also discusses the potential role structured finance and
credit derivatives can play in extending finance to micro-entrepreneurs on
a much larger scale than the mainly on-commercial microfinance industry.
He develops a hypothetical securitized instrument—a MiCDO—or micro-
finance CDO, to describe securitization and the tranching of microcredits.
The world’s first onshore securitization of microcredit receivables was
the BRAC Micro Credit Securitization, which closed in 2006 (Rahman
and Mohammed 2007; Hartig 2011).3 It was also a first in terms of a new
type of investment called a microcredit backed security (MCBS). There
are a number of reasons BRAC entered into the securitization transac-
tion. First, it would allow BRAC to have a more efficient balance sheet,
improve its asset/liability management, and reduce leverage. Assuming
the securitization was properly structured, there was the potential that the
transaction could also obtain a higher rating than BRAC could as an insti-
tution. Additionally, the deal could allow BRAC to raise lower-cost funds
and reach a broader investor base. Finally, the MCBS would allow BRAC
the ability to plan its future growth strategy.
The originator of the deal was BRAC and Eastern Bank Limited (EBL)
was the trustee (Rahman and Mohammed 2007). The issue’s transaction
size was 180 million in local Bangladesh currency and received a AAA
rated rating. The BRAC MCBS consisted of 12 equal tranches with the
asset pool backing each tranche. This mirrored the overall risk profile
of BRAC’s microcredit loan portfolio. The loans had an average life of
6.5 years and each tranche had a maturity of 12 months. The MCBS were
primarily sold to local Bangladesh investors.
In 2004 the first microfinance CDO was issued by BlueOrchard
Finance S.A., a Geneva-based microfinance investment consultancy in
cooperation with Developing World Markets, a US investment advisory
group. The Overseas Private Investment Corporation (OPIC), a US gov-
ernment development finance institution, guaranteed the investments and
supported the transaction’s credibility. JP Morgan Securities was respon-
sible for distribution of the securities to private and institutional investors
(Hartig 2011). USD 99 million of funding was provided for five years at
a fixed rate to 21 MFIs in 13 emerging markets. The countries included:
Albania, Azerbaijan, Bolivia, Bosnia and Herzegovina, Cambodia,
Colombia, Ecuador, Georgia, Mexico, Mongolia, Nicaragua, Peru, and
Russia (Jobst 2011).
3 SECURITIZATION IN LATIN AMERICA

During the global financial crisis securitization remained popular with
most emerging markets, particularly Latin America, which outperformed
other emerging markets. In 2011, securitization issuance in Latin America
grew by 23 percent (with an issuance of approximately $29 billion).
Forecasts for the following years were optimistic as Latin America secu-
ritization issuance appeared to remain resilient.4 Driving this optimistic
outlook was political and macroeconomic stability, as well as solid GDP
growth which bode well for further development of the Latin American
securitization market.
The earliest Latin American securitizations were in Brazil, Argentina,
Colombia, Venezuela, Peru, Honduras, and El Salvador (Hill 1998;
Scatigna and Tovar 2007). Chile took an early initiative to create a liberal
framework for securitization in 1994. Argentina adopted its comprehen-
sive securitization law, in January 1995 and launched the first residen-
tial mortgage-backed securities (RMBS) transaction in 1996. Due to
currency, political, and economic uncertainties involved in cross-border
transactions, sovereign risk has been a long-standing issue for financing in
emerging markets. In the case of Latin America, investors were fearful of
sovereign and political risk and the securitization of company receivables
became a useful tool in reducing that risk.
148 B.G. BUCHANAN
By 1996, the volume of Latin American transactions topped $10 bil-

lion (Hill 1998). In 2003, the securitization of residential and commer-
cial mortgages, auto and consumer loans and trade receivables began to
expand rapidly, driven largely by the Brazilian and Mexican markets. In the
late 1990s cross-border securitization was restricted to the most financially
sound and creditworthy originators. A Latin American CDO market has
been relatively undeveloped in the 1990s. Brazil saw the first CDO trans-
action in 2006. In 2006, Brazil and Mexico accounted for approximately
three quarters of all domestic securitized issues. At the time Argentina was
the third largest market in the region.
The expansion of the Brazilian and Mexican securitization markets can
be attributed to three factors: improved macroeconomic performance; fis-
cal and monetary management; and the development of a new securiti-
zation framework. In the region, items that were commonly securitized
as receivables included future credit card, money transfer, and telephone
service receivables as well as receivables generated by the sales of oil, cop-
per, and pulp. Hill (1998) contends that FFS offered Latin American firms
considerably lower financing costs than other alternatives. In fact, FFS is
the dominant securitization transaction in Latin American countries. The
FFS accounted for 26 percent of the securitization issuance in 2011 fol-
lowed by consumer loans (22 percent). Personal loans, RMBS, and trade
receivables account for 14 percent, 13 percent, and 11 percent of securi-
tization issues.
However, FFS presents a challenge for both developed and emerging
markets. The major risk is that the transactions involving say, receivables
are not yet in existence at the time the transaction occurs. But for many
Latin American companies FFS offered much lower rates than the compa-
nies’ financing alternatives (Hill 1998).
As Latin American economies started to become more liberalized after
the 1980s, their governments realized that traditional financing tech-
niques would not be effective to increase both the availability and afford-
ability of housing. As a result, focus shifted to the liquidity possibilities
offered by mortgage securitization—both in the residential and commer-
cial mortgage markets. However, the issue of how to structure a securi-
tized transaction (whether commercial or residential) was not enough. For
as smooth a transition as possible, two factors had to be in place. First, laws
governing issues such as the transfer of assets and the perfection of rights
to those assets had to be enacted. Also, residential and commercial mort-
gages have their own unique legal issues. Insuring a good title is more
important in a commercial transaction because there are fewer properties
worth proportionately more in a given mortgage pool. Failure of title in
one property could impact the pool severely. In the initial stages of mort-
gage securitization title insurance did not exist in Latin America as it does
in the USA. Applications were first attempted in Argentina and Mexico.
But rule of law on the books is not sufficient. Investors also had to have
confidence that the laws would function as enacted. Laws regulating issues
such as foreclosure, the ability to transfer or assign rights in mortgages,
and the creation of SPVs had to be scrutinized. Even well into the 2000s,
in a number of Latin American jurisdictions, securitization was still a rela-
tively new process. This meant the courts had not tested many of the exist-
ing and newly enacted laws. Even today, legal foundation, interpretation,
and enforcement still play a significant role in assessing the growth of the
commercial mortgage-backed securities (CMBS) market.
Despite the financial crisis, securitization in Latin America has con-
tinued to demonstrate a great deal of promise. Legal infrastructure for
securitizations has improved across many Latin American economies,
along with the possibility of introducing covered bond markets into the
region as a competing market. A major factor has been high commodity
prices boosting local economies. This includes both hard (i.e., metals and
mining) and soft commodities (i.e., agricultural goods). Due to sound
economic fundamentals (i.e., continued GDP growth), there have been
a growing number of investment grade countries (e.g., Brazil, Mexico,
Chile, Colombia, Peru, and Panama). RMBS have been relatively stable.
Local pension funds also represent a growing investor base, attracted by
the prospect of potentially higher returns compared with corporate bonds
of equal risk.
Latin American securitization markets have also attracted the interest
of multinational agencies such as the International Finance Corporation
(IFC). The World Bank also approved key loans to promote the develop-
ment of securitization secondary markets. For example, in 2000 a hous-
ing agency in Mexico received a US$500 million loan to reorganize the
primary mortgage market. This was intended to improve foreclosure
laws, develop mortgage insurance, and make mortgage rates in Mexico
more uniform. In Argentina the IFC also invested $150 million in the
country’s first major secondary mortgage company, Banco de Credito y
Securitizacion, and provided $50 million to the Banco Hipotecario, (for-
150 B.G. BUCHANAN
merly a state-owned company) to help fund primary mortgages. Viewed in

this light, the IFC has the potential to function in much the same manner
as to the Federal National Mortgage Association, Fannie Mae (FNMA) in
the USA (Poindexter and Vargas-Cartaya 2002).
However, a number of challenges remain. The cost of securitized debt
is increasing due to new regulatory costs. This is due to more complex
regulatory framework that has slowed the registration and authorization
processes across Latin American markets. Thus, the timing of the place-
ment process for structured bonds has lengthened. Finally, there is still
perceived performance volatility. Thus, an additional risk premium is still
reflected in securitized instruments.
Historically, Mexico has had a strong RMBS market because there has
been a strong political effort to offset a very large housing shortage and
a number of legislative reforms. Securitization issuance reached a peak in
2007 and steadily declined after 2008. The Mexican market is dominated
by CMOs, backed by whole business loans.
One of the first Latin American securitization markets transactions
involved the future telephone receivables of the Mexican telephone com-
pany, TelMex. It was based on an agreement between AT&T and TelMex.
A phone call made between Mexico and the USA involves the equipment
of both companies. At the end of every month TelMex bills people who
place a phone call from Mexico to the USA and vice versa for AT&T. At
the end of each month after computing what it had billed the other’s
account, whichever company had the net deficit paid the other. For
many years, it was usually AT&T who owed TelMex. The securitization
transaction entailed TelMex securitizing future receivables owed to it by
AT&T. Why would AT&T agree to do this? For one, it was an especially
attractive deal to US investors because the telephone receivables were pay-
able in US dollars.
One of the BRIC economies,5 Brazil passed its first major securitization
law in November 1997. This law established the Sistema de Financiamento
Imobilidrio (SFI)—a new real estate finance system—and set forth sub-
stantial reforms. The major reforms included: the formation of securitiza-
tion companies and a new type of security backed by mortgages acquired
from financial institutions, the certificado de recebiveis imobilidrios. Even
in the aftermath of the financial crisis, Brazil was one of the fastest grow-
ing securitization markets in the emerging markets. Brazil’s securitization
growth has been fueled by a strong economy (GDP was forecast to be
3.20 percent in 2012)6 and robust capital.
In 2012, there was optimism that a competing covered bond market

would soon emerge in Brazil. Factors driving new issuance volumes have
been trade receivables and CMBS. However, the Brazilian market still
faces limitations including: regulatory disincentives for banks and lack of
standardization from developers.
Ferreira de Mendonça and Barcelos (2015) focus on receivables in the
Brazilian securitization market, which now comprises 45 percent of the
Latin American securitization market. Their paper presents empirical evi-
dence from the Brazilian experience regarding analysis on securitization
transactions and credit risk. Based on panel data framework that takes into
account 60 financial institutions from October 2002 to September 2012,
they observe that securitization transactions imply an increase in the credit
risk.
4 SECURITIZATION IN ASIA
Securitization of bank loans, mortgages, and other liabilities started to
gain momentum in the Asia-Pacific region after the 1990s. Lejot et al.
(2008) examine the use of securitization in East Asian countries including
China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Philippines,
Singapore, Thailand, and Vietnam. The primary reason for the establish-
ment of the Asian securitization market was to deal with the NPLs left in
the wake of the 1997 Asian Financial Crisis.
ABS were initially issued in Korea, Thailand, Malaysia, and the
Philippines to address the credit risk that had accumulated in the NPLs
throughout the crisis. The appeal of securitizing NPLs is that it provides a
means to quantify pools of assets that are difficult to value, usually to make
their sale look more feasible. Alternatives to dealing with NPLs can include
discontinuation of the loss-making business segment; seeking cost reduc-
tions to improve margins; cutting excess labor or a merger and acquisition
with a financial viable partner. At the time securitization was considered
a more cost-efficient alternative to high cost financing. Secondly, a high
credit quality instrument could be created out of lower quality debt.
In the mid-1990s Hong Kong, Korea, Thailand, and Indonesia were
the first Asian markets to adopt securitization. In Asia there has been an
emphasis on existing receivables/flows securitization rather than FFS that
dominates Latin American markets (Hill 1998). However, in the later
1990s there was a marked shift toward FFS, especially in the Philippines,
Korea, and China. In 1999, Daewoo, a Korean firm, issued the first domes-
152 B.G. BUCHANAN
tic ABS. A major factor driving this was that future expected offshore dol-
lar cash flows could now be captured offshore. Additionally, there was no
perceived transfer or inconvertibility risk. In 2000, Asiana Airlines pursued
a FFS and Korean Air in 2011. By 2000, Japan and Korea were the domi-
nant securitization markets in Asia. However, in 2014 the number of new
securitization issues in the Chinese market overtook the South Korean
and Japanese securitization markets. That year the ratio of Chinese secu-
ritization issues relative to South Korea was a ratio of approximately three
to one. However, in 2015 there has been a decline in CLO issuances and
a rise in RMBS and ABS backed by smaller loans such as car loans. It is
also evident that the number of issuances in Japan started to wane after the
2007 financial crisis, whereas issuances increased in Korea. The introduc-
tion of a covered bond market is a new focus in Asia.
While issuance remained stable in Japan and declined in South Korea
between 2012 and 2015, securitization issuance in China surged between
2013 and 2014. In 2014, Chinese securitization issuance (69 issues) is
three times the figure for South Korea (22 issues). Between 2005 and
mid-2015 there were a total of 141 securitization issuances in China.
Japan’s issuance of securitized products declined as a result of the sub-
prime mortgage market crisis (Sekine et al. 2009) but it was not due to
any direct impact exposure to US subprime loans. The performance of
Japanese securitized products was also relatively stable with a much lower
downgrade rate (0.3 percent) compared with the global figure (27 per-
cent) (Sekine et al. 2009). The decline may largely be attributed to the
decline in investor sentiment on the part of insurance companies, trust
banks, and megabanks. The Japanese issuance trends downwards until
2012, when there is a reversal in the number of issues.
Securitization types in China, South Korea, and Japan between 2005
and mid-2015; CMOs are the most common type of securitization deal
in Japan and South Korea, whereas in China CDOs are the most com-
mon type of securitization, followed by ABS. Securitization collateral is
presented. In Japan and South Korea, whole business loans serve as the
most common form of securitization collateral between 2005 and mid-
2015. Chinese government owned banks and lenders continued to move
loans off their balance sheet and bundle them into collateralized loan obli-
gations (CLOs) which comprises the bulk of the Chinese securitization
market.
In 1997, Pakistan Telecommunications was able to securitize $250 mil-
lion in receivables from dollar-paying companies such as MCI WorldCom,
Sprint, and AT&T.7 BNP Paribas successfully securitized North Korea’s

debt, representing approximately one third of $800 million in foreign
commercial debt on which North Korea had defaulted in the 1990s.8
In 1999, the Asian Development Bank (ADB) made 13 recommenda-
tions to encourage the development of MBS markets in the Asia region
(Arner 2002). The recommendations were to:
1. Factor macroeconomic stability.

2. Establish legal infrastructure.
3. Establish secondary mortgage corporation.
4. Use special purpose trusts where there is a dominant mortgage
lender.
5. Standardization of mortgage underwriting process.
6. Create competitive domestic bond markets with appropriate
taxation.
7. Establish a benchmark yield curve.
8. Eliminate investment restraints.
9. Develop ratings system and improve disclosure.
10. Clearing, tranching, and settlement technology needs to be
established.
11. Have necessary legal infrastructure to promote credit
enhancement.
12. Enhance regulatory capacity.
13. Reduce or eliminate interest-rate controls and subsidies.
Korea was the first Asian country to introduce legislative reforms and
host a wave of securitization activity. Securitization became a valuable tool
for expanding the South Korean corporate and financial sector after the
1997 Asian financial crisis. South Korean legislation also allowed large
volumes of NPLs to be employed as collateral for new collateralized debt
obligations (CDOs) that were being issued in the country at the time.
In the USA, securitization has been used to accelerate the liquidity of
assets, whereas in Asian emerging markets it has often been used to rectify
the NPLs of state banks. Emerging markets drew on a previous financial
crisis for guidelines in securitizing NPLs (Hill 1998). The first mover in
the area of reorganizing non-performing assets was the Resolution Trust
Corporation (RTC) in the USA. In the 1980s it was through the “N”
series programs that the RTC first undertook the first securitization of
NPLs. In the wake of the Savings and Loans (S&L) crisis, RTC bought
154 B.G. BUCHANAN
the “dead” commercial mortgages at a deep discount and securitized

them in the market. The RTC obtained 750 S&Ls $640 billion in assets
and through securitization recovering approximately 90 percent.
5 SECURITIZATION IN INDIA
The Indian securitization market has been in existence since the early
1990s and auto loan securitization was the mainstay in these early years.
It was particularly successful in the early years because of the homogenous
nature of its receivables, The Indian securitization market matured after
the turn of the century and post-2000, the Indian securitization market
when it was characterized by a regular group of issuers and narrow field
of investors. Over time, the Indian securitization market has diversified
into housing loans, corporate loans, commercial mortgage receivables,
telecom receivables, lease receivables, medical equipment receivables, toll
revenues, project receivables and microfinance loans. During its growth
the Indian securitization market has not depended on the equivalent of
government sponsored entities.
Much of securitization activity in India on the demand side has been
driven by mutual fund requirements and insurance companies trying to
satisfy priority sector lending targets. On the supply side, securitization
activity has been driven by prevailing liquidity conditions and retail loan
portfolio growth.
There was a brisk start to the Indian securitization market. This contin-
ues well into 2008, but after 2009 and 2010 there is a substantial decline
in issuance due to the impact of the global financial crisis. The market
started to rebound after 2010 and appears to have been growing quite
healthily since then. Over the period 2002–2015, the most common secu-
ritized products have been ABS, CDO and CMOs. It is quite clear that
auto loans are the most common type of collateral followed by CLOs.
With regards to the MBS market in India there are a number of chal-
lenges, namely:
1. A lack of secondary market liquidity

2. Risk from repayment/re-pricing of loans
3. Longer maturity periods
4. Keeping the securitization structures simple
5. Maintaining stable ratings
6. Concerns over asset quality
6 MINI-CASE: SECURITIZATION IN CHINA

Securitization is relatively new to the Chinese financial market, with a pilot
securitization program introduced in 2005, but suspended in 2008 due
to the financial crisis. In 2012 the program was reinstated but each new
deal was still subject to regulatory approval, making issuance very slow. In
July 2013 this was compounded by the credit crunch in the Chinese inter-
bank money market. After the China Securities Regulatory Commission
(CSRC) issued definitive securitization regulations, the development of
a legitimate securitization market started to gain some momentum. In
2014, there was a thriving securitization market due to the more relaxed
rules that the CSRC had issued. This was clearly evident in the Chinese
collateralized loan obligation (CLO) market, which in 2014 was the fast-
est growing asset class in China and accounted for 90 percent of product
sales.9
Relative to the size of its economy, China’s securitization market is
much smaller than the US and Japanese markets. The value of the Chinese
securitization market as a percentage of GDP was 0.08 percent in 2005;
0.13 percent in 2006; 0.07 percent in 2007; and 0.127 percent in early
2008 (Sekine et al. 2009). According to the China International Capital
Corporation (CICC), outstanding securitized products now comprise 0.5
percent of GDP in China, compared to 60 percent in the USA and 3.6
percent in Japan.10
7 WHY SECURITIZATION?
Why the resurgence in interest by Chinese regulators about securitization?
The Chinese economy has been growing at its slowest pace since 1990.
Various regulatory responses have included cutting benchmark interest
rates; restricting initial public offerings; lowering housing down payments
(from 60 percent to 40 percent); extracting pledges from 21 brokers to
buy shares as long as the Shanghai Composite remains below 4500; sus-
pending trades in some stocks and easing rules on loans.11 All of these
measures have been implemented in an effort to prevent a liquidity crunch
in the financial system.
In early 2015, Baoding Tianwei Group (a power equipment manufac-
turer) became the first state-owned firm to fail to pay its bond interest.12
As a result there is also a renewed focus on the increase in NPLs. This was
once endemic in China reaching approximately 23 percent in 1990 (see
156 B.G. BUCHANAN
Fig. 5.1). Despite the fact that the ratio of NPLs to gross loans declined
over the last two decades, it has increased during the past year. In addi-
tion, the bad debt generated by China’s five largest state-owned banks
increased to 50.1 billion yuan—double the level for the same period one
year earlier.13 There was a rise in NPLs between 2013 and 2014. The big-
gest bank in the world measured by assets is Industrial and Commercial
Bank of China (ICBC). ICBC’s NPL ratio rose to 1.4 per cent at the
end of June 2015, from 1.29 per cent at the end of March 2015. The
Bank of China’s NPL ratio rose to 1.4 per cent from 1.33 per cent and
Agricultural Bank of China’s hit 1.83 per cent from 1.65 per cent over the
same period.14
The Chinese financial system has become more volatile over the last
couple of years. For nine consecutive days in July 2015 the Shanghai
Composite Stock Index dropped a total of approximately 40 per cent15
and foreign investors pulled cash out of mainland China markets. Margin
lending has declined and the Chinese housing market has also been slug-
gish. The People’s Bank of China (PBOC) introduced a new mechanism
for trading the renminbi, but its value subsequently fell.16
25
20
Percentage (%)
15
10
0
1990 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013
Year
Fig. 5.1 Chinese Bank non-performing loans to total gross loans.

