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The introduction of Asset Securitization, and its evolution over two

decades, has had a profound impact on consumers and financial institutions
as an innovative product and no doubt, it will continue to remain so. In the
light of recent events it is clear that more and better regulatory approaches
must be instituted in order to ensure that the original model and some of
its innovative iterations reconstitute to the original power and value they
provided. In this manner, the markets will reset, consumers will benefit and
Asset Securitization can regain its rightful perch as one of the most valuable
products and financial instruments in banking history.

Asset Securitization
Revolution, Evolution, Devolution
The rise and fall of the most important financial instrument in banking

(USA) Ron Nechemia

Since the Asset Securitization and was adapted to various types of

product was first introduced into the asset class. In recent years the market
United States banking and credit has grown and the use of securitiza-
system in the 1970s, it enabled the tion has likewise increased exponen-
unprecedented growth of markets in tially. Asset securitization has been
both the U.S. and abroad. It further recognized by eminent academics as
set new benchmark standards of the most important engine of reform
innovation and productivity, credit in our financial system to emerge in re-
enhancement and risk analysis. But cent times; it is viewed as a revolution
in the end, left unchecked and to open in the banking and financial services
market devices, is what he suggests, industry by industry practitioners. In
contributed greatly to the U.S. finan- its simplest form, it is a process where
cial collapse. Today, many measures ill-liquid assets owned by a financial
are required to repair what has be- institution are pooled and sold in the
come a badly damaged international legal or economic sense to a third
financial system and proven dysfunc- party referred to as a Special Purpose
tional financial architecture. Vehicle (SPV). The SPV in turn issues
securities backed by these asset pools
in financial markets to the general
Advance in Contemporary
Financial Technology public, usually after obtaining some
form of credit quality enhancement
Securitization got its start in the to the securities. Securities marketed
1970s, when home mortgages were in this manner are referred to as asset
pooled by U.S. government-backed backed securities (ABS).
agencies. Then, in the 1980s, other in-
come-producing assets also started to Asset securitization was initially
become securitized. Since then, secu- practiced by financial institutions
ritization technology evolved rapidly that securitized home mortgage
loans, transforming them to mort-

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International Financing

gage backed securities. Over time asset Structured financing is an exten- with the transfer of asset ownership
securitization has emerged as a main sion of asset securitization, which adds is avoided. Determining the capital
funding option for commercial banks a degree of complexity to the basic requirements relating to Synthetic Se-
to redress growing monetary con- process. In structured financing the curitizations can be complicated due to
straints and acquire diversified sources traded securities created by the secu- uncertainties regarding the degree of
of liquidity. Commercial banks have ritization process are structured into risk transference and the extent of risk
traditionally funded themselves on a several classes of derivative securities retained by the originator.
short-term basis. However, over the with different characteristics and sold
recent three decades, they have come to investors whose investment require-
The Subprime Implosion of the
under pressure from the customers to ments match those of these particular U.S. Housing Market
improve their term financing, as retail type(s) of securities. Structured financ-
deposits have not always kept up with ing has added value to the basic asset Subprime mortgages are pre-
surging credit growth of mortgage and securitization process and further dominantly securitized in the form of
consumer loans. served to develop the growth of asset- mortgage-backed securities (MBS).
backed financial markets. These securities are enhanced with
Aside from senior debt, balance mechanisms to protect higher-rated
sheet securitization of residential mort- With the advent of credit deriva- tranches from shortfalls in cash flows
gages, and later on the securitization of tive products, a further innovation in from the underlying collateral (for in-
retail credit, has become a key mecha- asset securitization processes has stance due to defaults or lower than ex-
nism to fund the US housing deficit. emerged in the form of a product called pected interest income). These mecha-
The bank-sponsored securitization of Synthetic Securitization. In Synthetic nisms include various kinds of explicit
retail asset portfolios, in particular car Securitization, a financial institution insurance, for instance as provided by
loans and residential mortgages has holding a pool of assets transfers the mortgage insurers. However, most of
been the main source of supply, with credit risk attached to the asset pool to the credit enhancement comes from
the biggest securitization asset classes a third party by means of credit deriva- structural features such as subordina-
mapping directly how the bank’s major tives, rather than by the direct transfer tion, overcollateralization, and excess
loan portfolio are comprised. of ownership of the assets. This “trans- spread.
fer” might also take place via a credit
Since its inception, the basic asset default swap, or a total return swap to Until the subprime crisis exploded
securitization process has now been transfer the credit risk attached to an on the U.S. housing market, the impact
extended in a variety of ways. Asset asset pool to a third party, rather than of securitization appeared largely to
securitization techniques are now ap- by selling the assets. be positive and benign. But securitiza-
plied to a wide range of different asset tion also has been indicted by some for
classes, and by a variety of institutions The popularity of Synthetic secu- compromising the incentives for origi-
ranging from financial institutions to ritizations among financial institutions nators to ensure minimum standards
trading and manufacturing firms, and has given rise to concerns about the of prudent lending, risk management,
even infrastructure project operators. regulatory aspects of addressing the and investment. This, at a time when
Non-financial institutions adopt asset risks associated with synthetic secu- low returns on conventional debt prod-
securitization techniques principally as ritization. Synthetic securitization has ucts, default rates below the historical
a financing technique, and as a means advantages over conventional securiti- experience, and the wide availability
of enhancing corporate liquidity. zation because the legal cost associated of hedging tools were encouraging in-
vestors to take more risk to achieve a
higher yield. Many of the loans were
not kept on the balance sheets of those
who securitized them, perhaps encour-
aging originators to cut back on screen-
ing and monitoring borrowers. This
subsequently resulted in a systematic
deterioration of lending and collateral
standards issued by financial institu-
tions and its impact on markets not just
in the United States, but by extension,
Government bodies, such as but
not limited to, the US Securities and
Exchange Commission (SEC) and the
Federal Reserve Board of Governors
in Washington DC, together with the
international organization failed to
understand the evolution in financial
technology, and perhaps were not sure
as to which of the government agencies
has responsibility for oversight. This