Source: World Bank. Bank NPLs to total gross loans are the value of NPLs divided
by the total value of the loan portfolio (including NPLs before the deduction of
specific loan-loss).
The size of China’s debt mountain has also been problematic.

Between 2008 and 2013 debt soared from 130 percent to 200 percent
of GDP. China is now more indebted than any other emerging market
country.17 Slowing growth, a weaker property market, deteriorating fiscal
conditions, and an increase in corporate debt has led to concerns about
repayment and default risk. Regulators are trying to balance the preven-
tion of extreme swings in the market by easing policy objectives. Since
July 2015, Postal Savings Bank of China and China Merchants Company
has issued 9.96 billion yuan of RMBS.18 RMBS are expected to attract
insurance companies and social security funds because of their longer-term
maturity. Investor demand is also expected to be encouraged by the intro-
duction of CMBS because their yields are generally higher than RMBS.
Chinese banks are under increasing pressure to curb balance sheet
growth due to tougher capital adequacy requirements like the new Basel
III rules. Securitization is being vigorously encouraged by the China
Banking Regulatory Commission (CBRC) and Central Bank of China.
Chinese Premier Keqiang has encouraged the benefits of using securi-
tization19 as a way to solve China’s increasing debt figures. It has been
promoted as a means of reducing reliance on the shadow banking system,
and to ensure enough credit keeps flowing to a slowing economy. In July
2015, the regulator announced that it would allow firms to securitize their
margin loans, which could potentially free up capital for more lending.
8 THE SECURITIZATION FRAMEWORK IN CHINA

Securitization in China has lagged other countries for numerous reasons:
relatively immature capital markets; inadequate and weaker legal infra-
structure and a shortage of regional investors. Wei (2007) recognizes that
in the past there has been a lack of incentives in China to securitize assets.
Mortgage backed securitization is historically not a widely practiced form
of securitization in China and this may be attributed to competition over
property subsidies, land ownership, and conflict with Communist party
policy (Chen 2004). Chinese banks are not really incentivized to securitize
mortgage loans because the loans have a low default rate. Chinese banks
retain part of the risk because the securitized mortgage loans are sold to
customers affiliated with the issuer.
The country’s regulatory system is frequently referred to as a “patch-
work system”. Kong (1998) recognizes that the Chinese securitization
market lacks an independent judiciary. Also lacking are any internal
158 B.G. BUCHANAN
restraints comparable to the US principle of “checks and balances”. Arner

(2002), Kong (1998), and Chen and Goo (2015) recognize that it is dif-
ficult to impose securitization templates onto emerging markets, especially
those countries with a civil law tradition. The Japanese system can offer
some guidance for securitization implementation in China because it fol-
lows a civil legal code (Kong 1998). As a result, the universal banking
model (which Japan’s corporate governance system is based upon) has
found favor in China. China has traditionally maintained a strict Glass–
Steagall style system whereby commercial banks are banned from under-
writing IPOs or acting as broker dealers.20
The Chinese legal framework comprises basic laws, administrative regu-
lations, regulatory provisions and self-disciplinary rules. Trust Law was
introduced in 2001. It was used by Huarong Asset Management in 2003
and ICBC in 2004 to securitize NPLs.21 Yet trust law is where the biggest
gap in the Chinese regulatory market has been because there are concerns
that the use of trust law and transactions may be construed by regulators
as a means of avoiding restrictions on the issuance of corporate bonds by
Chinese companies.
Battaglia and Gallo (2015) and Chen and Goo (2015) describe the reg-
ulatory and corporate governance framework. The banking sector plays a
key role in China’s economy and securitization market. Historically, 66
percent of income in the Chinese banking system comes from traditional
financial intermediation (CBRC Annual Report 2011). The Chinese
banking system may be categorized into four levels. The first category
contains the three main policy banks which are entirely state-owned: the
Agricultural Development of China, China Development Bank, and China
Exim Bank. In the second category are five large commercial banks which
were previously state owned but where the Chinese central government
still remains the largest shareholder (Battaglia and Gallo 2015). The third
banking category is based on 12 joint stock commercial banks and local
banks account for the fourth group. This last category is complex given
there are 144 city commercial banks, 212 rural commercial banks, 190
rural cooperative banks, 2265 rural credit cooperatives, and one postal
savings bank.
A timeline of major events in the Chinese securitization market may
be viewed in the Appendix 1 at the end of the chapter. Historically, the
Chinese securitization market has been divided into two government
sponsored schemes. The interbank bond market is supervised by the
People’s Bank of China (PBC) and any issuance of securitized products
by financial institutions is subject to the approval of the CBRC. For non-

financial companies who wish to issue securitized products, that is con-
ducted through the stock exchanges which are supervised by the China
Securities Regulatory Commission (CSRC) (Kong 1998; Wei 2007; Chen
and Goo 2015). Chen and Goo (2015), Rutledge (2015), and Buchanan
(2015a) detail the legal, constitutional, and regulatory framework of the
two securitization schemes at length.
Prior to 2005 the Chinese legal system had not been able to accommo-
date securitization projects because it was unlawful for a SPV to both hold
assets and issue securities (Hu 2008). In 2005, the first rules concern-
ing asset-backed securitization were under the Administrative Measures
on Pilot Projects of Credit Assets Securitization and The Measures for
Pilot Supervision and Administration of Securitization of Credit Assets of
Financial Institutions. The PBC and CBRC made a joint announcement
about the rules for the pilot program: “regulate the pilot securitization of
credit assets, protect legitimate interests of investors and relevant involved
parties, improve the liquidity of credit assets and enrich securities prod-
ucts” (Hu 2008).
Under the CBRC scheme the main participants in a securitization pro-
cess are: the issuer (who can be a bank or non-bank credit institution),
trustee, servicer, custodian, enhancers, underwriter, security registrar, and
investors who buy and sell ABS in the interbank bond market. At least
two ABS tranches are issued, of which the subordinate one is usually held
by the originator. Securitized assets were also to be subject to mandatory
and continuous credit ratings (Wei 2007). The CBRC scheme accelerated
after 2012 and many common asset classes have included NPLs, car loan
receivables, RMBS and CMBS (Chen and Goo 2015; Buchanan 2015).
In 2005, the other securitization scheme that was launched was the
CSRC scheme. This was under the regulation titled Interim Measures on
Managing Client Assets by Securities Firms. The CSRC allowed for the
establishment of a Specific Asset Management Program (SAMP). In a
deal worth RMB9.5 billion, China Unicom issued China’s first SAMP in
2005 with cash flows backed by its mobile telephone network receivables
(Sekine et al. 2009). Under this structure, SAMPs are a securitized form
of specified cash flows that non-financial companies transfer to securities
companies. SAMPs are traded on both the Shanghai and Shenzhen stock
exchanges. Neither banks nor insurance companies may invest in SAMPs
due to China Insurance Regulatory Commission (CIRC) rules and because
they are not members of a stock exchange (Sekine et al. 2009). Compared
160 B.G. BUCHANAN
with the CBRC scheme, the rules regarding legal, tax, and accounting
issues are more complex. As far as disclosure requirements, the SAMPs are
only required to report to SAMP investors. One hurdle in the initial stages
was that with CSRCs has been that bankruptcy was not guaranteed and
the notion of a true sale and bankruptcy remoteness had never been tested
by a Chinese court.22 Approvals of CSRC ceased after September 2006.
9 THE EARLY DAYS OF THE CHINESE SECURITIZATION

MARKET
The Bank of China started off-balance sheet activities in October 1979
despite the separate operation and regulation of China’s banking sector.
The 1990s was characterized by a decollectivization of land ownership and
a move toward private residential ownership. In 1995 the China Housing
Fund targeted housing subsidies for low-to-middle income workers and
three years later housing benefits were integrated as part of total worker
compensation. Over the last three decades there have been measures
taken to make the Chinese market more conducive to mortgage-backed
securitization. In 1998, the Shanghai Housing Authority announced the
establishment of a MBS program, involving the central agency as both
mortgage broker and guarantor.
In 1992, Hainan Sanya conducted the first bank-sponsored asset-
backed securitization in China. The securitization market remained fairly
quiet until 2005, with three major issues totaling RMB17 billion. In
April 1997, China Ocean Shipping Company (COSCO) securitized the
government owned company’s shipping revenues. Despite the lack of a
comprehensive legal system, successful completion of the COSTCO trans-
actions led to the announcement of plans for a second securitization worth
$500 million. In 1998, the Vice President of the State Development Bank
of China advocated asset securitization to fund infrastructure projects
(Kong 1998). The government passed laws and regulations to facilitate
the securitization of large infrastructure projects such highways and proj-
ect finance (Kong 1998).
In 1999, the Asset Management Companies (AMC) was established to
specifically deal with NPL disposal from the Chinese banking system. The
intention was to emulate the US 1980s RTC program. The AMC even
employed RTC’s former Chairman, William Seidman to guide the Chinese
AMC program. This response was regarded as a significant step to extract
liquidity and capital from bad loans secured by real estate collateral. The
Chinese government transferred approximately RMB 1.4 trillion of assets

to four AMC programs under this program (Chen 2004). As far as credit
enhancements are concerned, Chinese securitization schemes have also
drawn upon the Brady plan. Credit enhancement for AMC issued securi-
ties issued to both onshore and offshore SPVs China drew on the success
of the Brady Bond program. In the case of China, credit enhancement was
provided in the form of foreign reserves held in the form of US Treasuries.
In 2003 Chinese NPL securitization started to become more tailor-
made as the process could now incorporate different geographic locations
and different loan structures for reallocating NPL risk. Prior to the 2005
Pilot Securitization Program, Chinese banks engaged foreign banks. In
2002 Macquarie Bank of Australia became the first foreign bank to pro-
vide securitization services in China and Credit Suisse First Boston and
ICBC completed the first securitization of non-performing bank loans in
China in April 2004 (Buchanan 2015).
There were four primary objectives in the Chinese 2005 pilot program
(Sekine et al. 2009): (1) transfer and spread the risk of banks’ loan assets;
(2) dispose of banks’ NPLs; (3) make it easier for non-financial companies
to raise funds; and (4) give investors a greater choice of investments. Some
of the early ABS issuances in December 2005 were China Construction
Bank which issued US$360 million in residential mortgage-backed
securities and China Development Bank which offered US$500 million
in securities backed with unsecured credit from various state industries
(Buchanan 2015).
10 THE IMPACT OF THE 2008 FINANCIAL CRISIS

ON CHINESE SECURITIZATION
As for the number of securitization issuances in Japan, South Korea, and

China between 2005 and 2015, Japan and South Korea dominated the
Asian securitization market up until 2001. Between 2005 and 2011,
Japanese issues declined. In 2008, while ABS issuance was declining in
Europe and the USA, there was a small surge in the Chinese securitization
market. In 2008 China’s financial authorities issued a notice to banks to
tighten control on securitized assets and emphasized that attention needed
to be paid to the control of credit risk; ensuring “true” sales of prod-
ucts; accurate judgment of transfer risk; capital requirements compliance;
improved risk management and internal controls; improved disclosure;
and standardization (Sekine et al. 2009).
162 B.G. BUCHANAN
European issuance fell to 3 billion euros (a 91 percent decline) in the

first half of 2008. However, in China there was actually increased demand
for ABS, especially from other Chinese banks, insurance companies, and
pension funds. As the Chinese securitization market was awaiting more
clarity on matters such as risk transfer, asset pool quality, and trust law
and enforceability the ABS market in China came to a halt in 2008 due
to the global financial crisis. The Bank of China was one of the largest
Asian financial institutions to invest in securities backed by US subprime
mortgages and in the early days of the crisis was expected to write off
approximately one quarter of its $8 billion in securities (Hu 2008). By
2010, Chinese banks were expected to issue US$2.2 trillion in new loans
over the following five years, and were also facing more stringent capital
adequacy requirements. At the time ICBC president, Yang Kaisheng, pre-
dicted that China’s four largest publicly traded banks would need to raise
a further US$70 billion by 2015 in order to meet capital adequacy ratios
of 11.5 percent.23 His proposals included further progress to be made
on asset-backed securitization as well as selling loans to third-party pur-
chasers. At the time the target market for ABS remained unclear because
Beijing placed strict limits on securities investments by institutional inves-
tors like insurers. In addition, the newly established legal and regulatory
framework was largely untested. There were also added complications
such as dealing with moral hazards because of China’s poor reputation for
discriminating worthy borrowers.
11 POST 2012—THE CHINESE SECURITIZATION

PROGRAM IS REINSTATED
After 2008 issuance of securitized products ceased but was reinstated
in 2012, although new issuance was initially slow. China Development
Bank announced the sale of $1.6 billion in ABS, the first ABS deal in
over three years.24 In 2012, a $950 million CMBS deal involved the Bank
of China teaming up with Goldman Sachs group Inc., Deutsche Bank
AG, and UBS AG to lend to a partnership between Vornado Realty Trust
and Donald Trump.25 In March 2013 the China Securities Regulatory
Commission (CSRC) issued definitive securitization regulations. In 2013,
the State Council said it would expand the pilot ABS program to encourage
economic and credit growth and to reduce reliance on the shadow bank-
ing system.
In 2013, there was major restructuring of NPLs for the four major banks
(Buchanan 2015). The CSRC also changed the quotas on the Qualified
Foreign Institutional Investor (QFII) Program26 in order to internation-
alize the renminbi. In the QFII program accredited foreign investors
can buy CLOs in the interbank bond market or on the stock exchange.
Growth in securitization products was relatively lackluster in 2012–2013,
largely due to the fact that investors could generate higher yields from
wealth management products issued by banks and trust companies.
China’s money market experienced a series of credit crunches in 2013,
mainly liquidity crunches due to a classic maturity mismatch, between
long-term assets used to generate higher yields and the shorter-term
products that were being sold. Lacking a secondary market for the wealth
management products meant that investors were constrained to hold
them until maturity. Banks were rushing to raise cash to pay off matur-
ing shadow bank products which could not be easily sold. Global mar-
kets were adversely impacted by this credit crunch in the Chinese market.
Regulations also curbed banks and trusts to offer wealth management
products at yields as high as 10 percent.27 The securitization market was
thus provided a boost, coinciding with this reduction in competitive
advantage in wealth management products.
In 2014, CLOs served as the most common form of securitization in
China. It is evident that the most active issuer of CLOs is the policy banks
(34 percent of originations). Of this group, China Development Bank, a
state-owned lender has been the most active issuer packaging infrastruc-
ture loans such as railway construction loans. Banks account for an aggre-
gate issuance of 76 percent of CLOs. It is also evident that corporate loans
account for 86 percent of underlying assets of CLOs, followed by residen-
tial mortgages and auto loans. In China resecuritized products (think of
CDO2) are rarely seen, which was not the case in the USA prior to 2008
(Schwarcz 2013).
In January 2015, HSBC became the first foreign bank to complete a
Chinese securitization deal selling CLOs in the interbank market while
retaining the equity tranche on its own balance sheet (Buchanan 2015).
Gyntelberg and Remolona (2006) compare the appeal of collateralized
bond obligations (CBOs) versus CLOs. They observe that CBOs may well
be less liquid than the assets in the underlying pool. On the other hand
bank loans to companies are already highly illiquid, so the resulting CLO
is likely to be more liquid than the underlying assets. Most Chinese CLOs
are usually backed by company loans which are kept on the balance sheet.
164 B.G. BUCHANAN
In June 2014, Ping An Bank listed an ABS backed by small con-

sumer loans (worth approximately $423 million) on the Shanghai Stock
Exchange.28 This was the first time that a credit-backed security traded on
a Chinese bourse. The Shanghai Exchange cited that the Ping An Bank
listing, “will help to expand the investor base and substantively disperse
risk away from the banking system.”29 Whereas most ABS had previously
been backed by corporate loans, the Ping An asset pool was based on con-
sumer loans with an average of RMB 400,000 each and with an average
maturity of two years. The move was intended to expand the investor base
and substantively disperse risk through the Chinese banking system.
Sales of ABS had increased from $3 billion in 2013 to $19.7 billion in
2014.30 A thriving securitization market triggered concerns about poten-
tial risks to the Chinese financial system, especially in light of how the
technique had impacted developed markets after 2007. In 2014, other
challenges included the point that central bank quotas of RMB 40bn
for credit-backed ABS to be shared among 20 large banks. The CBRC
released guidelines in February 2014 to govern securitized capital in
banks’ risk measurement.
There was a shift toward mortgage securitization in 2014. In July 2014,
the first MBS market in seven years was launched in China. Postal Savings
Bank of China issued 6.8 billion yuan ($1.1 billion) in a MBS (termed the
Youyuan 2014) offering which was 1.25 times subscribed.31 In the first six
months on 2014, home prices in 70 Chinese cities had declined, and so
the move was viewed by investors as an effort on the part of the Chinese
government to support a slowing housing market. The characteristics of
the loans were that the loans were drawn from a pool of home buyers in
10 provinces and 12 cities and that the borrowers tended to be owner-
occupiers. This implied that stability of cash flows was more certain as
opposed to those borrowers who sought out properties for purely specula-
tive purposes.
Receivables (such as those from car loans) became a popular basis for
ABS in China. For Asian firms there tends to be an emphasis on exist-
ing receivables as opposed to securitizing future flows receivables, which
are far more common in Latin American securitization transactions.
The Chinese securitization market even attracted the financing units of
Volkswagen AG and Ford Motor Co and the auto loans were subsequently
transformed into ABS. In a move meant to reassure overseas bond buyers,
the Volkswagen Auto-loan ABS issued in 2014 was the first debt instru-
ment in China to receive international credit ratings (Buchanan 2015).
The main risk concern in the case of ABS based on car loans is whether
the car buyer will repay the loan installments. In the case of a CLO the
primary default risk concern is whether the company will repay the loan.32
Accounting for credit risk in Chinese business transactions is not necessar-
ily straightforward because many investors are also lenders (think of the
US analogy in the lead up to the 2007 crisis where banks who were issu-
ers also were ABS/MBS investors). Risks are also compounded by poorly
regulated informal lending channels and thus many of the risks are likely
to remain in the financial system.
In January 2015, the CBRC streamlined its registration procedure,
allowing approval requirement for 27 commercial banks to conduct secu-
ritization deals. At the same time with record low bond yields in Europe,
investors were seeking higher yields in alternative investments such as
ABS. The global ABS issuance market had risen nearly 16 percent by mid-
2015, with the biggest contribution coming from China.33 In 2015, the
Chinese government took steps to ban asset management companies from
securitizing local government debt. There was uncertainty as to whether
the move would have any substantial impact, unless banks and trust com-
panies followed suit.34
The Central Bank of China relaxed rules on the sale of ABS in April
2015. This made it easier for banks to transfer outstanding loans into trad-
able notes and institutions did not need to seek approval from regulators
for each ABS sale. ABS are now tending to becoming more standardized.
If they become more transparent and closely regulated, this should create
a more active market for the Chinese securitization market.
Despite these significant changes, as 2015 has progressed, there has
been a 50 percent drop in ABS volume around CLO issuance in China.
Banks have been less incentivized to sell CLOs because they are able to
obtain more liquidity through various interest rate and capital ratio cuts.
Of concern is that NPLs have started to increase (see Fig. 5.1). Bad debt
generated by China’s five largest state-owned banks increased to 50.1 bil-
lion yuan in the first quarter of 2015, double the level relative to the same
period in 2014. So if China’s growth continues to decline, NPLs are likely
to increase, and then it is likely to follow that the write-down of ABS will
continue to increase (Buchanan 2015).
166 B.G. BUCHANAN
12 SOME CONCLUDING THOUGHTS

After 2012, Chinese policymakers became increasingly more vocal with
the idea of securitization. In June 2013, Li Daokui (the Director of the
Center for China in the World Economy) termed securitization as a
“breakthrough point for China’s financial reform.” The following month,
China’s State Council identified securitization as a mechanism for eco-
nomic structural adjustment, transformation, and upgrading. At the same
time Premier Li Keqiang announced the further expansion of China’s
securitization pilot market project. PBC Governor Zhou Xiaochuan called
for an “orderly roll out of securitization to channel funds for revitalizing
small enterprise” in September 2013. At the end of 2013, China’s Third
Plenum rolled out detailed, ambitious growth and reform goals. At the
plenum securitization was termed a particularly effective financial solution
or catalyst (Rutledge 2015).
However, a number of impediments and risks remain. A lack of data
robustness can be an impediment to the development of the Chinese
securitization market. Since China has had more than 30 years of rapid
and continuous economic growth, the portfolio data has been reported
under an extended, more benign economy and as such does not capture
any stressful periods, such as an economic downturn. Such data provides
limited insight for gauging future performance. This is also a criticism that
was made of similar instruments in developed markets in the lead up to
the 2008 financial crisis. In addition, there is sometimes an unavailability
of a long history of portfolio data that is generally required in Chinese
securitizations, due to the short history of certain asset classes. Added to
this the three-year break in data availability surrounding the suspension of
the Chinese securitization market after 2008 makes prediction of future
performance even more difficult.
There is also the tarnished reputation of credit ratings in the after-
math of the 2008 crisis. Ratings agencies have struggled for credibility in
the Chinese market. Schwarcz (2013) proposes two credit rating system
alternatives for China. They are the requirement of dual credit ratings
for securitization projects and the encouragement of an investor-payment
model for rating agency fees. Ratings may more accurately reflect credit
risk if based on dual ratings, but this has to be balanced against potentially
significant costs.
Other risks including legal isolation, commingling, and bankruptcy
remoteness continue to be challenges for the Chinese securitization market
(Chen and Goo 2015) mainly because these issues remain largely untested
in its courts, so there is no legal precedent. Chen and Goo (2015) recom-
mend that the best thing that could happen for Chinese securitization
market development (for both domestic and cross-border transactions), is
for the National People’s Congress (NPC) to enact a formal securitization
statute.
NOTES
1. Jaffee, D. and Renaud, B. 1997 World Bank Study. Strategies to
Develop Mortgage Markets in Transition Economies 4 (World
Bank Policy Research Working Paper 1697).
2. Based on the 5/6 loan in the Philippines. This is where 5 pesos is
loaned in the morning and six pesos has to be repaid in the eve-
ning, equivalent to 20 % daily or 5000 % annually.
3. BRAC is an international development organization based in
Bangladesh.
4. Securitization in the Global Marketplace, P.A. Burke and J.P. de
Mollein, American Securitization Forum, 2012.
5. BRIC stands for Brazil, Russia, India and China.
6. Securitization in the Global Marketplace, P.A. Burke and J.P. de
Mollein, American Securitization Forum, 2012.
7. An Exit Plan for Japan? Brenner and Peterson, Business Week,
October 26, 1998, 132–134.
8. Euroweek (492), March 7, 1997.
9. China CLO market stutters on economic slowdown, Xiao Wang,
Asia Risk, 27 July 2015.
10. Sliced and diced loans take off in China, Gabriel Wildau, Financial
Times, February 19, 2015.
11. China’s problem is the economy itself, not the market sell-off,
David Daokui Li, Financial Times, August 30, 2015.
Asia Risk, July 27, 2015.
Asia Risk, July 27, 2015.
14. China’s banks face tightening bad loans squeeze, Ben Bland,
Financial Times, August 30, 2015.
15. Beijing’s Big Push Raises a Red Flag, Chao Deng and Fiona Law,
Wall Street Journal, July 18, 2015.
16. China’s problem is the economy itself, not the market sell-off,
David Daokui Li, Financial Times, August 30, 2015.
168 B.G. BUCHANAN
17. The Debt Dragon, Financial Times, August 28, 2013.

18. China Seen Expanding Mortgage Bonds to Revive Property
Market, Bloomberg News, April 16, 2015.
19. I will define asset securitization, as the transformation of illiquid
assets into freely tradable liquid assets, which provides an alterna-
tive method for raising capital.
20. China Commercial Lenders Expand Investment Banking
Operations”, Gabriel Wildau, Financial Times, April 5, 2015.
21. Moves on Asset Securitization, Michelle Taylor, Financial Times,
June 14, 2005.
22. Chen and Goo (2015) provide a more detailed account of the
structure of the CSRC guidelines.
23. No security in securitizations, Financial Times, May 1, 2010.
24. China Lifts Bar on Securitization Sales, Simon Rabimovitch,
Financial Times, September 5, 2012.
25. Bank of China Makes Debut in US Securitization Market, Lingling
Wei, Al Yoon, Wall Street Journal, November 29, 2012.
26. Deepening China’s Capital Markets through Innovation. Jingdong
Hua, July 22, 2013.
28. China bourse approves landmark securitization deal, FTimes, June
16, 2014.
29. China bourse approves landmark securitization deal, FTimes, June
16, 2014.
30. Chinese Securitization Surge Raises Concerns, Fiona Law, WSJ,
September 2, 2014.
31. China issues first mortgage-backed securities in seven years, Esther
Fung, Wall Street Journal, July 23, 2014.
33. Thompson, Christopher (2015) Risky loan deals hit post-crisis
high, Financial Times, June 29.
34. China plans to ban local government debt for securitized products,
Hong, Shen, Wall Street Journal, December 16, 2014.
APPENDIX 1: CHINESE SECURITIZATION TIMELINE
1979 The Bank of China starts off-balance sheet activities.

1992 Hainan Sanya issues China’s first bank sponsored ABS.
1996 Zhuhai City issues municipal toll-road backed financing.
1997 China Ocean Shipping Company (COSCO) securitizes future shipping revenues.
1997 First FFS from SPVs between Chonqing and Horizon ABS.
1998 Shanghai Housing Authority announces establishment of a MBS program,
involving a central agency as both mortgage broker and guarantor.
1998 State Administration of Foreign Exchange (SAFE) issued.
1999 Asset Management Company program founded.
2002 Macquarie Bank of Australia becomes the first foreign bank to provide
securitization services in China.
2004 Credit Suisse First Boston and ICBC complete their first NPL securitization.
2005 The People’s Bank of China (PBOC) and CBRC publish the Administrative
Measures of Pilot Projects of Credit Assets Securitization.
2005 China Unicom issues China’s first SAMP for RMB 9.5 billion.
2008 China’s securitization program halts due to global financial crisis.
2012 Peoples’ Bank of China reopens Credit Asset Securitization Program.
2012 China Banking Regulatory Commission (CSRC) grants RMB350 billion ($806
billion) in quotes to asset management companies, commercial banks, policy banks
and auto-financing companies.
2012 Agricultural Development Bank of China becomes the second largest policy bank
to use securitization.
2012 Bank of China makes debut in US securitization market.
2013 CSRC upgrades its framework for Enterprise Asset Securitization.
2013 Administrative Provisions on the Asset Securitization Business of Securities
Companies regulations are issued.
2013 Orient Asset Management receives CSRC approval for China’s first microloan
securitization.
2014 Ping An Bank lists an ABS on Shanghai Stock Exchange.
2014 Postal Savings Bank of China issues the first MBS in seven years.
2014 Ford Motor China issues first auto MBS.
2015 CBRC eliminates the approval requirement for 27 commercial banks, which allows
new securitization deals to be conducted under a streamlined registration
procedure.
2015 HSBC becomes the first foreign bank to complete a Chinese securitization deal.
170 B.G. BUCHANAN
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CHAPTER 6
Alternatives to Securitization
1 COVERED BONDS
The growth of the US securitization market has been primarily due to
mortgage-backed securities, whereas Europeans have historically tended
to trade in covered bonds. Covered bonds are very much part of the
European bond framework. As of mid-2007, the covered bond market
ranked as the sixth-largest market in the world and the largest asset class in
Europe. One of the strongest cases for a covered bond market is in reac-
tion to the 2007 global financial crisis. Relative to the US securitization
market, the covered bond market is regarded as having had a “good crisis”
(Blommestein 2011) because the market continued to be very resilient
against the backdrop of the 2007 global financial crisis. When bank fund-
ing markets seized up European lenders were still able to issue covered
bonds.
The argument for increased use of covered bonds has been made due to
the protection the covered bond market offered to investors throughout
the 2007 global financial crisis. Yet even prior to the crisis, the covered
bond market showed lots of growth in Europe. According to Dealogic,
the global issuance of covered bonds rose by 78 percent between 2001
and 2005. In 2011, a record $335 billion of covered bonds were sold in
Europe.1 Today the European covered bond market continues to enjoy a
strong reputation and is dominated by Germany and Denmark. Issuance
in the global covered bond market between 2003 and 2010 is profiled in

DOI 10.1057/978-1-137-34287-4_6
174 B.G. BUCHANAN
Fig. 6.1. One and the new covered bond issuers during the same period
are displayed in Fig. 6.2. According to the figure, Germany, Denmark,
and the UK are the biggest covered bond markets in terms of size. In late
2015, as part of its asset purchase program, the European Central Bank
was buying billions of euros worth of covered bonds each month.2
250000
200000
2003
150000
2004
2005
100000 2006
2007
2008
50000
2009
2010
0
Fig. 6.1 CB issuance (mill. EUR) by country excl. total
16
14
12
2003
10
2004
8 2005
2006
6
2007
4 2008
2009
2
2010
0
Fig. 6.2 CB new issuers by country excl. total

ALTERNATIVES TO SECURITIZATION 175
1.1 What Are Covered Bonds?

The fundamental problem of mortgage-backed securities derives from
the fact that when mortgages are removed off banks’ balance sheets, the
mortgages are no longer the responsibility of the lending institutions. An
added problem exists when the original mortgages are of doubtful or little
value. The subsequent focus on underwriting and collecting fees affects
the long-term performance of mortgage-backed securities. The “covered”
nature of European mortgage bonds derives from the fact that the bonds
are the direct liability of a mortgage institution and rely solely on the cred-
itworthiness of that financial institution.
Covered bonds are defined to be debt obligations of a financial insti-
tution by a “ring-fence” bankruptcy remote pool of assets known as the
“cover pool”. A cover pool usually consists of high-quality, low-risk assets.
Cover pools are commonly comprised of residential mortgage-backed
securities, but it can also consist of public debt or shipping loans. Asset
coverage tests are applied to determine whether mortgages are eligible for
the cover pool. Cover assets have to meet minimum underwriting require-
ments related to credit scores, loan to value (LTV) ratios, and delinquency
rates. If the minimum requirements are not met, a technical default can be
triggered as well as an increase in capital requirements.
A ring fence means that although the assets remain on the issuer’s bal-
ance sheet, they serve as collateral exclusively for the covered bond inves-
tors. To avoid significant deterioration, the cover pool is overcollateralized
and remains on the bank’s balance sheet. Covered bonds are regarded as
dynamically managed because the nonperforming loans must be periodi-
cally (e.g., on a quarterly or monthly basis) replaced with eligible collat-
eral. When there are difficulties with a poorly performing mortgage, the
bank that issued the covered bond will remove the troubled loan and
replace it with a better performing mortgage. That is, the issuer maintains
some “skin in the game”. In Europe bonds are usually overcollateralized
by 20–30 percent. The dynamic nature of the cover pool ensures that cov-
ered bondholders remain overcollateralized even following downgrades
of the issuer. In addition, the management of the cover pool must be
supervised and in the event of an issuer bankruptcy, the covered bond-
holders have first priority ahead of other debt holders. This dual course
characteristic means that covered bondholders will demand a lower inter-
est rate. The majority of covered bonds carries a AAA grade rating and
are periodically “marked-to market” to make sure the LTV ratios do not
176 B.G. BUCHANAN
exceed 80 percent. Apart from attractive features such as liquidity and

covenants, covered bonds do not entail complex tranching or prepayment
risk arrangements.
Investors in the global covered bond market usually include pension
funds, central banks, insurance companies, asset managers, and bank trea-
suries. For example, the European Central Bank holds covered bonds as
collateral for their repo activities. Regarding regulatory risk-weighting
requirements, covered bonds receive a lower risk weight. In some
European countries, covered bonds are allowed to meet reserve require-
ments for banking regulation.
Table 6.1 provides a summary of the differences between asset-backed
securitization and covered bonds.
Structured covered bonds fit one of two possible models. Under the
first model, the special purpose vehicle (SPV) holds the assets and guaran-
tees the bond issued by the originating bank. This model is generally used
by UK and Dutch banks. US banks follow the second model. Under this
structured covered bond model, a subsidiary, not the bank that originated
Table 6.1 Differences between asset-backed securities and covered bonds

Asset-backed securities Covered bonds
Issuer Special purpose entity (SPE) Usually it is the loan

originator
Issuer motivation Risk reduction/reallocation; Refinancing
refinancing; regulatory arbitrage
Any recourse on the Typically, no Yes
originator?
Structure Assets are moved off balance sheet Assets are identified as
to SPE belonging to cover pool
and remain on balance
sheet
Asset pool Static Dynamic
management
Asset prepayment Usually full pass-through Since assets are replaced,
there is no pass-through
Tranching Yes, common No
What is impact on Reduced None
issuer’s capital
requirements?
Legal restrictions on Usually none Yes
eligible collateral or
issuer?
the mortgages, issues the covered bond. The subsidiary lends the funds to
the parent bank. The parent bank retains and guarantees the cover assets.
The issuer will take possession of the cover assets and continue to service
the bond in the event of insolvency.
Prior to the 2007 financial crisis, two banks adopted covered bonds
in the USA, namely Washington Mutual (WaMu) and Bank of America.
When WaMu became the first US covered bond issuer in 2006 it did so
with a dual tranche 6 billion euro issue. The WaMu covered bond struc-
ture was somewhat unusual, in that the collateral for the covered bonds
was not the mortgages directly, but mortgage bonds. Mortgage-backed
bonds were issued by WaMu Bank to a SPV, the Washington Mutual
Covered Bond Program. The SPV was responsible for issuing covered
bonds to investors. Deutsche Bank was designated to be the indenture
trustee for the mortgage bonds. In the event of a default by WaMu Bank
Deutsche Bank was to be responsible for seizing and liquidating collat-
eral. The mortgage bonds, not the mortgages served as collateral for the
covered bonds. Deutsche Bank would then be responsible for deposit-
ing the proceeds a GIC account—AIGMFC was the provider. AIGMFC
would pay the interest and principal amounts for the covered bonds to
the Bank of New York. The Bank of New York served as the trustee for
the covered bonds. Note the trustee for the covered bonds and mortgage
bonds were different. The covered bonds were denominated in euros.
WaMu Covered Bond Program first had to swap the dollar-denominated
proceeds from the mortgage bonds into euro-denominated payments for
investors (most were European pension funds and banks). The swap pro-
gram, typical of covered bond programs, was used to manage timing and
currency mismatches between payments to the covered bondholders and
payments from the underlying mortgages. That is where Barclays Bank
comes in. Barclays served as the counterparty to the SPV on the currency
swap agreement.
In summary, the main benefits of covered bonds are:
1. The covered bondholders have dual recourse: a claim against the

issuer and a preferential claim embodied in the statute in the event
of insolvency. So the legal framework is very clear.
2. Alignment of incentives between issuers and investors (who retain
the credit risk).
3. It finds only real assets in an economy and is not used as an arbitrage
product.
178 B.G. BUCHANAN
4. Traditionally, covered bonds are issued by depositary institutions

that are strictly supervised entities in most countries.
5. A cover pool will only reference high-quality assets whereas a secu-
ritization issue may include a variety of assets of differing quality.
6. Due to a lack of tranching in covered bonds, there is not a conflict
between different classes of investors.
There are few potential disadvantages. Legal uncertainties arise due to
the track record of zero defaults. Identical treatment of covered
bonds is difficult due to different legal frameworks and practices
across countries.
1.2 Brief History of the German Covered Bond Market

In Europe reselling mortgages and covered bonds is a key source of bank
financing that dates back centuries. Covered bonds are a mainstay of the
European market, having been in existence since the 1770s. In Germany
(where they are known as Pfandbriefe) the covered bond market was
a response to the Seven Years War. In 1795 in Denmark the covered
bond market was the response to the Great Copenhagen fire. In both
cases, market was established to convert illiquid mortgages into tradable
securities. After the Seven Years’ War, the aristocracy was short of credit.
Frederick the Great established the Landschaften. These were public law
cooperative associations of landed nobles that enabled the aristocracy to
access credit by issuing full recourse bonds using their estates as collat-
eral. The landowner put up his estate as collateral and the Landschaften
issued Pfandbriefe. Credit was delivered in the form of the Pfandbriefe
which a member could sell in order to raise cash. The Pfandbriefe system
became popular for refinancing public debt in Germany. A formal frame-
work was established in the 1900 German Mortgage Bank Act, which
included the codified feature of ring fencing and recourse to both the
cover pool and issuer in the event of a bankruptcy. The jumbo Pfandbrief
was introduced in the mid-1990s, where “jumbo” is based on a size
requirement of €500 million. Its liquidity is ensured by strict market
making requirements.
Eventually the covered bond market extended to France (in 1852
through the Credit Foncier), UK, Spain and Italy. The main objective of
the mortgage-backed covered bond market in these instances was to pro-
vide liquid products and to lower refinancing costs.
In the immediate aftermath of the 2007 global financial crisis many

regulators looked to the covered bond market in Denmark as a model for
possible for recovery measures. The argument for increased use of covered
bonds in the US has been made due to the protection the Danish covered
bond market offered to investors. I discuss the Danish covered bond mar-
ket in the next section.
1.3 The Covered Bond Market in Denmark

The Danish covered bond market is the second largest market after
Germany. In Denmark covered bonds are known as “real kreditobliga-
tioner” and the bonds are traded on exchanges so that the yield to matu-
rity is market determined and transparent. In 2009, the Danish covered
bond market was worth $300 billion3 and did not freeze up during the
global financial crisis. In April 2014, international investors held 45 per-
cent of all Danish covered bonds (Haldrup 2014).
The Danish covered bond market is dominated by high-quality residen-
tial mortgages, commercial mortgages, shipping loans, and public sector
debt. Yet there is a big gap between the size of the Danish and German
covered bond markets. Public sector debt makes up a large part of the
German covered bond market, yet is non-existent in the Danish market.
In terms of mortgage covered bonds, the Danish market is well ahead of
the German and Spanish covered bond markets.4
The Danish covered bond market dates back to the great fire of
Copenhagen of 1795. Approximately 25 percent of houses were destroyed
and as a result, credit provision was extremely scarce. The city looked to
the new German Pfandbriefe market as a basis for its own covered bond
market. The Danish covered bond market was established to finance large
reconstruction costs after the 1795 fire. From its earliest days, the Danish
covered bond market was characterized by clear, secure transparent rights.
The first mortgage credit association dates back to 1797 and was
the only one in Denmark until 1850. In 1850 the first Mortgage Bond
Act was passed in Denmark, making it one of the oldest in the world.
In time this led to the creation of a large number of “co-op” organi-
zations, namely savings banks, mutual insurance companies, and mort-
gage credit associations. This was to meet a vast need for financing of
farm workers’ land acquisitions from the aristocracy. For the “middle and
down-market” borrowers there was no access to credit. Since the nation
had a significant agricultural industry there was significant event risk due
180 B.G. BUCHANAN
to the probability of a poor harvest. One solution was for mortgage credit
institutions to pool borrowers’ funds, diversifying event risk for both the
lender and investor. The basic principles have remained almost unchanged
for 150 years in the Danish mortgage and covered bond market. In its first
100 years, the Danish mortgage credit sector consisted of many mortgage
credit associations, where mutuality was emphasized. Mutuality contrib-
uted to a very restricted lending policy for Danes. The most important
duty of the mortgage credit associations was to safeguard the interests of
its members. The Danish system is a very robust system that has survived
several subsequent crises. For example, in the 1880s farm crisis there was
less than 1 percent loan loss and this figure was repeated during the Great
Depression and throughout changes in the macroeconomic regime in the
1980s and 1990s.
A more liberal lending policy was introduced after the 1950s. After
the 1970s reform included a provision that new mortgage banks would
only be approved if there was an apparent need for them. Subsequently,
the number of mortgage banks in Denmark was reduced from 24 to 7
banks. In addition, the system became a two-tier system (previously it was
a three-tier system) of ordinary and special mortgage credit loans.
In 1989, in order to comply with European Union internal market
standards, the ownership structure was transformed into limited compa-
nies (Haldrup 2014). The bonds were also subsequently referred to as
mortgage bonds.
1.4 How the Danish Model Works

Denmark is considered a curious case of a country with a sophisticated
economy and a relatively simple mortgage market, probably because its
market is so transparent and regulated. The IMF (2006) considers the
Danish mortgage market to be one of the more sophisticated housing
financial systems in the world. The Danish model is very straightforward
and each bank handles the entire covered bond process. What this means
is that each bank is responsible for originating and repackaging the loan, as
well as selling the bonds to investors. The Danish banks first sell the bonds
then fund the loan which is different to the US model where mortgages
are made and the originator recoups the money when the bonds are sold.
Most importantly, the loans stay on the Danish bank’s balance sheet, or
the issuer maintains skin in the game. In Denmark only seven mortgage
banks currently issue mortgage bonds—this adds to market concentration
and increased liquidity in the market. Realkredit Danmark and Nykredit/

Totalkredit account for almost 73 percent of the total mortgage bond
market in Denmark.5
The Danish mortgage market has a range of mortgages that share many
of the key features of the US mortgage market. Historically, like the USA,
Denmark is the only country where a 30-year fixed rate mortgage is call-
able by the borrower without penalty. However, one option not available
in the USA but available to Danish borrowers is that when they sell their
homes they can pass on their mortgage to the next homeowner.
There are significant differences between the US and Danish mort-
gage markets. For example, in Denmark, borrowers must fit a strict and
uniform set of underwriting criteria for a mortgage. The required down
payment on a house is much higher in Denmark compared to the USA
and UK in recent years—an 80 percent LTV for a house and a 60 per-
cent LTV for commercial property. There is a subprime mortgage market
in Denmark but credit quality is kept up because the borrower receives
mortgage insurance support. In Denmark, mortgage banks are specialized
institutions committed by law to mortgage lending only and any other
auxiliary business, such as banking, insurance, or asset management, must
be carried out through subsidiary institutions.
In addition, the Danish mortgage market is much more homogenous
in terms of credit risk and therefore it is very easy to convert mortgages
into covered bonds. Danish covered bonds are highly standardized and
they are identical to and interchangeable with the underlying mortgages.
So what this means is that house owners can redeem their mortgages at
any time by purchasing the equivalent mortgage bond in the market and
exchanging it for the mortgage. House prices and bond prices usually
move together so there is a remote chance of householders having nega-
tive equity in their houses.
The Danish system provides a high degree of security due to the fol-
lowing regulations:
1. The Danish Financial Authority.

2. Specific LTV limits and regular revision of the limits.
3. There must be regular and independent valuation of the cover assets.
4. Mortgages must be entered into the Danish Land Register.
5. Mandatory overcollateralization must be provided by the mortgage
banks.
182 B.G. BUCHANAN
The success of the Danish model has been attributed to its balanc-
ing principle, which includes interest rate matching; duration/liquidity
matching; and currency matching. This balancing principle and fund-
ing mechanism keeps cash flows simple and protects the financial system
against mismatching. In the 1970s, even though the Danish financial
system experienced difficulties investors did not suffer losses due to
bankruptcy.
In 2005, George Soros marketed the Danish Mortgage Solution on a
worldwide basis with the Absalon Project and the first loans were issued
in Mexico in 2007. During the 2007 financial crisis Soros (2008) advo-
cated making some modifications to the US based system. With regard to
the massive losses sustained in the mortgage industry, Soros believes the
US system broke down because the originators did not retain any part of
the credit risk—instead they were motivated to maximize fee income. In
other words, there was no “skin-in-the-game”. This would be termed an
agency conflict because the interest is not identical with the interests of
the ultimate owners. Soros praises service companies in the Danish system
that have to replace mortgages that are in default because they retain the
credit risk.
The US government sponsored entities also came in for harsh criticism
by Soros. Again he cites the Danish system which does not have a reliance
on Fannie Mae and Freddie Mac style entities. Instead it is an open sys-
tem where all the mortgage originators participate equally while operat-
ing without government guarantees. Even during the recent crisis Danish
mortgage bonds retained their traditional high AAA rating even though
they often yield less than government bonds. The bonds are highly rated
because the mortgage originators retain the credit risk and just pass on the
interest rate risk. Even after foreclosure and bankruptcy the borrower is
still responsible for the full loan.
From the mortgage banks’ point of view there are distinct advantages
to the Danish system. Firstly, there is the “in-house” principle where all
functions are performed within the same company. This includes funding,
credit evaluation, and loan processing—all of these actions are conducted
in-house instead of services offered from different organizations. Secondly,
the loans are distributed cheaply and efficiently, representing controlled
costs. In addition, in terms of risk management, the only primary risk
remaining is credit risk. Finally, the specialized mortgage institutions rep-
resent a good basis for co-operation with commercial banks. From the
investors’ point of view, the balance principle ensures a high bond rating
and the bonds behind each loan are perceived as safe and low cost. These
covered bonds consequently serve as an important investment for pension
funds and credit institutions.
1.5 So Why Has the USA Lagged the European Covered Bond

Market?
The US covered bond market is a two-tiered structure and cover pools are
considered to be dynamic pools (as opposed to “static” pools for MBS)
of revolving loans. Prior to the recent financial crisis in 2006 only two
American banks issued covered bonds: Washington Mutual (the largest
thrift institution in the USA) and Bank of America. However, after 2006
the US covered bond market still lagged the European market in terms
of issuances. There are two primary reasons for this. Firstly, until 2008,
the Federal National Mortgage Association (FNMA), Freddie Mac and
the Government National Mortgage Association (GNMA) provided more
attractive alternatives to residential mortgage funding. Secondly, there had
been a lack of certainty as to the availability of the cover pool to investors
in the event of a sponsoring bond failure.
However, after 2006 the US covered bond market still lagged the
European market. There are two primary reasons for this. Firstly, until
2008, FNMA, Freddie Mac and GNMA provided attractive alternatives to
residential mortgage funding. Secondly, there had been a lack of certainty
as to the availability of the cover pool to covered bond investors in the
event of a sponsoring bond failure.
Nevertheless, the US Treasury issued a best practices guide for the US
covered bond market and in 2008 the FDIC issued a policy statement on
covered bonds. The FDIC policy statement on covered bonds stated:
Insured depository institutions (“IDIs”) are showing increasing interest in

issuing covered bonds. Although covered bond structures vary, in all cov-
ered bonds the IDI issues a debt obligation secured by a pledge of assets,
typically mortgages… Proponents argue that covered bonds provide new
and additional sources of liquidity and diversity to an institution’s funding
base.6
However, when the FDIC made the public statement, it gave no indi-
cation as to whether the cover pool of assets would remain segregated
from other bank assets in the event of a bankruptcy. Even though cov-
184 B.G. BUCHANAN
ered bonds have been viewed as an alternative to mortgage securitization,

implementation in the USA has not been without obstacles. The lack of
a legal framework and resistance on the part of the FDIC made a covered
bond system difficult to pass through the US Congress.
In 2009 the Senate Banking Committee started listening to testimony
on the issue of creating a framework for a US covered bond market.
Covered bond legislation was reportedly not included in the Dodd-
Frank Act due to a dispute over whether the OCC, the FDIC or the US
Department of Treasury would act as a regulator. The US trade groups
strongly supported efforts to bring covered bonds to the USA as a corol-
lary to the securitization industry. The 2009 Financial Standards Board
(FSB) Report also encourages greater uses of the contractual framework
seen in the covered bond market. The explanation for this is that it ties
the issuers to the instrument by requiring them to act as default guarantor
in the event of underperformance of the underlying assets but provided
the depositors are not disadvantaged. In 2009 the European Central Bank
launched the Covered Bond Purchase Program (CBPP). In 2011 a bill
supporting the US Covered Bond Act was introduced in the US House
of Representatives. The proposed bill had two potential benefits in that
it would help alleviate financing demands on the government’s hous-
ing agencies and it would also redirect a portion of institutional investor
money. There have also been proposals to give regulatory authority to the
US Treasury.
One hurdle to overcome for the expanded US covered bond market is
that there is no legislative framework that prescribes the priority claims of
covered bonds over the cover pool in the event of an issuer bankruptcy.
Nor in 2011 was there a framework (as we saw with the WaMu bank-
ruptcy) that even establishes how covered bondholders may exercise their
claims. In a receivership scenario, the FDIC has not provided any guid-
ance regarding the regulatory treatment of covered bonds. There is also
concern over the suggestions to broaden the underlying assets available
as a basis for covered bonds because a wider variety of asset classes could
result in higher-risk premiums (Blommestein 2011).
In 2012, the SEC approved a $12 billion covered bond program to be
sold by the Royal Bank of Canada as “registered securities” meaning that
covered bonds may be bought by retail investors for the first time.7 Under
the “144 A” rule governing securities sales, only qualified institutional
investors could participate in the US covered bond market. But for the
unsecured creditors this may not be such great news because in the event
of bankruptcy, they may be left with fewer assets with which to settle their
claims. This is called the “encumbrance issue” and is a major concern of the
FDIC. Until that is resolved US lenders will continue to miss the low-cost
funding that covered bonds provide. Yet what is agreed is that regulation
and supervision remain stringent. It is also of paramount importance that
the quality and homogeneity of the cover pool be crucial in the resilience
of the covered bond market.
1.6 Current State of Covered Bond Markets

The geographical scope of covered bond issuance has broadened consid-
erably over the last decade. By 2009 29 countries had either introduced
specific covered bond legislation or allowed structured bonds based on
the existing commercial law (Schwarcz 2011). In 2013, the Royal Bank
of Canada issued the first covered bonds registered with the SEC (Bhanot
and Larsson 2015). Banks in Singapore and South Korea have broadened
and diversified their financing by launching covered bonds for the first
time. In late 2015 United Overseas Bank announced an $8 billion issue
of covered bonds backed by Singaporean mortgages. The South Korean
bank Kookmin issued the country’s first (and Asia’s second) covered bond
issue.8 South Africa’s central bank is considering introducing covered
bonds over the next three years. Covered bond markets have been under
development in Poland, Romania, and Turkey. The regulatory future
(especially Basel III) for the covered bond market seems rather bright and
the yields on covered bonds are usually higher than on sovereign debt,
without a significant rise in credit risk.
2 ISLAMIC SECURITIZATION
After the market turmoil of 2008, the securitization market effectively
ground to a halt. Banks tried to deliver, sell non-core assets, and raise
capital, all in an attempt to boost their balance sheets. Central banks
had to support the inter-bank money markets with substantial liquidity
injections. The securitization market remained stagnant. At the time,
securitization was viewed as a disrupter of financial markets because of
imprudent credit origination, opaque valuation methods, and insuffi-
cient regulatory oversight. Conventional securitization was viewed as
having adverse consequences for global financial stability and economic
growth. A lot of doubt was cast upon securitization as a technique to
unbundle, transform, and reallocate credit risk. Yet the demand for
credit remained unabated.
186 B.G. BUCHANAN
An alternative to conventional securitization could be found in the

Islamic capital markets. Islamic finance is governed by shariah principles,
which ban profit taking without real economic purpose. Shariah prin-
ciples prohibit the sale and purchase of debt contracts and activities that
are not shariah compliant (known as halal). Haram deals with the pro-
hibition of interest based forms of income as well as socially detrimental
and sinful activities.9 Islamic finance tenets also stress the importance
of maintaining a mutually beneficial balance between the borrower and
lender with a view to serving the public interest (maslaha). A central
precept of Islamic finance is riba, which bans interest and stipulates
that income must be derived as profits from shared business risk rather
than through guaranteed return. The financial crisis highlights a major
distinction between conventional finance and Islamic finance because
shariah-based financing substitutes the temporary use of assets by the
borrower for a permanent transfer of funds from a lender as a source of
indebtedness (Jobst 2007). The investment return must come from the
assets used to support them.
Since 2002 Islamic capital markets have demonstrated impressive
growth. Sukuk markets are the largest component of Islamic capital
markets (McMillen and Curtis 2016). Sukuk issuance between 2002
and 2008 was approximately US$88 billion. This growth is largely
attributable to improved capital market regulations and a favorable
macroeconomic environment. Some Middle Eastern countries with
large infrastructure development plans required shariah-compliant
financing. Sukuk issuances declined to US$38 billion in 2009, but then
rebounded and soared to US$140 billion in 2012 and US$116 billion
in 2014 (McMillen and Curtis 2016). In 2014, 63 percent of sukuk
issues were sovereign originated, followed by corporations (22 percent)
and quasi-sovereign issues (16 percent). The sukuk issuance market
is relatively young, starting in Malaysia in 1990 with a US$30 mil-
lion issuance by Shell Malaysia. In 2002 international recognition was
achieved when Kumpulan Guthrie issued the first global Islamic finan-
cial product via its US$150 million Sukuk Ijarah.10 In the same year the
Malaysian government issued the world’s first global Islamic Sukuk via
a US$600 million five-year floating rate security. To date, the largest
issuance size has been by Rantau Abang Capital Berhard for US$2.7
billion. Historically, the Malaysian market has dominated the global
sukuk market, representing just over two thirds. A discontinuance of
short-term sukuk issuance by Bank Negara Malaysia in 2015, led to a
decline in 2015 issuance figures.
Sukuk are structured in a similar way to conventional asset-backed secu-

rities (ABS) and covered bonds. However, they have significantly differ-
ent underlying structures and provisions based on shariah tenets. Islamic
securitization is a two stage process. In the first stage the type of assets
underlying the portfolio must be identified and chosen. Due to shariah
principles, Islamic structured products have tended to be oriented toward
more tangible and substantial assets such as commodities and real estate.
The second stage involves structuring the sukuk. In Islamic securitization,
assets can be removed from the balance sheet but a “true sale” of assets
implies there is a clear link between the underlying ownership of the asset
to an identifiable economic activity. There must also be an exclusive dedi-
cation of future cash flows. Such a transaction should not involve an inter-
est payment at any stage of the process. Given that sharia principles ban
interest income, the Islamic securitization process must be structured in
such a way that it compensates the investor for direct exposure to business
risk. The underwriting standards regarding issue placement and ratings
are also subject to religious scrutiny. Ratings agencies such as Standard
and Poor’s have published criteria as to how sukuk instruments should be
rated (McMillen and Curtis 2016).
Sukuk issuances are medium-term, asset-backed notes issued by gov-
ernments, quasi-sovereign agencies, and corporations. According to
Vishwanath and Azmi (2009) the Accounting and Auditing Organization
for Islamic Financial Institutions defines an “investment sukuk” as “…
certificates of equal value representing undivided shares in ownership of
tangible assets, usufruct and services or (in the ownership of) the assets
of particular projects or special investment activity”. AAOIFI allows for
14 possible sukuk categories by asset class using nine different contracts
(McMillen and Curtis 2016).
Compared to conventional securitization, the sukuk can be considered
to be most similar to the mortgage pass-through certificates. It is rela-
tively straightforward to construct a shariah-compliant asset-backed struc-
ture that delivers a risk-return profile similar to conventional securitized
structures (Jobst 2007). The structure of the sukuk replicates the cash
flows of conventional bonds. Sukuks can be traded through conventional
organizations and are tradable on exchanges. The sukuk issuer sells the
certificate to an investor group and this group then rents it back to the
issuer for a predetermined rental fee. The issuer also makes a contractual
promise to buy back the security at a future date at par value. The rent is
often benchmarked to a well-known rate such as the London Interbank
Rate (LIBOR).
188 B.G. BUCHANAN
Among the advantages of Islamic securitization are active management

and control of asset portfolios as well as a more diversified funding option
that widens the choice for alternative investment products, especially a low
yielding environment. The process also provides a good liquidity tool and
it is easy to mobilize fresh funds. Existing asset-backed transactions can be
bundled together and transformed into a new sukuk issuance.
Sukuk is also regarded as a financial instrument that can resolve many
of the agency conflicts associated with conventional securitization (Jobst
2009). This includes asymmetric informational problems that exist
between: the asset manager and investor; originator and issuer; issuer and
investor; servicers and investor/asset manager; borrower and originator;
and arranger and guarantor. For example, consider the agency conflict
between borrower and originator. The sukuk addresses the conflict of
interest issue by prohibiting debt modification and unilateral (potentially
exploitative) gains. Because shariah tenets stress the importance of social
benefit, predatory lending (or moral hazard of originators) would be pro-
hibited under sukuk issuance.
In summary, Islamic securitized products must comply with a series of
clearly stipulated conditions:
1. The type of collateral assets that generate the securitized revenue

must be clearly identified. There must be a clearly discernible reason
behind why the securitization process is being conducted.
2. Every participant in the securitization process must share in both
risk and return and the investor must be compensated for business
risk.
3. The assets that are being collateralized cannot be associated with
sinful activity (known as “haram”) or gambling or speculative activ-
ity from non-productive investment (known as “gharar”).
4. There must be sufficient ownership conveyed to the investor.
5. The proceeds from issued notes that go to investors cannot be
invested in debt or short-term cash instruments.
6. Takaful, or insurance, should be employed.
7. Any form of credit and/or liquidity enhancement and any restric-
tions regarding prepayment risk must be in a permissible form. As
long as it does not change the overall character of the transaction,
credit enhancement is not ruled out.
Jobst (2009) states that from 2010 to 2013 approximately US$2 tril-
lion of credit demand is estimated to be unmet as the conventional securi-
tization market remains in flux. The current situation creates a number of
opportunities in alternative markets. In addition, some financial centers are
looking at ways they can best accommodate the trading of sukuk bonds.
For example, in order to retain its financial clout as a global financial cen-
ter, London is looking at ways to issue shariah-compliant bonds and has
started to adjust its tax regulations so that sukuk bonds can be held and
traded. As an alternative to conventional securitization, sukuk issuance is
believed to be an efficient means of capital allocation and financial stability.
NOTES
1. Invasion of Covered Bonds Stall at US Gate by Tracy Alloway on
May 25, 2012.
2. Covered bonds advance beyond Europe, Financial Times,
December 10, 2015.
3. National Real Estate Investor, Securitization’s Sole Survivor,
Bennett Voyles, February 1, 2009, Vol. 51, No. 2.
4. Danish covered bonds—a primer. Global Credit Research, 2008.
5. Danish Mortgage Bonds, Realkredit Denmark.
6. https://www.fdic.gov/news/news/press/2008/pr08060a.html
7. Invasion of Covered Bonds Stall at US Gate by Tracy Alloway on
May 25, 2012.
8. Covered bonds gain ground in Asia, Thomas Hale, Financial
Times, November 25, 2015.
9. This prohibits investment in alcohol, tobacco, gambling, and por-
nography, for example.
10. The Ijarah sukuk is the most popular sukuk bond and represents
leased assets.
REFERENCES
Bhanot, K., & Larsson, C. (2015). Should financial institutions use covered bond
financing? Working paper.
Blommestein, H. J., Harwood, A., & Holland, A. (2011). The future of debt
markets. OECD Journal: Financial Market Trends, 2011(2), 263–281.
Haldrup, K. (2014). On security of collateral in Danish mortgage finance: A for-
mula of property rights, incentives and market mechanisms. European Journal
of Law and Economics, 1–29.
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IMF. (2006). Denmark: Financial sector assessment program–detailed assessment of

the securities clearance and settlement systems. IMF Country Report, No.
07/117.
Jobst, A. (2007). The economics of Islamic securitization. Journal of Structured
Finance, 13, 1–22.
Jobst, A. (2009). Islamic securitization after the subprime crisis. Journal of
Structured Finance, 14, 41–56.
McMillen, M. J. T. (2016). Critical factors for stimulating private sector Sukuk
markets. Institutional Investor, April 3 (forthcoming). Retrieved from SSRN,
https://ssrn.com/abstract=2758297
Schwarcz, S. (2011). The conundrum of covered bonds. Business Lawyer.
Vishwanath, S. R., & Azmi, S. (2009). An overview of Islamic Sukuk bonds.
Journal of Structured Finance, 14, 58–67.
CHAPTER 7
Reforming the Global Securitization Market
In 2009 at the London School of Economics Stamp Lecture then Federal

Reserve Chairman Ben Bernanke presented the following outlook on the
global financial crisis:
Rising credit risks and intense risk aversion have pushed credit spreads to
unprecedented levels, and markets for securitized assets, except for mort-
gage securities with government guarantees, have shut down. Heightened
systemic risks, falling asset values, and tightening credit have in turn taken
a heavy toll on business and consumer confidence and precipitated a sharp
slowing in global economic activity. The damage, in terms of lost output,
lost jobs, and lost wealth, is already substantial.
Lawsuits were also on the rise. A rising trend in lawsuits filed against
lenders, originators, and home builders erupted as the US housing market
started to decline during late 2006 and into 2007. There were a number
of other surprising responses to the US mortgage crisis, including the sug-
gestion that local governments use “eminent domain”. Eminent domain
usually applies to the government seizure of real property (not loans), such
as homes for an urban renewal project or highway construction project. In
this case, eminent domain was intended to take underwater, but performing
mortgages, in the private label securitization market. The seizure of trou-
bled mortgages would enable the homeowners’ debt to be written down.
San Bernardino County in California was one of the first and more visible
cases during the crisis where eminent domain was proposed. Numerous
criticisms by Wall Street groups and the mortgage industry argued that

DOI 10.1057/978-1-137-34287-4_7
192 B.G. BUCHANAN
60
50
40
No. of Filings
30
20
10
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2007 2007 2007 2007 2008 2008 2008 2008 2009
Fig. 7.1 Credit crisis filings. Source: “An update on the credit crisis litigation: a
turn toward structured products and asset management firms”, NERA Economic
Consulting Working Paper (2009)
such a plan would spark lawsuits, higher interest rates, and a tightened
market for borrowers.1 The measure was eventually voted down in 2013.
In 2007, 35 percent of the lawsuits were filed against lenders and home
builders and 14 percent were filed against asset management firms. By the
end of 2007, lawsuits started to specifically focus on structured products
and investment management firms. In 2008, 17 percent of the lawsuits were
filed against lenders and home builders while 33 percent were filed against
asset management firms (Sabry et al. 2009). Most cases involved allegations
relating to the purchase, ownership, or sale of securities. According to Sabry
et al. (2009) in this initial wave of litigation the key allegations included (i)
the concealment of subprime risk exposure and failure to adequately allo-
cate reserves for such exposure; (ii) misrepresentation of subprime exposure
and failure to write down assets in a timely manner; and (iii) misrepresenta-
tion of the collateral underlying the securities. Figure 7.1 shows the surge
in credit crisis filings between the first quarter of 2007 and first quarter of
2009. The figure shows the dispersion of 303 credit crisis filings over the
same period. Sabry et al. (2009) find that credit crisis filings increased to
172 percent in 2008 relative to 2007, rising to 188 cases from 69 cases.
REFORMING THE GLOBAL SECURITIZATION MARKET 193
Ninety-five percent of Fortune 500 companies maintain director and

officer liability insurance (Sabry et al. 2009). As the number of lawsuits
increased in 2007–2008, the impact of director and officer insurance
liability on the insurance was estimated to be severe. Carpenter (2007)
estimates the director and officer losses exceeded $2 billion. The percent-
age of cases in which directors and officers were named as defendants was
high, with 62 percent named in suits in 2008 compared to 68 percent in
2007 (Sabry et al. 2009).
Much of the litigation in the early phase of the financial crisis comprised
of Rule 10b-5 class actions against a number major financial firms, includ-
ing Citigroup, Merrill Lynch, Morgan Stanley, and UBS AG. Class action
suits were also filed against a number of mortgage originators, such as
Countrywide Financial Corp., New Century Financial, IMPAC Mortgage
Holdings, Coast Financial Holdings, Thornburg Mortgage, and Washington
Mutual. Since pension funds were major investors in securitized products, it
is not surprising to see that ERISA class action lawsuits also followed during
this period. Litigation was also pursued against a number of firms, includ-
ing Morgan Stanley, Citigroup, MBIA, Merrill Lynch, and State Street
Corporation. State Street Corporation was facing multiple ERISA suits con-
cerning the operation of some of its funds and set aside a reserve of $618 mil-
lion in the fourth quarter of 2007 to cover legal exposure (Sabry et al. 2009).
As the credit crisis grew more severe, an increasing number of lawsuits
centered on complex financial instruments such as collateralized debt obli-
gations (CDOs) and credit default swaps (CDS). Bethel et al. (2008) exam-
ine 193 CDOs issued as far back as 2002 which had experienced default,
acceleration in poor performance, and liquidation during the credit cri-
sis. Much of the litigation was directly related to extensive write-offs that
financial institutions had to take. The CDO-related cases alleged failures to
disclose proper valuations and misrepresentations about the quality of the
underlying collateral. Out of the sample, 87 CDOs had declared default by
May 2008, approximating $215 billion in issuance value.
Some of the more recent allegations in the investor suits include (i)
misrepresentations of the investment characteristics of the securities in
terms of liquidity and/or exposure to non-prime loans; (ii) false and mis-
leading registration statements for newly issued securities due to omissions
regarding exposure to subprime loans, CDOs, and CDS; and (iii) misrep-
resentations about investments in Lehman Brothers securities.
In addition to breach of contract lawsuits, CDS were at the center of a
number of shareholder class action lawsuits. For example, a suit brought
against AIG by the Jacksonville Police and Fire Pension Fund alleged that:
194 B.G. BUCHANAN
…AIG consistently assured investors of the security of its ‘super senior’

credit default swap (‘CDS’) portfolio, representing to investors the material
fact that it was ‘highly unlikely’ to suffer any actual losses as a result of the
mortgage meltdown.2
Alleged fraud and material misrepresentation were at the center of the

lawsuit’s charges. The suit charged AIG with misrepresenting the expo-
sure and value of the CDS portfolio and failing to disclose other expo-
sures, such as $6.5 billion in liquidity puts written on CDOs linked to
subprime mortgages. The suit went on to assert that: “Defendants’ know-
ing or reckless statements and inadequate disclosure of the massive losses
inflicted on the Company’s CDS portfolio artificially inflated the price of
AIG stock throughout the Class Period…”3
There have been a total of 1120 credit crisis-related filings between
January 2007 and November 2014 (Sabry et al. 2015). The authors
also observe that the number of new cases filed has declined significantly
over the last year—154 cases filed in 2013 versus 48 cases filed in 2014.
According to Sabry et al. (2015), ERISA and Rule 10b-15 claims have
continued to decline since 2007.
In the initial stages of the financial crisis filings against the residential
mortgage-backed securities (RMBS) trustees represented less than 2 per-
cent of total US filings. However, in 2014 lawsuits against RMBS trustees
had increased and now accounted for 31 percent of new claims being
filed against RMBS trustees. Between 2007 and 2012 lawsuits against US
mortgage lenders accounted for only 8 percent of filings. However, at the
end of 2013 filings against mortgage lenders had increased and accounted
for 45 percent of the cases filed against mortgage lenders that year. In
2014, the proportion declined and 33 percent of cases filed were brought
against mortgage lenders (Sabry et al. 2015)
Sabry et al. (2015) also detail settlements involving ABS and RMBS,
and observe the largest settlements involved claims that were brought by
investors, monoline insurers, and regulators. They also detail a significant
increase in substantial RMBS litigation as well as an increase in new cases
against RMBS trustees and mortgage lenders. They estimate $72 billion in
settlements for credit crisis-related litigation between 2007 and 2014. This
includes three significant settlements with the US Department of Justice.
In 2013 and 2014 the Department of Justice agreed to three settlements
for a total of $37 billion. In addition, Sabry et al. (2015) calculate a total
of $35 billion (covering state and federal credit crisis-related lawsuits) in
non-Department of Justice settlements from 2007 to 2014, of which $14
billion was recorded in 2014 alone.
Established in 2008 the Federal Housing Finance Agency (FHFA) was

the regulator of, and eventually became the conservator for Fannie Mae
and Freddie Mac when the agencies were effectively nationalized in 2008.
In 2011, the FHFA filed lawsuits against 18 financial institutions related
to RMBS securities sold to Fannie Mae and Freddie Mac. In the filings,
the FHFA alleged that the 18 financial institutions made material misstate-
ments and omissions about the mortgage loans underlying the securities.4
In 2013 and 2014, the FHFA settled 16 of the 18 matters for approxi-
mately $18 billion. In 2014, three significant settlements, worth approxi-
mately $8.3 billion, were made with the FHFA.
1 US REGULATORY RESPONSES TO THE GLOBAL

FINANCIAL CRISIS
In the aftermath of the 2007 financial crisis regulatory authorities around
the globe undertook numerous actions to make securitization transac-
tions safer and simpler, and to ensure that appropriate incentives would
be in place to manage risk. This includes higher capital requirements, due
diligence, and conduct of business requirements as well as mandatory risk
retention requirements. These reforms were necessary to ensure financial
stability in capital markets.
Since the global financial crisis was triggered, there has been a barrage
of well-intentioned legislation and regulatory initiatives on a global basis
regarding reforms such as: (i) how to make securitized products more trans-
parent and less complex, (ii) forcing banks to keep “more skin in the game”,
and (iii) to change the way ratings agencies work to reduce conflicts of inter-
est. Historically, regulation had focused on commercial banks, but during
the 2007 financial crisis, there was now the shadow banking system to take
into consideration. This includes hedge funds, money market mutual funds
(MMMF), commercial paper, and structured investment vehicles.
Agencies in the US and European Union sought to ensure that appro-
priate incentives were in place to quantify and manage risk through
improved capital requirements, due diligence, and risk retention. This
was intended to ensure that the Originate-to-Distribute (OTD) model
was not being used for purely speculative purposes. The global regulatory
reforms are necessary to ensure financial stability, to free up bank balance
sheets, and to keep open an important funding channel in the economy. I
now detail the key responses in the USA after August 2007.
The Term Auction Facility (TAF) established on December 12, 2007,
was a very important liquidity response which permitted banks to borrow
196 B.G. BUCHANAN
funds over a 28- or 84-day time period as opposed to the overnight matu-
rity for the discount window. The initial response by the US Congress was
to pass the Economic Stimulus Act of 2008, signed into law by President
Bush on February 13, 2008. Focusing on tax rebates and incentives, the
Economic Stimulus Act was estimated to cost approximately US$152
billion. President Bush also signed into law the Housing and Economic
Recovery Act of 2008 on July 30, 2008, and this law principally reformed
the regulation of government-sponsored enterprises such as Fannie Mae
and Freddie Mac.
Fannie Mae and Freddie Mac were placed into government conserva-
torship in September 2008. Along with Ginnie Mae, these three agencies
were funding 90–95 percent of US mortgages by 2011. The US govern-
ment also raised the maximum GSE conforming loan limit in high-cost
areas from USD 417,000 to USD 729,790 in 2008. It was set to expire in
2011 and fall back to a loan limit of USD 625,000. These measures also
had the effect of crowding out the private label securitization market. This
is best illustrated in Fig. 7.2.
4,000.00
3,500.00
3,000.00
2,500.00
2,000.00
1,500.00
1,000.00
500.00
0.00
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Agency NonAgency
Fig. 7.2 American securitization issuance 1996–2014, USD bn.

Source: SIFMA
As more regulatory responses were unveiled, short selling on Fannie

Mae and Freddie Mac securities was prohibited. After two rounds, the
US Congress passed the Emergency Economic Stabilization Act of 2008
on October 3, 2008. This established the $700 billion fund known as
the Troubled Asset Relief Program (‘TARP’). Finally, US Congress passed
the US$787 billion economic stimulus package on February 17, 2009.
This package was formally referred to as the American Recovery and
Reinvestment Act of 2009.
Under the 1913 Federal Reserve statute, the central bank is limited
to secured lending activities and purchasing securities. Yet dealer banks
were at the center of the financial crisis not regulated depositary institu-
tions (or commercial banks). Dealer banks5 do not have access to the
discount window at the US Federal Reserve. So in response to difficul-
ties in the securitization market the US Treasury and US Federal Reserve
introduced a number of unprecedented programs. The Federal Reserve
referred to this strategy as its ‘large-scale asset purchase programs’ and
its purpose was to support the housing market and foster improved
conditions in the financial markets. One such response to stabilize the
housing markets was the purchase of mortgage-backed securities (MBS).
The Federal Reserve was an active purchaser of fixed- rate MBS guar-
anteed by Fannie Mae, Freddie Mac, and Ginnie Mae through its MBS
Purchase Program. The amounts purchased were then recycled back into
the housing lending market, permitting banks to make additional resi-
dential loans.
The Fed’s purchase of MBS has not been without controversy. The
Fed’s balance sheet has increased significantly since August 9, 2007. On
August 8, 2007, total assets of the Federal Reserve were valued at $869
billion, and by early 2009 was over $2 trillion.6 The Federal Reserve con-
tinued to purchase MBS securities well into 2014, increasing the size of its
balance sheet to $4.5 trillion by mid-2015. Federal Reserve critics com-
plained that such a massive and sustained purchase was setting the stage
for another housing bubble, which could possibly trigger another finan-
cial crash. Figure 7.3 illustrates the changing nature of the US Federal
Reserve’s balance sheet.
The US Federal Reserve created a number of lending facilities to assist
non-depository institutions under its Section 13(3) lending authority.
The various measures to non-depository institutions that were enacted
through Section 13(3) of the Federal Reserve Act included:
198 B.G. BUCHANAN
5000000
4500000
4000000
3500000
3000000
in US $ millions
2500000
2000000
1500000
1000000
500000
0
8-Aug-07 8-Aug-08 8-Aug-09 8-Aug-10 8-Aug-11 8-Aug-12 8-Aug-13 8-Aug-14
Date
Fig. 7.3 Total assets of the US Federal Reserve.

Source: Federal Reserve flow of funds Data
• Primary Dealer Credit Facility

• Term Securities Lending Facility
• Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility.
• Commercial Paper Funding Facility
• Money Market Investor Funding Facility
• Term Asset-Backed Securities Loan Facility (TALF)
All told, these lending facilities provided hundreds of billions of dollars

of liquidity to non-depository institutions which had difficulties accessing
the credit markets.
The Term Asset-Backed Securities Loan Facility (TALF) was one of the
largest Section 13(3) lending facilities. It was announced in November of
2008, but did not begin operations until March of 2009. The objective
of the Term Asset-Backed Securities Loan Facility was to support the mar-
ket for ABS that securitized the following: Small Business Administration
guaranteed loans, floor plan loans, insurance premium finance loans, com-
mercial mortgage loans, and residential mortgage servicing advances. In
February 2009, the Federal Reserve and the Treasury jointly announced
the expansion of the facility up to US$1 trillion due to further deteriora-
tion of the financial markets.
The Primary Dealer Credit Facility (PDCF) was created on March 16,
2008, in response to the liquidity crisis facing primary market dealers in
the spring of 2008, especially after events at Bear Stearns. PDCF was dif-
ferent to other lending programs that were implemented because this is
an overnight fully collateralized loan facility for primary market dealers
who deal and trade in US Treasury securities with the Federal Reserve
Bank of New York. The facility was intended to provide liquidity for only
six months, but after two years, the program was officially terminated on
February 1, 2010. The Term Securities Lending Facility (TSLF) was cre-
ated on March 11, 2008, during the same time the PDCF was announced.
The facility was suspended on July 1, 2009, and the program was termi-
nated on February 1, 2010.
As a response to the crisis at Bear Stearns, the Federal Reserve lent
US$29 billion to a special purpose investment vehicle named ‘Maiden
Lane’ in March of 2008. Later in the year, the Federal Reserve also made
two additional loans to AIG which was similar to the Bear Stearns Maiden
Lane facility. It was implemented through two special purpose vehicles
(SPVs) referred to as Maiden II and Maiden III. Regarding the Maiden II
vehicle, the Federal Reserve lent funds on a non-recourse basis in order to
purchase residential mortgage-backed securities from the AIG subsidiar-
ies securities lending portfolio. The Federal Reserve also lent funds on a
non-recourse basis to Maiden Lane III, but this was in order to purchase
multi-sector CDOs on which AIG Financial Products had written CDS.
As they were at the core of the financial crisis, the value of ABS as col-
lateral was brought into question, causing runs on the asset-backed com-
mercial paper and repo markets. During 2008 the market for commercial
paper quickly dried up, and companies that usually depended on com-
mercial paper for short-term debt financing found it extremely difficult
to finance their activities. As a response, the Commercial Paper Funding
Facility (CPFF) was announced on October 7, 2008. The average matu-
rity for the majority of commercial paper issued during 2008 was less than
a week (even though the maturity for commercial paper can be up to
270 days).
After the Lehman Brothers failure, a run on money market mutual
funds (MMMFs) was triggered after shares issued by the Reserve Primary
Fund “broke the buck”. This now meant that shares in the Reserve
Primary Fund were trading at less than one US dollar per share. Many
200 B.G. BUCHANAN
MMMFs held Lehman’s short-term notes. So when Lehman failed, the

MMMFs incurred runs by nervous shareholders. This was due to pressure
from redemption requests from investors and losses on commercial paper.
As a response to the run on MMMFs, the Money Market Investor Funding
Facility was created.
The Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (AMLF) was created on September 19, 2008. The
AMLF provided funding to US depository institutions and bank holding
companies to finance the purchases of high-quality asset-backed commer-
cial paper from money market mutual funds. In order to meet inves-
tor redemption requests, the facility was planned to provide liquidity to
money market mutual funds. On October 8, 2008, the facility had a high
balance of US$145 billion and was terminated on February 1, 2010.
In 2009, SIFMA President and CEO Tim Ryan said, “The securiti-
zation market has seized up… We are convinced that getting securitiza-
tion started again is the single most important question facing the capital
markets today.”7 By 2009 it was strongly apparent that the revival of the
securitization markets was vital to support provision of credit to the global
financial system. Standardization of terms and structures of securitized
products as well as enhancing transparency became of paramount impor-
tance among regulators.
The 2009 Financial Standards Board (FSB) Report called for improved
disclosure of securitization exposures in trading books, SPVs, resecuritiza-
tion exposures, valuation assumptions, and pipeline risks. In 2010, FSB
started to look more closely at a number of other issues and urged adop-
tion of higher risk weights for securitizations and resecuritizations as well
as strengthening of capital treatment. FSB also called for more rigorous
due diligence of externally rated securities in order to satisfy higher capi-
tal requirements as well as tighter prudential guidance for bank manage-
ment on off-balance sheet exposures arising from securitization parties
(Buchanan 2016).
Moving forward, any reform needs to address why the securitization
market bubbles (especially private-label market) formed prior to 2007,
why they failed and how the securitization market can be improved. There
have been calls for much-needed reforms in the following areas: standard-
ization, greater transparency, having simpler securities, requiring origina-
tors to keep more “skin in the game”, and the role of ratings agencies.
One common objective has been to realign previously misaligned incen-
tives that existed in the securitization process.
The Dodd-Frank Wall Street Reform and Consumer Protection Act

(hereafter Dodd-Frank) was signed into law on July 21, 2010. Initially
running at 849 pages, Dodd-Frank created new federal offices and agen-
cies, hundreds of new rules as well as the formation of the Financial
Stability Oversight Council.8 The proposed Volcker Rule9 restricted US
banks from making certain kinds of speculative investments that do not
benefit their customers). Title II of Dodd-Frank prevents large banks and
non-bank institutions from being disorderly liquidated. “Living wills” had
to be regularly submitted by covered institutions. Dodd-Frank also allows
the SEC to create and oversee the utilization of universal credit rating
notation. It also emphasizes more independent corporate governance in
the CRA ratings with stricter internal controls. The Dodd-Frank Act also
called to establish the Office of Credit Ratings within the SEC.
With regard to shadow banking, the Dodd-Frank Act had many
responses including:
• Much of the OTC derivatives trading would be moved to exchanges

and clearinghouses.
• Systematically important institutions would be regulated by the US
Federal Reserve.
• The new Consumer Financial Protection Bureau would be created.
• Hedge funds would have to register with the SEC.
Dodd-Frank takes a three-pronged approach to reforming securitiza-

tion—risk retention, due diligence, and disclosure and credit ratings agen-
cies. Nearly five years later, there remains substantial ongoing rule-making
in order to implement specific provisions of the act.
First, under Title IX of the Dodd-Frank Act requires that securitiza-
tion sponsors to have some “skin in the game,”10 specifically that compa-
nies that sell, transfer or convey products such as MBS to retain at least
5 percent of the credit risk, unless the underlying loans meet standards
that reduce riskiness.11 The objective of this rule is to minimize moral
hazard and then securitizers will be better incentivized to monitor the
quality of the loans they originate. This is important to bear in mind
since between 2001 and 2006 approximately 75 percent of non-agency
residential mortgages were originated by independent finance compa-
nies. Because these originators quickly sold the mortgages, the finance
companies were not incentivized to scrutinize the quality of the mort-
gages. Dodd-Frank also does not allow for hedging of the retained risk
202 B.G. BUCHANAN
position, so the pure risk must be retained. The proposed rules regard-
ing risk retention exempts transactions guaranteed by Fannie Mae and
Freddie Mac.
Under Dodd-Frank, there was an exception to the 5 percent risk reten-
tion rule. The lender did not need to retain any risk in mortgages deemed
to be super safe. These mortgages were termed Qualified Residential
Mortgages (or more colloquially, QRM). When the regulators first pro-
posed terms to carry out the risk retention rules in 2011, the idea was that
there would be a two-tier mortgage market. Mortgages deemed to be
QRM would be characterized by substantial down payments that would
minimize the risk of default. The second tier of mortgages would include
riskier loans—although still safer than the ones characterized the boom
(such as no-document loans, interest only loans, negative amortization
loans, and balloon payment loans). The second-tier mortgages could only
be securitized if the originators responsible for either the loans or the secu-
ritizations kept some of the risk. These details on the risk retention rules
were left to regulators, but it was not until October 2014 that the details
were finally settled. Essentially, the idea above was dropped leaving Barney
Frank, the former chairman of the House Financial Services Committee
to comment, “The loophole has eaten the rule, and there is no residential
mortgage risk retention.”12
Under the 2014 terms, it appears that government-sponsored enter-
prises would have the major advantages, leaving many to wonder if there
would be a private securitization market at all in the future. If they guar-
antee a loan, there is no need under the rules for any risk retention by
those who made the loans. According to Mr. Frank those fighting the risk
retention rules included mortgage lenders, homebuilders and consumer
groups.
Section 942 of the Dodd-Frank Act mandates improved disclosures
and ongoing reporting obligations for all ABS issuance. This includes
individual loan data and use of computer programs indicating the
cash flow waterfall. The type of assets involved in the transaction are
important for the due diligence and disclosure reporting requirements.
The review of actual assets underlying the ABS must be performed by
registered issuers who are also required to disclose their findings. If
the underlying assets in the securitization pool have been originated
under different conditions, then the issuer must disclose these facts.
The Dodd-Frank Act also has specific due diligence proposals regard-
ing loan level data. It suggests revising the previous reporting regime
where issuers were only required to report pool-level data. The new
requirements would include: terms of the asset, service identity, an
identity number, whether or not it conforms to applicable underwrit-
ing criteria and obligor characteristics.
Gorton and Metrick (2010) state the Dodd-Frank Act has three sig-
nificant gaps—in securitization, repos, and money market mutual funds
and require even further regulation. Their suggestion is the formation
of Narrow Funding Banks (NFBs). Gorton and Metrick (2010) propose
NFBs as a complement to traditional banking and securitization activi-
ties. Traditional banks would continue to fund loans through securitiza-
tion but the ABS must be purchased by NFBs. Under their proposal, the
NFBs would fund themselves with repos and other debt instruments. The
Group of Thirty MMMFs proposed the clustering of NFBs to monitor
and control securitization. This would be in combination with regulatory
oversight for what serves as minimum acceptable collateral. So the NFBs
are intended to accomplish one task: to buy securitized products and issue
liabilities for investors. This would bring a former major participant in the
shadow banking system under a regulatory umbrella. Just like commercial
banks, the NFBs would have capital funding requirements and discount
window access. However, the NFB would not be able to buy anything
except ABS. Gorton and Metrick (2010) term this “securitized banking”,
which is a combination of repos and securitization.
2 EUROPEAN REFORM PLANS

Compared with the European Union securitization market, the US secu-
ritization market has made a stronger recovery. The stronger US recovery
may be attributable to the fact that 80 percent of securitization instru-
ments benefit from guarantees from government sponsored entities
(GSEs) (e.g., Fannie Mae and Freddie Mac). This also means that finan-
cial institutions that invest in GSE sponsored securitization products also
benefit from lower capital charges.
Yet there is another way we could compare the US and EU securitiza-
tion markets. Actual loans on securitized instruments originated in the
EU have fared much better than the US market. In the USA, AAA-rated
RMBS incurred default rates of 16 percent in the subprime market and
3 percent in the prime market. Yet in the EU defaults on RMBS never
exceeded 0.1 percent. This disparity is even larger if one compares BBB-
rated securitized products. In the USA, default rates peaked at 62 percent
204 B.G. BUCHANAN
in the subprime market and 46 percent in the prime RMBS market. In

the EU, BBB-rated securitized products reached a peak default rate of 0.2
percent.
In attempting to explain the moribund behavior of the EU securitiza-
tion market possible factors include the current interest rate environment
and the stigma attached to securitization. There are also structural reasons
such as the regulatory treatment of securitization and insufficient informa-
tion about asset performances. The EU market differs from the US market
in terms of size, structural complexity, and to a degree, product type. If we
measure current securitization debt outstanding, the European securitiza-
tion market is approximately one-quarter the size of the US securitization
market.
Does a one-size-fits-all template to securitization products result in
overregulation of high-quality assets? If so, that will threaten the revi-
talization of a long-term funding source in Europe. The problem is that
securitization continues to be discussed as if it were an homogeneous
product. In a way this is understandable because most of the debt issued in
the European securitization market is a plain vanilla structure rather than
the synthetic CDOs that were more prevalent in the US. No subprime
RMBS were sold by European securitization issuers. As a result, default
rates remained below 1 percent in Europe. Cumulative default rates on
European ABS between mid-2007 and late 2013 is 1.5 percent compared
with the US figure of 18.4 percent over the same period.
Blommenstein et al. (2011) and Humphreys and Jaffe (2012) draw a
distinction between the recent European and US securitization experi-
ences. Historically, securitization has acted as a legitimate funding tool in
Europe as opposed to one of capital arbitrage reasons, or an end in itself,
as was the case with many US securitizations. They observe in Europe
regulation and underwriting standards appear to be significantly more
robust, and this is exhibited by a tendency of many European underwriters
to keep “more skin in the game”. US provisions emphasize regulation of
issuers whereas the European Union (EU) securitization reforms empha-
size the investor perspective.
There remain key segments of the European securitization market that
continue to rely on support from the European Central Bank’s liquidity
program and this is termed “retained” issuance. Prior to the crisis, virtu-
ally all primary issuance was placed with end-investors and other banks. In
2008, a drastic change in the composition of placed versus retained issu-
ance occurred, as evidenced from Fig. 7.4. After 2008 and up until 2014,
3,50,000.00
3,00,000.00
2,50,000.00
2,00,000.00
1,50,000.00
1,00,000.00
50,000.00
0.00
Dec-09
May-10
Dec-14
May-15
Jun-07
Jun-12
Jan-07
Apr-08
Oct-10
Mar-11
Aug-11
Jan-12
Apr-13
Nov-07
Sep-08
Feb-09
Jul-09
Jul-14
Nov-12
Sep-13
Feb-14
Placed Retained
Fig. 7.4 European issuance—placed versus retained 2007–2015.

Source: SIFMA
the vast majority of issued transactions were retained by the issuing banks.
Blommenstein et al. (2011) document that by the end of March 2011
more than half (57.1 percent) of the €2.1 trillion European securitization
market was being “retained” by originating banks in Europe. The grow-
ing share of retained issuance over the 2008–2014 period is an indication
of funding difficulties faced by European banks and the role of the ECB as
liquidity provider to the European banking system.
European regulators responded quickly to enact regulations and
update existing ones. Various regulatory reforms have included the
Capital Requirements Directive (CRD), the Credit Agency Regulation
(CAR), Solvency II Proposals as well as the Basel II, 2.5 and III Accords.
Regulatory efforts regarding credit ratings agencies have included improv-
ing transparency, disclosure requirements, internal governance structures,
supervisory oversight, and registration requirements.
Since 2007 the EU securitization market has been stalled and thus a
key financing channel could potentially be lost. Without securitization, a
bank’s ability to sell assets is constrained. In Europe 80 percent of finan-
cial intermediation takes place through banks, the implications for growth
206 B.G. BUCHANAN
without a stable securitization market are substantial. What has unfolded

in the EU since 2007 is a path of stricter regulation. The major regulatory
responses that have occurred in the European Union since the financial
crisis are now addressed.
The G20 Retention Principles are a regulatory initiative that was in line
with statements following the 2009 Pittsburgh Summit of G20 leaders.
The objective was to align the incentives of issuers and investors. Under
this initiative, a 5 percent retention requirement was set and banks and
other regulated investors able to invest in securitized products must meet
the threshold. These requirements were to come into force after 2011
(Buchanan 2016).
In response to the Eurozone debt crisis, derivatives and structured
finance have been increasingly embraced by countries to help them out
of crisis. The European Financial Stability Facility (EFSF), created by the
Eurozone countries in May 2010, was regarded as the largest CDO ever
created.13 Marketed as a way to reduce risk, the EFSF was created to assist
countries facing “illiquidity”, and buy the bonds of the countries which
found it difficult to finance themselves. It then issued bonds that are AAA
rated. Once again, the idea relied on overcollateralization, an assumption
on the joint distribution of possible outcomes, and the approval of the
credit ratings agencies. The overcollateralization took the form of guaran-
tees by other Eurozone countries.
In January 2011, risk retention requirements came into effect in Europe
under Article 122a of the Second Capital Requirement Directive (CRD
II). Under CRD II, originators and investors are required to undertake
heightened due diligence, risk management, and disclosure practices on
an ongoing basis. Beginning in January 2011, the CRD applies to both
private and public securitizations. Under Article 122a of CRD II rules, a 5
percent retention requirement is stipulated. In the EU, banks and invest-
ment advisors are currently the biggest investors in securitized products.
Article 122a of CRD II also requires originators and investors to under-
take due diligence, risk management, and disclosure practices on an ongo-
ing basis. Punitive penalties can be applied if compliance does not occur.
Higher capital charges are also stipulated in the directives.
The European Market Infrastructure Regulation (EMIR) entered into
force on August 16, 2012. EMIR was designed to increase stability of the
OTC market throughout the EU. It also provided more effective protec-
tion of the right to information. EMIR also details very clear measures to
reduce counterparty and operational risk, as well as reporting and clearing

obligations for OTC derivatives.
The Basel Committee on Bank Supervision embarked upon a funda-
mental review of the ways in which securitization risks work. From the
viewpoint of regulating capital prior to Basel III, the treatment of securi-
tization has been viewed as unsatisfactory. Calomiris and Mason (2004),
Pennacchi (1988), and Uzun and Webb (2007) describe how banks used
securitization to reduce capital requirements, or what became known as
regulatory arbitrage of Basel I, or “gaming Basel”. Basel II which came
into effect in the majority of EU countries in 2008 remedied the weak-
nesses in the Basel I framework. Basel II used risk-sensitive capital ratios,
and thus regulatory arbitrage may have factored into the increased use
of securitization (Minton et al. 2004). Under Basel II, the lower capital
requirements permitted banks to make an increasing number of loans with
the same amount of initial capital which further increased the supply of
capital during the buildup of the housing bubble.
Basel II does not address securitization vehicles themselves, but rather
the capital requirements of securitization done by banks. In terms of secu-
ritization, the deficiencies that the Basel Committee identified after the
latest financial crisis include:
1. undue reliance on external ratings;

2. that there were too low risk weights for highly rated securitized
products;
3. for low-rated senior securitization exposures the risk weights were
considered too high;
4. the “cliff effects” in capital requirements resulting from the underly-
ing pool’s deteriorating credit quality. A cliff effect is the case where
a small difference in credit quality or other parameters produce large
differences in capital requirements.
The Basel 2.5 proposals were introduced in July 2009. Basel 2.5 was
intended to revise the securitization framework and strengthen the trading
book regime. The CRD III contains new rules on resecuritizations and
capital requirements for trading book exposures. A definition of resecu-
ritization was also introduced. The punch line in this directive is that the
capital charges for securitizations and resecuritizations have gone up con-
siderably. CRD III also requires higher collateral haircut of securitization
208 B.G. BUCHANAN
in repo transactions, as well as higher-risk weighted assets for securitiza-

tion liquidity facilities and self-guaranteed exposures.
The G20 initiative has led many global regulatory reforms, including
the endorsement of the Basel III reforms. Implementation of the Basel
III reforms14 will be phased in before 2019. There are three corner-
stones to the Basel III reform, namely: (1) capital reform (quality and
quantity of capital, risk coverage, buffers, and controlling leverage) (2)
liquidity reform (short term and long term), and (3) systemic risk and
interconnectedness. Like Basel II, Basel III provides capital rules which
are designed to enhance the quality and quantity of loss-absorbing bank
capital. The objective is to make securitization capital requirements more
prudent and risk-sensitive.15 There has been vigorous debate regarding
the calculation of risk-weighted assets, a variable that is crucial in decid-
ing which banks have adequate capital buffers and which banks need to
improve asset quality problems. The more stringent requirements of Basel
III will likely affect the incentives of banks to securitize their assets, as
well as investing in securitized products. Another objective of Basel III
is to improve the banking sector’s ability to absorb shocks in response to
financial stress. In terms of reducing the complexity of the hierarchy and
the number of approaches (three versus multiple), the revised Basel III
securitization framework represents a significant improvement to the Basel
II framework.
Under the Basel II framework, much of the treatment of credit risk
exposure depended on whether the bank was an originator; investor or
providing a third-party facility. The ratings-based approach (RBA) offered
either the standardized approach (SA) or the internal ratings-based
approach (IRB). Less sophisticated banks typically adopted SA. The IRB
was aimed at more sophisticated banks and a more granular approach to
risk with the securitization exposures. Under the Basel III framework the
hierarchy application no longer depends on the role that the bank plays in
the securitization, whether investor or originator. Nor does the Basel III
framework depend upon the credit risk approach that the bank applies to
its securitization exposures. The revised hierarchy of approaches now relies
on the information that is available to the bank and on the type of analysis
and estimations that it can perform on a specific transaction. Therefore,
the mechanistic reliance on external ratings has been reduced; not only
because the RBA is no longer at the top of the hierarchy, but also because
other relevant risk drivers (such as tranche thickness and maturity) have
been incorporated into the External Ratings Based Approach (ERBA).
Basel III also presents other improvements over Basel II in terms of

risk sensitivity and prudence. Additionally, capital requirements have been
significantly increased, proportionate with the risk of securitization expo-
sures. However, if senior securitization exposures are backed by good
quality pools, then the capital requirements will apply risk weights as low
as 15 percent. The objective of ceilings to risk weights of senior tranches
and limitations on maximum capital requirements is to promote consis-
tency with the underlying IRB framework, not to discourage securitiza-
tions of low credit risk exposures.
In the early 2000s, asset markets boomed and funding was available
at a relatively low cost. The financial crisis emphasized the importance of
liquidity to the proper functioning of the banking sector and the econ-
omy. The early stages of the 2007 financial crisis was characterized by a
“liquidity phase”, in which many banks—despite having adequate capital
levels (and thereby being technically solvent)—still experienced difficul-
ties because the bank’s liquidity was not managed in a prudent manner.
Liquidity rapidly evaporated during the reversal in market conditions and
the illiquid market conditions lasted for a relatively long period of time.
The revised Basel III framework also introduced new liquidity stan-
dards, including the Liquidity Coverage Ratio (LCR) requirement. The
objective of the Liquidity Coverage Ratio is to develop a more resilient
banking sector, especially in terms of the liquidity risk profile of banks.
The LCR requirement has to ensure that banks have an adequate stock of
unencumbered high-quality liquid assets (HQLA) that can be converted
easily and immediately in the private markets into cash to meet a bank’s
liquidity needs for a 30-calendar-day liquidity stress scenario. With this
new requirement, the LCR is intended to improve the banking sector’s
ability to absorb financial and economic shocks, regardless of the source
of liquidity risk.
The financial crisis highlighted how disruptions to a bank’s regular
sources of funding can erode its liquidity position in such a way that it
increases the risk of its collapse and possibly lead to broader systemic
stress. An additional measure to promote a more resilient banking sec-
tor under Basel III is the Net Stable Funding Ratio (NSFR). This key
reform requires banks to maintain a stable funding profile in relation to
the composition of their assets and off-balance sheet activities. The NSFR
limits overreliance on short-term wholesale funding, encourages better
assessment of funding risk across all on- and off-balance sheet items, and
promotes funding stability.
210 B.G. BUCHANAN
The EU Money Market Funds Regulation places a prohibition on

some securitization investments. The regulation proposed a new regu-
latory framework for money market funds including the prohibition on
such funds to invest in securitizations other than certain narrowly defined
eligible securitizations (i.e., certain short-term securities backed by short-
term, high quality, and liquid corporate obligations) and subject to a 10
percent exposure limit.
Consultation papers have been issued by the Basel Committee
on Banking Supervision (BCBS) and the European Insurance and
Occupational Pensions Industry (EIOPA). Since late 2013, the BCBS’
consultation documents have effectively lowered the floor on capital
requirements for all securitized products. The EIOPA consultation docu-
ments suggest a two-tier approach when it proposes new capital charges.
EIOPA proposes that insurers need to adopt a two-tiered approach when
holding AAA-rated securitized products compared to other products.
The BCBS presented a revised securitization framework in December
2014. The capital requirements aim to address the imprudently low risk
weights that had previously been in place; cliff-edge effects and the reli-
ance on external credit ratings. The revised securitization framework pro-
poses increased regulatory capital charges for securitization positions for
investing institutions. The BCBS capital requirements stipulate that banks
hold capital against investment in securitization. It also allows for bank
originators to obtain capital relief on securitized assets that have been sold
to third parties if certain conditions are met. It also stipulates a revised
hierarchy of approaches to the calculation of capital requirements on secu-
ritization positions. Introduction of risk-based capital requirements for
securitization positions is described under the EU Solvency II Directive.
The directive published revision of capital requirements for insurance and
reinsurance undertakings.
By 2014, inflation was at a five-year low in the Eurozone and growth
was at a stuttering pace. In September 2014, the ECB announced that it
would start buying both ABS and covered bonds. The program translated
into a €60 billion per month purchase of ABS. The change in asset size
of the ECB’s balance sheet is displayed in Fig. 7.5. Like the US Federal
Reserve, the ECB’s balance sheet in terms of asset size has grown dra-
matically. The ECB purchase program in 2014 pushed for a more capital
markets based economy than a bank-based economy. This would allow
European banks to trim their balance sheets and free up capital for lend-
ing. It was anticipated that the private sector asset purchases would likely
weaken the Euro, aiding an export led recovery. The ABS purchases were
3500
3000
2500
Asset Size (Euros)
2000
1500
1000
500
0
06
07
08
09
10
11
12
13
14
15
20
20
20
20
20
20
20
20
20
20
1–
1–
1–
1–
1–
1–
1–
1–
1–
1–
–0
–0
–0
–0
–0
–0
–0
–0
–0
–0
06
06
06
06
06
06
06
06
06
06
Fig. 7.5 Total assets of European Central Bank
also designed to reinforce ECB monetary policy. BlackRock helped design

the ABS purchase program.16 BlackRock, had previously worked for the
New York Federal Reserve and the central banks of Ireland and Greece.17
At the same time, one concern that arose was would the ECB intro-
duce quite a lot of credit risk exposure on its balance sheet? Mario
Draghi announced the ECB would not take too much risk on to its
balance sheet without the backing of lawmakers. Regarding tranches,
a crucial aspect of the ECB’s plan was to pledge to buy the riskier
“mezzanine” tranches, albeit only with a government guarantee.18
Finance ministers’ agreement to guarantee any losses on purchases of
the mezzanine slices was necessary because otherwise the ECB would
be confined to buying only the safest senior tranches of the ABS. But
this would have a drawback in that the senior tranches are so safe that
the ECB’s purchases of them would do little to free up space for more
lending for the banks.
During this period MBS accounted for two thirds of ABS in the
Eurozone. At the time European banks depended on banks for 80 per-
cent of corporate loans compared with 50 percent for the comparable US
figure. For small and medium-sized enterprises (SMEs), the ABS purchase
212 B.G. BUCHANAN
program could prove to be a favorable opportunity because SMEs could

now borrow money and invest in their businesses.
What was uncertain at the time was how willing the ECB would be to
buy “retained” ABS. The majority of ABS in the Eurozone was retained
by the banks that issue them. Often the banks use the retained ABS as col-
lateral in exchange. Mario Draghi announced in late 2014 that through
the ABS purchase program the ECB would expand its balance sheet by up
to €1 trillion. The program would last into 2016.
Against this backdrop of increased liquidity ratio regulation and higher
Solvency II capital charges and general uncertainty regarding banking
reform, there has been a shift toward issuing covered bonds and other,
less expensive sources of funding—including loans from central banks.
In September 2014, the European Central Bank announced its covered-
bond program. The ECB started buying covered bonds as part of a stim-
ulus program to boost the Eurozone’s economy. The aim was that by
effectively printing money to buy the covered bonds, it will raise the sup-
ply of money in the economy, enabling banks to lend more to households
and businesses, especially SMEs. At the time it was estimated that the
covered bond program along with a new bank-lending program—could
be worth at least €700 billion.19 This was the third covered bond purchase
program the central bank had pursued since the start of the financial crisis.
Initially the ECB bought short-dated covered bonds from a number of
different countries, in sizes up to €25 million ($31.9 million). However,
Barclays commented that even though there was potentially €545 billion
of covered bonds available in the secondary market, dwindling new issu-
ance means investors may be reluctant to sell existing holdings, making it
difficult for the central bank to buy bonds in large quantities.
European regulatory responses have also posed the question, how
should institutions handle “qualifying securitizations?” In 2014–2015,
the Bank of England and ECB issued a consultation document with rec-
ommendations for a simple, transparent, and standardized framework.
In 2014, the ECB and BoE published The Case for a Better Functioning
Securitization Market in the EU. It discusses the loose regulatory treat-
ment that had been in place prior to the financial crisis. This looks at the
issue from a four-pronged approach:
(i) Absence of retention requirements: this weakened lenders’ incen-

tives to apply stringent underwriting standards, and with investors’
overreliance on credit ratings, this compromised incentives even
further.
(ii) Loose capital requirements:

(iii) Lack of disclosure requirements
(iv) The use of accounting rules that allowed many exposures to be
held off-balance sheet. This created further uncertainty about
creditworthiness.
The Basel Committee on Banking Supervision (BCBS) and International

Organization of Securities Commission (IOSCO) established a joint task
force to establish criteria for identifying an STC securitization frame-
work. STC stands for: Simple, Transparency and Comparability. Simple
means that the securitization structure should be homogeneous, not com-
plex. So this rules out CDO2 and CDO3 type instruments. Transparency
denotes that the securitized product should contain sufficient informa-
tion on the underlying assets, as well as a thorough understanding of the
risks involved. Comparability of securitized products should also take into
account differences across international jurisdictions. It should enable
investors to have a more direct comparison of securitized products within
an asset class.
This joint task force on securitization markets was also charged with
additional responsibilities including: (i) identifying the factors that may
be hindering the development and progress of a sustainable securitization
market and (ii) developing criteria that identify and assist in the develop-
ment of simple and transparent securitization structures.
Figure 7.6 lists the 14 Simple, Transparent, and Comparability
(STC) criteria that aim to identify asset risk, structural risk, and fidu-
ciary and services risk. The recommendations are non-exhaustive and
non-binding.
On November 26, 2014, the European Commission presented the
Investment Plan for Europe which created a sustainable market for securi-
tization, without repeating the precrisis mistakes. This market was identi-
fied as one of the five areas where short-term action was needed. The aim
of these new reforms is to promote securitization to longer-term investors
including non-bank institutions. On July 23, 2015, the BCBS and the
IOSCO issued a set of global criteria to identify simple, transparent, and
comparable securitization instruments, which came to be known as the
STC criteria.
On September 30, 2015, the European Commission unveiled new
regulatory proposals to boost the European securitization markets. The
proposed securitization framework is titled Securitization Regulation and
214 B.G. BUCHANAN
Section Criteria Summary Purpose

A. Asset Risk 1 Nature of the Assets S, T, C
2 Asset Performance History T, C
3 Payment Status S, T, C
4 Consistency of Underwriting S, C
5 Asset Selection and Transfer S, T, C
6 Initial and Ongoing Data S, T, C
B. Structural Risk 7 Redemption Cash Flows S
8 Currency and interest rate asset and liability mismatches S,C
9 Payment priorities and observability S, T, C
10 Voting and enforcement rights S, T, C
11 Documentation disclosure and legal review T, C
12 Alignment of interests S, C
C. Fiduciary Risk 13 Fiduciary and contractual responsibilities T, C
14 Transparency for Investors T, C
S = simple; T = transparency; C = comparability
Fig. 7.6 A Summary of the European Comission’s framework on securitization

Regulation and Amendments to the Capital Requirements Directive.
Amendments to the Capital Requirements Regulation. The new frame-

work has several main objectives including:
• The revival of markets on a more sustainable basis so that simple,

transparent, and standardized securitization can act as an effective
funding channel to the wider economy;
• Efficient and effective risk transfers to a broad set of institutional
investors;
• That securitization function as an effective funding mechanism for
some companies such as insurance companies as well as banks;
• To manage systemic risk and protect investors.
The September 2015 proposal is also intended to promote a safe, robust,

liquid, and deep market for securitization, with the capability of attract-
ing a broader and more stable investor base to help reallocate finance to
where it is most needed in the economy. That being said, it will still not
be a market for retail investors. The securitization framework proposed

in the September 2015 document is then transmitted to the European
Parliament and the Council for adoption under the codecision procedure.
The provisions are also legally binding in all EU Member States without
transposition into national law from the day of entry into force.
The European Commission aims to distinguish between simpler and
more transparent securitization products and other products which do
not satisfy such criteria. European regulatory agencies have made it very
clear that this time will be different and the precrisis days of opaque and
complex subprime instruments will not be possible. According to the
European Commission such differentiating features should restore an
important funding channel for the EU economy.
The September 2015 initiatives20 introduce a straightforward set of cri-
teria to identify simple, standardized, and transparent securitization (STS).
Rules on transparency, due diligence, and risk retention rules are provided
in the new EU framework. “Simple, transparent and standardized” (STS)
refers to the process by which the securitization is structured and not the
underlying credit quality of the assets involved. Each of the terms is now
elaborated upon. A “simple securitization” means that:
• Assets (such as loans/receivables) packaged in securitization must be

homogeneous.
• No resecuritizations are allowed. So this means no CDO2 and CDO3.
• There must be a sufficiently long credit history of the underlying
loans to allow reliable estimates of credit/default risk.
• Loan ownership must be transferred to the securitization originator.
The terms “transparent and standardized securitization” must satisfy

the following criteria:
• The loans that are bundled and pooled in the securitization process
must be created using the same lending standards as any other loan.
This is intended to eliminate any “cherry-picking”, or adverse selec-
tion problems.
• The originator must retain at least 5 percent of the loans portfolio.
So effectively, the originator is now “on the hook” for those loans.
• The supporting securitization documentation must provide details
of the structure used and the ‘waterfall’ payment structure (i.e., the
division of payments to each of the tranches)
216 B.G. BUCHANAN
• Data on packaged loans must be frequently updated and regularly

published.
• The contractual obligations, duties, and responsibilities of all key
parties to the securitization must be fully disclosed.
The European Commission’s proposal also includes precise disclosure

requirements from the originator, the sponsor, and the issuer. To ensure
that the issuer is legally responsible for any misreporting that could occur,
compliance of the securitized product with the above STS criteria is to be
communicated to the European Securities Markets Authority (ESMA).
After the issuer has notified ESMA, the securitized instrument has to be
listed in a centralized web data repository. The website will be accessible to
all investors for free and the site will list all STS securitizations. The ESMA
now is exclusively responsible for registration and supervision of CRAs in
the European Union.
In a true sale securitization the ownership of the underlying exposures
is transferred to a SPV. The September 2015 proposal only allows ‘true
sale’ securitizations to become STS. Prior to September 2015, no STS
criteria had been developed for synthetic securitizations on an interna-
tional level (BCBS-IOSCO), nor on a European level (EBA). There are
additional layers of complexity and more counterparty credit risk with
synthetic securitizations because the credit risk related to the underly-
ing exposures is transferred by means of a derivative contract or guar-
antee. Thus in the September 2015 proposals there is insufficient clarity
on which synthetic securitizations should be considered STS and under
which conditions. The European Banking Authority and the European
Commission are currently formulating more precise criteria to identify
simple synthetic securitizations.
What happens if a regulatory authority deems that a previously con-
sidered STS no longer fulfils the STS requirements? Short term measures
include removing the securitized instrument from the website listing the
STS products. Financial sanctions are also available to the authorities which
include a penalty imposed on the originator (minimum €5 million, or up
to 10 percent of the annual turnover of the legal person or other simi-
larly large sums). Further civil penalties can include banning the originator
temporarily from issuing STS products. The option of introducing crimi-
nal charges is available to member states but they are not obliged to do so.
The introduction of both financial and criminal sanctions is regarded as
essential for the functioning and the credibility of the EU financial system.
In order to establish a closer relationship between the riskiness of a

securitization and the prudential capital required from banks and insur-
ance companies investing in the instruments, the European Commission
plans to amend the current prudential treatment for both banks (CRD)
and insurance companies (Solvency II). The new, more risk-sensitive pro-
visions on regulatory capital requirements and the new STS criteria are
intended to make investing in simpler, safer securitization products more
attractive for EU credit institutions. It should also make available addi-
tional capital for lending to businesses (especially SMEs) and households.
Historically, credit institutions have been the main investors in European
securitizations. It is likely that credit institutions will form a large part
of securitization’s investor base in the EU. The Capital Markets Union’s
objective is to expand the investor base of European Union securitiza-
tion markets by making it more attractive for non-bank investors to fund
securitizations.
After the September 30, 2015, report was released response was imme-
diate. Banks and insurance companies expressed concern that securitiza-
tion would be treated less favorably than covered bonds, and that the
securities would still face tougher capital requirements.
NOTES
1. “San Bernardino County abandons mortgage plan”, Alejandro
Lazo, LA Times, January 25, 2013.
2. Complaint for Plaintiff at 2, Jacksonville Police and Fire Pension
Fund v. American International Group, Inc., et al. No. 08-CV-
47727 (S.D.N.Y. filed May 21, 2008).
3. Complaint for Plaintiff at 2, Jacksonville Police and Fire Pension
Fund v. American International Group, Inc., et al., No. 08-CV-
47727 (S.D.N.Y. filed May 21, 2008).
4. “FHFA’s update on private label securities actions”, Federal
Housing Finance agency, September 12, 2014.
5. Explain difference between a dealer and investment bank.
6. http://www.federalreserve.gov/monetarypolicy/bst_fedsbal-
ancesheet.htm
7. Financial Times, July 7, 2009.
8. Plender (2015) provides some wonderful data on the Glass-Steagall
documentation versus Dodd-Frank documentation. The Glass-
Steagall Act ran to 37 pages. The initial Dodd-Frank was 848
218 B.G. BUCHANAN
pages, but required an additional 400 pages for implementation.

In July 2015, one third of the rules had been enacted, added a
further 8843 pages. Plender (2015) estimates the final version of
Dodd-Frank will possibly contain 30,000 pages of rule-making.
9. This rule was not finally approved until January 21, 2014.
10. In September 2010, the Federal Deposit Insurance Corporation
(FDIC) passed a “safe harbor rule” which includes a 5 percent risk
retention and this is the only US risk retention ratio that has been
finalized at the time of writing.
11. Various alternatives have been suggested with respect to what is
retained. Is it the equity or first loss tranche, vertical slices (equal
amounts of each tranche), or representative sample of underlying
loans?
12. “Banks Again Avoid Having Any ‘Skin in the Game’”, Norris,
Floyd, New York Times, October 24, 2014.
13. Appetite for French and Spanish bonds remains solid, Financial
Times, October 20, 2011.
14. Public comments on the Basel III securitization reforms closed on
March 15, 2013.
15. The minimum total capital has increased from 8 to 10.5 percent.
16. ECB Preview—Three Key ABS Challenges, Claire Jones, Financial
Times, October 2, 2014.
17. Asset-backed securities: Back from disgrace, Christopher
Thompson and Claire Jones, Financial Times, September 30,
2014.
18. Asset-backed securities: Back from disgrace, Christopher
Thompson and Claire Jones, Financial Times, September 30,
2014.
19. “ECB Starts to Buy Covered Bonds; Bond-Buying Program is Part
of a Package of Measures Announced in September”, Edwards,
Ben; Blackstone, Brian, Wall Street Journal (Online), October 20,
2014.
20. Proposal for a REGULATION OF THE EUROPEAN
PARLIAMENT AND OF THE COUNCIL laying down common
rules on securitization and creating a European framework for sim-
ple, transparent, and standardized securitization and amending
Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and
Regulations (EC) No. 1060/2009 and (EU) No. 648/2012.
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arising from the 2007–2008 credit crisis. Harvard John M. Olin discussion
paper.
Blommenstein, H. J., Keskinler, A., & Lucas, C. (2011). Outlook for the securiti-
zation market. OECD Journal – Financial Market Trends, 2011, 1–18.
Buchanan, B. G. (2016). The way we live now: Financialization and securitization.
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profits. Guy Carpenter Specialty Practice Briefing.
Gorton, G., & Metrick, A. (2010). Regulating the shadow banking system. Working
paper.
Humphreys, P., & Jaffe, B. (2012). Regulatory developments in the United States
and Europe: An analysis of recent reforms affecting securitization transactions.
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Minton, B.A., Sanders, A., & Strahan, P. (2004). Securitization by banks and
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CHAPTER 8
Conclusion
In 2010, at the American Securitization Forum, John Dugan, former

Comptroller of the Currency, presented the following view: “we are at a
crossroads: the collective decisions we make in the next year in an effort to
reform and revitalize the securitization market will have profound conse-
quences for consumer and business credit in the United States and abroad.”
The 2007 global financial crisis continues to have a lasting impact on
consumer behavior, financial markets, financial institutions, interaction of
economies, and the nature of government policies. Atkinson et al. (2013)
estimate that the financial crisis cost to the USA to be an estimated 40 per-
cent to 90 percent of one year’s output. In dollar terms this is an estimated
$6–$14 trillion or the equivalent of $50,000–$120,000 for every US
household. If we consider the loss of total US wealth from the crisis (which
includes human capital and the present value of future wage income) this
is estimated to be as high as $15–$30 trillion, or 100–190 percent of 2007
US output. Adelson (2013) estimates the global costs of the financial crisis
to be between $5 trillion and $15 trillion.
Clearly, the costs of the 2007 financial crisis are enormous. It is impor-
tant to understand the causes, consequences, and implications of the crisis
to help individuals and businesses better manage risk and also to assist in
designing regulations and establishing policy responses. As the previous
chapters indicate, this will also help us better understand the structural
flaws in the securitization framework.
Despite the onslaught of postcrisis regulation, securitization remains
a viable and effective financing tool. After the crisis, the market began to

DOI 10.1057/978-1-137-34287-4_8
222 B.G. BUCHANAN
demand that loans be fully documented, and most lenders either elimi-
nated non-traditional products or began using them more selectively. This
was codified by the ability-to-repay rules promulgated by the Consumer
Financial Protection Bureau. In late 2015, the SEC will require that third
party due diligence to the ratings agencies be furnished, and the results
should be furnished with the SEC as well. The Federal Reserve imple-
mented a comprehensive capital analysis and review (CCAR). CCAR anal-
ysis calls for a broad-based, macroeconomic stress test by the banks.
Securitization has since resumed in most asset classes, including auto-
mobiles, credit cards, collateralized loan obligations (CLOs), and com-
mercial mortgage-backed securities (CMBSs). In 2015, securitization
issuance, including agency and non-agency mortgage-backed securities
(MBS) and asset-backed securities (ABS), totaled $1.9 trillion—a 19.8
percent increase from 2014. Since ABS issuance volumes fell by 14.1
percent, the increase was driven entirely by agency and non-agency MBS
issuance (SIFMA 2016). Outstanding volumes rose to $10.1 trillion, rep-
resenting an increase of 0.4 percent. This was largely driven by agency
MBS, agency collateralized mortgage obligations (CMOs) and ABS. On
the other hand, in 2015 non-agency outstanding volumes have fallen
7.2 percent. In 2015, average daily trading volumes were $196.7 billion,
an increase of 7.4 percent from the previous year and this was driven by
agency MBS trading. Non-agency MBS and ABS volumes fell 17.1 per-
cent and 3.1 percent (SIFMA 2016).
In terms of delinquencies, loss rates on credit card ABS have been low
and have been declining since the financial crisis (SIFMA 2016). This is
most likely because consumer ABS quality appears to be strong in terms of
liquidity and market depth. Approximately 8.4 percent of credit card ABS
were delinquent in 2015; 3.3 percent of auto loan ABS were delinquent and
11.1 percent of student loan ABS were delinquent in 2015 (SIFMA 2016).
The MBS performance metrics are back approximately halfway to where
they were prior to the financial crisis (SIFMA 2016). In May 2013, the
US housing market appeared to display signs of improved performance, in
fact, the most optimistic figures in approximately six years.1 In the USA,
Fannie Mae, Ginnie Mae, and Freddie Mac are presently funding more
than 90 percent of mortgages.2 In early 2013, Freddie Mac reported
2012 earnings of $11 billion income, its first annualized profit since 2006.
However, after the crisis, Fannie Mae and Freddie Mac faced a potentially
reduced role for the future as regulatory changes were debated. There
was a proposal for creating a new two-tier company that would establish
a single securitization platform which would be intended to decrease the
CONCLUSION 223
dominance of Fannie Mae and Freddie Mac. The proposed new platform
would also be independent of Fannie and Freddie and would provide a
framework whereby issuers could securitize home loans and be able to
track payments from borrowers to buyers of MBS, thus forming a new
secondary market infrastructure.
During the financial crisis, eminent domain was a program that gener-
ated considerable investor wrath but never took effect. Under eminent
domain, performing, underwater loans were to be seized out of pri-
vate label securitizations. The investors would be paid whatever the city
deemed appropriate, and the loans would be written down and then refi-
nanced into an FHA loan. The eminent domain program was proposed by
several cities throughout the USA. These cities claimed that they would
pay a fair market rate. However, investors indicated that the only way the
economics worked was if the loans were purchased at a deep discount to
the market value of the troubled property. Eminent domain essentially
took advantage of the weak investor protections in the private label securi-
tization market, and bank portfolio loans and loans from the FHA, GSEs,
and the Department of Veterans Affairs were not subject to this program.
Due to steps taken by regulators and investor protests, the eminent
domain proposals were never implemented in any municipalities. In
August 2013, the Federal Housing Finance Agency (FHFA) released a
statement which dampened any future for the eminent domain proposal.
In December 2014, Congress settled the issue when it announced it would
prohibit the FHA, Ginnie Mae, or HUD from insuring, securitizing, or
establishing a federal guarantee on any mortgage or mortgage-backed
security that refinances or otherwise replaces a mortgage that had been
subject to eminent domain condemnation or seizure. Even though no US
municipality utilized eminent domain, the issue highlighted to investors
that the private label securitization structure did not adequately protect
their interests. It is argued that because the eminent domain issue took
several years to resolve, this hindered the return of the private label secu-
ritization market after the financial crisis.
Today, much of the long-term health of the securitization market
depends on revival of the private label residential mortgage-backed secu-
rities (RMBS) market, which still remains relatively stagnant. Warranties
and representations are two conflicting issues in the private label RMBS
market. So what has to change in the private label securitization market
to restore issuance? First, the market needs to standardize the documenta-
tion so that investors can quickly understand how each deal differs from
others. Secondly, a deal agent (who should not be the trustee) should be
224 B.G. BUCHANAN
introduced. Finally, there also needs to be clearer servicing standards in

the private label market.
In Europe, new ABS issuance has fallen from a peak of $539 billion in
2004 to $75 billion in early 2014.3 Even so, Europe’s ABS inventory is
in better shape—a 2 percent default rate on ABS notes compared with 20
percent for US ABS.4 For much of 2014, Europe was stuttering on the
brink of economic stagnation. Mario Draghi, ECB President, announced
that a reinvigorated ABS market would allow banks to start lending again
to small and medium-sized enterprises. Since then there has been much
optimism that a reinvigorated European ABS market would stimulate
economic growth in the Eurozone. In March 2016, the Greater London
Authority announced it would be investing in RMBS as a means of diver-
sifying its investment portfolio.5
In 2015, the VW emissions scandal posed a challenge for the European
securitization market. VW is the largest issuer of auto ABS in Europe,6
and second-hand car sales are used in transaction structures. When news
of the emissions scandal broke, VW stock declined, as well as the price of
VW bonds. The day after the emissions scandal broke, VW issued €800
million of securities backed by Spanish loans. In the aftermath of the VW
emissions scandal, second-hand car prices continued to look fragile. Why
is this challenging for the securitization market? A person who borrows
money for a car loan has an option to return the car at the end of the
loan period in lieu of a fixed payment. If that option is exercised, then the
financing arm of the company reclaims the vehicle. The car company then
needs to sell the car to repay investors who have funded the initial loans
through securitizations.
The ratings of European securitization issues in 2015 are displayed in
Table 8.1. The bulk of ratings are investment grade.
Table 8.1 Ratings of European securitization issues in 2015

2014 2015
AAA €115bn €92bn

AA €14bn €52bn
A €46bn €29bn
BBB and below €13bn €12bn
Not rated €29bn €29bn
Source: AFME
CONCLUSION 225
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
May-07
May-08
May-09
May-10
May-11
May-12
May-13
May-14
May-15
Jan-07
Sep-07
Jan-08
Sep-08
Jan-09
Sep-09
Jan-10
Sep-10
Jan-11
Sep-11
Jan-12
Sep-12
Jan-13
Sep-13
Jan-14
Sep-14
Jan-15
Sep-15
Fig. 8.1 European securitization issuance—Percentage Retained 2007–2015
In Europe many key segments of the securitization market continue to

rely on the European Central Bank’s liquidity program, which is termed
“retained” issuance. In Fig. 8.1, the percentage of retained issuances by
European institutions is detailed. The proportion that is being retained on
bank balance sheets for the purpose of generating liquidity and funding
difficulties at the ECB has been high but has been reduced to 70 per-
cent by 2012. Placed issuance has mainly comprised UK and prime Dutch
RMBS and after 2010 there has been a surge in whole business securitiza-
tions in the UK and small to medium-enterprise securitizations in Spain.
Attempts to deal with the opacity problem associated with the ratings
process have been varied. The European Data Warehouse was created
in 2012 with the support of the ECB to restore investor confidence in
European securitization markets.
Prime collateralized securities (PCS) are a European led initiative that
identifies the best practices in securitization quality, standardization, and
transparency. These are qualities that are needed to improve future sec-
ondary market liquidity. PCS will also exclude asset classes such as CMS,
CDOs, synthetic securitizations, resecuritizations which do not meet the
eligibility criteria. The PCS label will only be awarded to securitizations
226 B.G. BUCHANAN
that are backed by asset classes that have performed well throughout the
financial crisis. Also considered to be eligible are European SME loans,
auto loans, and leases and credit card receivables.
In the wake of the financial crisis, alternative models are being formu-
lated to create a more transparent and efficient securitization market. One
solution is the Open Models Company (OMC). The OMC detours the
credit ratings agency system and allows participants to independently input
their assumptions on future economic activity and run a “what-if” analysis
on asset pricing. This independent network of modelers is also encouraged
to comment on underlying data and assumptions. Tapscott and Williams
(2012) compare the OMC process with the scientific peer review pro-
cess. The OMC business model is intended to deal with new securitization
offerings as well as existing problematic offerings. Additional efforts have
been made at “rebranding” the securitization process.
Peer-to-peer (or P2P) lending is presenting opportunities for securiti-
zation as well. Under the P2P model, lenders seek to use online platforms
to directly connect borrowers with lenders, often at cheaper rates than
those available at banks, and at significantly increased returns for inves-
tors. The prospective higher yields from investing in the P2P asset class
have drawn interest from many Wall Street participants. These investors
are also attracted to the potential opportunities of securitized P2P loans.
The securitization process transforms illiquid assets (the P2P loans) into
marketable securities (the tranches of the securitized deal). This provides
access to a new asset class and potentially favorable risk/return payoff for
asset managers, pension funds, and wealth managers because the process
lowers cost of funding for the originators and replenishes capital. ABS
based on P2P platforms potentially provides a new source of revenue and
risk diversification and will continue to be a much-watched asset class in
the near future.
Nevertheless, securitization will be an important channel for long-term
recovery despite many of the short-term hurdles it faces. It is apparent that
securitization can be a powerful facilitator of economic growth if imple-
mented judiciously. Global regulatory reform has been gradual but is nec-
essary for confidence gains in financial markets. Questions remain about
how the securitization market should be designed, supervised, and regu-
lated in the future. It is difficult to find a “single bullet” solution because
of competing factors such as different coupon types, maturity profiles,
asset types, and interest rate determination techniques. Different, legal,
cultural, and market frameworks add to this complexity.
CONCLUSION 227
NOTES
1. Home Prices Rise, Putting Country in Buying Mood, Catherine
Rampell, New York Times, May 28, 2013.
2. Fannie and Freddie set for Reduced Role, Shaheen Nasiripour,
Financial Times, March 5, 2013.
3. Asset-Backed Securities: Back from Disgrace, Christopher
Thompson and Claire Jones, FTimes, September 30, 2014.
4. Asset-Backed Securities: Back from Disgrace, Christopher
Thompson and Claire Jones, FTimes, September 30, 2014.
5. Securitisation industry battles with stigma, Financial Times, March
23, 2016.
6. VW Issues Raises Questions about ABS Safety, Thomas Halen,
October 21, 2015.
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Index
A asset backed commercial paper

ABACUS 2007-AC1 deal, 131–3, (ABCP), 11, 17, 24, 37, 39, 113,
137–9 133, 198–200
ABCP. See asset backed commercial Asset-Backed Commercial Paper Money
paper (ABCP) Market Mutual Fund Liquidity
ABS. See asset backed securities Facility (AMLF), 198, 200
(ABS) asset backed securities (ABS), 5, 17,
accounts receivable securitization, x, 21, 23, 26, 27, 30, 31, 57, 71–3,
80–3 77, 78, 81, 87, 88, 91–3, 101,
adjustable rate mortgages (ARMs), 22, 102, 105–7, 113, 118, 120,
36, 37, 114, 115, 132 123–5, 127, 128, 143, 151, 152,
agency risk, 113 154, 159, 161, 162, 164, 165,
alchemy, 2 187, 194, 198, 199, 202–4,
American Express (CDO transactions), 210–12, 222, 224, 226
118–22 auto loan securitization, 154
American Recovery and Reinvestment
Act of 2009, 197
ARM. See adjustable rate mortgages B
(ARMs) balance sheet(s), viii, 3, 13–15, 17, 20,
Asia Development Bank 21, 23, 24, 31, 38, 39, 50, 57,
Recommendations (ADB), 58, 81, 101, 105, 107, 112, 116,
153 129, 142, 146, 152, 157, 163,
Asian financial crisis, 142, 151, 153 175, 180, 185, 187, 195, 197,
Askin hedge fund (CMO use), 122 210–12, 225
Note: Page numbers followed by “n” refer to foot notes

DOI 10.1057/978-1-137-34287-4
246 INDEX
Bank of America, 4, 14, 38, 72, 77, collateralized loan obligations (CLO),
125, 177, 183 x, 16, 25, 78, 79, 114, 118, 120,
Basel III reforms, 208 136, 141, 152, 154, 155, 163,
Basel II Principles, 205, 207–9 165, 222
Basel 2.5 Principles, 207 collateralized mortgage obligations
Bear Stearns, 5, 22, 37, 199 (CMO), 16, 18, 73, 77, 79, 114,
Boston Mortgage Company, 62 122, 136n7, 150, 152, 154, 222
Bowie bonds, x, 80, 94–5, 127 collateralized synthetic obligations
Brady Bonds, 142 (CSO), 16, 79
brand name securitizations, x, 80, 97–8 commercial mortgage backed securities
British East India Company, 53 (CMBS), 25, 26, 77, 78, 149,
Bühring, 58 151, 157, 159, 162, 222
Commercial Paper Funding Facility
(CPFF), 198, 199
C compera, 51, 52, 74n3, 74n4
capital regulatory requirements, 3 conduits, 6, 11, 23, 24, 73, 113
Capital Requirements Directive Conseco Financial Corporation, 125
(CRD), 205–7, 217 Consolidated Association of Planters
capture theory, 88–90 of Louisiana (CAPL), 54–5
Carrington Capital Asset Management counterparty risk, 99, 113
(CCAM), ix, 34–6 Countrywide Financial, 5, 38, 193
CDO. See collateralized debt covered bonds, 39, 50, 60, 173–85,
obligations (CDO) 187, 210, 212, 217
Chinese market, securitization, x, 141, CRA. See credit ratings agencies (CRA)
152, 160, 163, 166 CRD. See Capital Requirements
Citigroup, 4, 22, 34, 103, 193 Directive (CRD)
CLO. See collateralized loan Credit Agency Regulation (CAR), 205
obligations (CLO) credit card securitization, 2, 14, 15,
CMBS. See commercial mortgage 23, 30, 73, 78, 83, 91, 92, 114,
backed securities (CMBS) 145, 148, 222, 226
CMO. See collateralized mortgage credit enhancement, viii, 3, 21, 35, 36,
obligations (CMO) 81, 98, 106, 113, 142, 144, 153,
collateralized commodity obligation 161, 188
(CCO), 16, 79 Credit Foncier, 61, 68, 178
collateralized debt obligations (CDO), Credit ratings agencies (CRA), 3, 18,
4, 5, 16, 18, 19, 22, 25–6, 27, 31, 25, 130, 201, 205, 206
34, 36–8, 40, 78, 79, 113–16, credit risk, viii, 3, 15, 17, 19, 20, 22,
118–21, 122, 123, 131–8, 146–8, 54, 56, 59, 99, 103, 113, 115,
152–4, 163, 193, 194, 199, 204, 119, 132, 133, 143, 151, 161,
206, 213, 215, 225 165, 166, 177, 181, 182, 185,
collateralized foreign exchange 201, 208, 209, 211, 216
obligations (CXO), 16, 79 currency risk, 113
INDEX 247
D Eurostat rules, 101, 103–5

Danish covered bond market, 179, Eurozone crisis, 105–7
181 External Ratings Based Approach
debt, 1, 3–5, 7–9, 13–19, 25, 31, 35, (ERBA), 208
37, 40, 51, 52, 54–8, 60, 61, 63,
66, 68, 69, 71, 74n2, 77, 78,
80–5, 91–3, 98–107, 114–16, F
119, 124, 125, 128, 136, 136n7, Fannie Mae, 5, 12, 13, 49, 61, 69, 72,
142, 143, 145, 150, 151, 153, 77, 112, 121, 150, 182, 194–7,
156, 157, 165, 175, 178, 179, 202, 203, 222
183, 185, 186, 188, 191, 193, Federal Home Loan Mortgage
199, 204, 206, 293 Association (FHLMC), 5, 12, 49,
default correlations, 23, 114, 121, 122 71–3, 121
default delinquencies, 36, 83, 126 Federal Housing Authority (FHA), 12,
De Neufville bank, 57 13, 69, 72, 223
Deutz Company, 52, 53 Federal National Mortgage Association
Dodd-Frank Wall Street Reform and (FNMA), 5, 12, 13, 49, 61,
Consumer Protection Act, 201 69–72, 112, 121, 150, 182, 183,
dowry funds (Monte delle Doti), 55–6 194–7, 202, 203, 222
Dutch Hope Company, 53, 54 FFS. See future flow securitizations
(FFS)
FHA. See Federal Housing Authority
E (FHA)
EC. See European Commission (EC) FHLMC. See Federal Home Loan
ECB. See European Central Bank Mortgage Association (FHLMC)
(ECB) film securitizations, 95–7
Economic Stimulus Act of 2008, 196 financial bubbles, 50, 84, 98, 114,
Emergency Home Finance Act, 71 128, 197
emerging markets, 16, 21, 98, 128, Financial Crisis Inquiry Commission
141–69 (FCIC), 2, 4, 50, 111, 112, 116,
eminent domain, 191, 223 118
Equipment Trust Certificate (ETC), financial innovation(s), 4, 9, 19, 49,
69 62, 68, 73, 113, 114
equity tranche (residual tranche), 18, financialization, 1, 2, 4–12, 16, 17,
22, 24, 34, 35, 163 144
European Central Bank (ECB), 5, 31, Freddie Mac, 5, 12, 13, 49, 61, 71,
105–7, 174, 176, 184, 204, 205, 72, 77, 112, 121, 182, 183,
210–12, 224, 225 194–7, 202, 203, 222
European Commission (EC), 103, Frederick the Great, 58, 178
213, 215–17 future flow securitizations (FFS),
European Financial Stability Facility 92, 98, 126–9, 144, 148,
(EFSF), 206 151, 152
248 INDEX
G internal ratings based approach (IRB),

Gaussian copula function, 114, 121 208, 209
Ginnie Mae, 5, 12, 49, 70, 77, 196, Islamic securitization, 185–9
197, 222, 223
global financial crisis, 5, 13, 129–30,
147, 154, 162, 173, 179, J
195–203, 221 jaybirds, 66
globalization, 2, 3, 12, 16 J.B. Watkins Company, 66
GNMA. See Government National JP Morgan, 4, 38, 147
Mortgage Association (GNMA)
governance risk(s), 113
Government National Mortgage L
Association (GNMA), 5, 12, 49, Landschaften, 58–60, 178
70–2, 77, 183 lawsuit settlements, 4
government sponsored entity (GSE), “lemons problem”, 21, 59, 89, 91
12, 18, 72, 154, 182, 196, 203, leverage, 19, 37, 56, 74n2, 101,
223 111, 115, 119, 128, 129,
Greek securitization market, 101–3, 107 146, 208
G20 Retention Principles, 206 life insurance securitization, 127
GSAMP Trust 2006-S3 securitization, Liquidity Coverage Ratio
129–30 (LCR), 209
GSE. See government sponsored entity liquidity risk, 3, 98, 113, 128, 209
(GSE) Lombard Investment Company of
Guaranteed Mortgage Certificate, 72 Kansas, 66
guaranteed mortgage participation London Interbank Offer Rate
certificates (GMPC), 68 (LIBOR), 37, 41n18, 87, 187
LTV Steel, 123, 124
luogo di monte, 51
H
Heilig-Meyers (ABS), 83, 125
Housing and Economic Recovery Act M
of 2008, 196 market risk, 113
housing bubble, 9, 197, 207 maturity mismatch, 163
maturity transformation model, 11
MBS. See mortgage backed securities
I (MBS)
idiosyncratic risk, 23, 114, 121, 122 Mercantile Trust Company, 63
IMF, 5, 33, 77, 78, 101, 180 mezzanine tranche(s), 18, 19, 24, 118,
information asymmetry, 20, 21, 88, 211
143, 188 microfinance securitization, 145–7
intellectual property securitization, 80, Minsky, Hyman, 3, 16, 23
92–8 MMMF. See money market mutual
interest rate risk, 71, 113, 115, 182 funds (MMMFs)
INDEX 249
money market mutual funds (MMMFs), overcollateralization, 21, 33, 40n13,

12, 24, 195, 199, 200, 203 113, 181, 206
Moody’s, 3, 17, 68, 88, 94, 97, 106,
118, 122, 130
moral hazard, 23, 55, 59, 81, 98, 116, P
128, 162, 188, 201 pass-through mortgage backed
mortgage backed bonds, 57, 67, 177 securities, 14, 72, 73, 77
mortgage backed securities (MBS), 2, pay-option ARM, 114, 115
4, 18, 19, 24–5, 26, 27, 30, 31, peer-to-peer lending, 95, 226
33, 34, 38, 42, 49, 50, 52, 57, Pfandbriefe, 30, 57–61, 178, 179
61, 62, 70, 72, 73, 77–109, PLS. See private label securitization
115–19, 121, 126–9, 131, 136, (PLS)
143, 153, 154, 160, 164, 165, Point Pleasant CDOs, 135
173, 175, 183, 197, 201, 211, prepayment risk, 70, 113, 176, 188
222, 223 Primary Dealer Credit Facility
mortgage market(s), 4, 12, 13, 16, 19, (PDCF), 198, 199
33, 35–9, 65, 68, 72, 73, 84, 86, private label securitization (PLS), 5,
90, 112, 127, 129, 133, 144, 16, 22, 77, 78, 191, 196, 223
148, 149, 152, 180, 181, 202 Prussian mortgage market, 68
public label securitization, 206
N
narrow funding banks (NFB), 203 Q
negotiates (plantation loans), 52 qualifying securitizations, 212
non-performing loan (NPL), 5, 16,
141, 142, 151, 153, 155, 156,
158–61, 163, 165 R
Northern Rock, 38–40 Ranieri, Lewis, 2, 13, 40n4, 72, 78,
NPL. See non-performing loan (NPL) 107n1, 107n2, 112
ratings based approach (RBA), 208
Regulation Q, 69, 70
O regulatory arbitrage, 20, 207
off balance sheet financing, 22, 23, 96, regulatory responses, 155, 195–203,
97, 101, 112, 113, 122, 160, 206, 212
200, 209, 213 residential mortgage backed securities
originate-to-distribute model (OTD), (RMBS), 18, 24–6, 30, 33, 34,
17–19, 116–17, 195 37, 40n13, 70, 77, 78, 106, 113,
Originate-to-Hold model (OTH), 118, 120–2, 131–3, 147–50, 152,
17–19, 116, 128 157, 159, 161, 175, 194, 195,
OTD. See Originate-to-distribute 199, 203, 204, 223–5
model (OTD) Resolution Trust Company (RTC),
OTH. See Originate-to-Hold model 13, 78, 153, 154, 160
(OTH) ring fence, 175
250 INDEX
risk,, 2, 3, 20–2, 50, 56, 69, 70, 81, 136, 144, 145, 149, 159, 161,
98, 111–39, 142, 143, 145, 150, 176, 177, 199, 200, 216
151, 175, 195, 221 SPV. See special purpose vehicle (SPV)
RMBS. See residential mortgage Standard and Poor’s, 3, 17, 88, 106,
backed securities (RMBS) 187
standardized approach (SA), 208
Straus bonds, 68
S structured investment vehicles (SIV),
Sallie Mae, 84–6, 87, 89–90 18, 23, 133, 195
Salomon Brothers, 12, 14, 72, 78, 112 student asset backed securities
Sears (securitization), 95, 97 (SLABS), x, 27, 80, 83–92
SEC, 4, 36, 78, 131–3, 138, 184, student loan securitization, 87
185, 201, 221, 222 subprime borrowers, 33, 36
securitization synthetic collateralized debt
Asia, 151–4 obligations, 4
benefits, ix, 19, 22–4, 98, 99, 157
complexity issues, 36, 119
definition, 13–15 T
disadvantages, 121 teaser rates, 36, 37
ethical issues, 111 Term Asset-Backed Securities loan
India, 154 Facility (TALF), 91, 198
Latin America, 147, 149–51, 164 Term Auction Facility (TAF), 195
lawsuits, 4, 191, 193–5 Term Securities Lending Facility
servicing risk, 113 (TSLF), 199
Seven Years War, 53, 56, 57, 178 Timberwolf CDOs, 133–5
shadow banking, 11, 157, 162, 195, tranches, 3, 16, 18, 23–5, 35–7, 51,
201, 203 52, 79, 81, 87–90, 98, 103,
“simple, transparent and standardized” 112–16, 118, 120, 121, 130,
securitization (STS), 215 131, 143, 146, 159, 209, 211,
SIV. See structured investment vehicles 215, 226
(SIV) “transparent and standardized”
skin in the game, 36, 58, 175, 180, Securitization, 214, 215,
182, 195, 200, 201, 204 218n20
SLABS. See student asset backed trente demoiselles de Geneve, 55–6
securities (SLABS) Troubled Asset Relief Program
solar lease securitization, 98–9 (TARP), 197
sovereign debt securitization, 80, “true” securitization, 142
99–107, 136
sovereign ratings, 103, 143, 145
sovereign risk, 113, 142, 145, 147 U
special purpose vehicle (SPV), x, 3, 17, United States Mortgage Company, 63
18, 24, 57, 81, 82, 93, 94, 96, U.S. Housing Act, 70
98, 101–3, 111, 115, 123, 124, U.S. western mortgages, 63, 65, 67
INDEX 251
V W
Value at Risk (VaR), 36 Watkins Land Company, 66
Veteran’s Authority West Indies plantation mortgages, 52
(VA), 12 Workers’ Remittances Securitization,
Villard, Henry, 62 144–5

Securization and The Global Economy

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Securitization and

the Global Economy

Securitization and the

ISBN 978-1-137-34972-9 ISBN 978-1-137-34287-4 (eBook)

Library of Congress Control Number: 2016957538

© The Editor(s) (if applicable) and The Author(s) 2017

Cover image © Roman Milert / Alamy Stock Photo

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

In 1858 William Gladstone wrote, “Finance is, as it were, the stomach of

“Securitization was meant to reduce risks through risk-tiering and geo-

ples such as accounts receivables securitization market and student loan

Many people have provided me with feedback and encouragement on my

5. An example of this is Bowie bonds based on music royalties of David

1 Securitization and the Way We Live Now1

2 What History Informs Us About Securitization49

3 Beyond Mortgage-Backed Securities77

4 Securitization and Risk Transfer111

5 Securitization in Emerging Markets141

7 Reforming the Global Securitization Market191

Fig. 1.1 Topography of the conceptual field of financialization 3

Table 3.1 Examples of securitized asset classes 80

Securitization and the Way We Live Now

© The Author(s) 2017 1

Securitization Disintermediation Liquidification Liberalization Privatization

Fig. 1.1 Topography of the conceptual field of financialization.

became a popular method of financing not only in the mortgage market

Financialization refers to the increasing importance of financial markets,

Similar definitions are offered by Phillips (2008), Krippner (2005, 2009),

the increasing dominance of financial actors, markets, practices, measure-

Aalbers (2015) offers three conceptualizations of the term: (1) financializa-

Fig. 1.2 US total credit/GDP (%).

Fig. 1.3 US financial and non-financial debt.

Financial innovation has made it easier to provide credit to companies

Fig. 1.4 Private sector credit as a % of GDP 1990–2013.

Fig. 1.5 Public sector debt as a % of GDP 2007–2013.

Fig. 1.6 US mortgage debt/GDP (%).

being issued, which were subsequently securitized. Much of this incremen-

Fig. 1.7 Finance, insurance, and real estate (FIRE)/GDP.

market. Much of this is attributable to the provision of household credit

In the literature, the development of a consistent working definition of

[A] serviceable definition is the sale of equity or debt instruments, repre-

Compare the previous definition with the SIFMA definition:

Asset securitization is the structured process whereby interests in loans and

which generally gives them access to broader funding sources at more

A reliable working definition of securitization needs to reflect the process’

3.2 The Securitization Process

1. the cash flows must be regular and predictable;

In recent years the more popular securitized assets have included:

Strahan 2009). If we view securitization through the lens of financializa-

3.3 Originate-to-Hold (OTH) versus Originate-to-Distribute

3.4 Why Do Institutions Securitize?

3.5 The Lemons Problem

protect himself through recourse clauses in the contract, or by requiring

3.6 Benefits and Costs of Securitization

worthier cash flows a company would be able to borrow at AAA rate, or

be inflated during boom times when investors are inclined to be more

3.7 Mortgage-Backed Securities (MBS)

Since the 1980s, MBS have taken on many permutations, including

MBS -Agency CMO-Agency

Fig. 1.8 US mortgage securitization issuance 1996–2015/(USD billions).

Fig. 1.9 US ABS issuance (USD $millions).

In terms of more specific issuances, one observes in Fig. 1.9 that US

1 Securitization and the Way We Live Now1

2 What History Informs Us About Securitization49

3 Beyond Mortgage-Backed Securities77

4 Securitization and Risk Transfer111

5 Securitization in Emerging Markets141

7 Reforming the Global Securitization Market191

Fig. 1.1 Topography of the conceptual field of financialization 3

Table 3.1 Examples of securitized asset classes 80

3.10.1 Mini-Case: Carrington Capital Asset Management

3.11.1 Mini-Case: Northern Rock

GNMA- guaranteed security system was undoubtedly successful for a