2009 APRIL | 65

lack of oversight coupled with a failure we have now seen all but disappear. It the necessary steps to revise rating
to establish new guidelines that would is further true that the originating and methodologies for structured prod-
mitigate risks associated with evolution arranging entities lacked appropriate ucts; only now are they taking steps to
of contemporary financial technology credit screening and monitoring incen- separate rating activities from other
by imposing stricter safety standards tives, with many investors failing to business activities; delink rating man-
and higher capital requirements in sufficiently question such incentives agers’ compensation from the financial
overall terms on the financial institu- or examining the quality of the loans performance of their business unit;
tions in developed financial markets, underlying structured products. In- enhance the surveillance of the rating
compared to the previous standards stead, institutions/investors, rightly or process; and strengthen internal over-
contributed greatly to the present day wrongly, relied excessively if not osten- sight of rating methodologies.
global financial debacle. Both the scale sibly, on the reputation of the institu-
and persistence of the attendant credit tions involved and on the credit ratings Uses of ratings
crisis seems to suggest that securitiza- of the instruments. Investors should not use ratings to
tion—together with poor credit origi- replace strong risk analysis and man-
nation, inadequate valuation methods, Quality of the rating process and agement methodologies that would be
and negligently insufficient regula- conflicts of interest consistent with the complexity of the
tory oversight—have severely damaged Credit rating agencies have instruments they buy and relative to
global financial stability. assigned high ratings to complex the importance of their holding. In this
structured subprime debt based on context, supervisory authorities might
The Credit Rating Agencies limited historical data; in some cases, consider reviewing the use of ratings
on flawed models; and on inadequate in regulations to ensure that such use
Obtaining a Satisfactory Credit Rating due diligence of underlying collat- does not induce uncritical reliance on
One of the critical factors deter- eral. Agencies also failed to adequately credit ratings as a substitute for inde-
mining the success or otherwise of an disclose assumptions, criteria, and pendent evaluation.
asset securitization process is the credit methodologies; they failed to clarify
rating obtained for the securitized debt the meaning and risk characteristics A Remedial Approach to Endemic
sold to the market. The credit quality of structured finance ratings; nor did Problems
of the security is directly related to the they address conflicts of interest. Fi- a. Rating agencies should be
yield of the issue. The higher the credit nally, financial institutions did not al- turned into single-activity or single-
quality the lower will be the yield and ways sufficiently disclose the type and product line firms. They should
the more successful will be the issue. magnitude of their on-and-off balance- provide just ratings, not any other
The credit rating must also achieve at sheet risk exposures, particularly those products or services, including advice.
least the threshold investment grade. related to structured products. The programs for Rating agencies vary
A lower than investment-grade quality Furthermore, shortly after the widely by the type of product, its po-
rating will not be favorably viewed by eruption of the current financial crisis, tential risks, and the regulatory powers
investment funds and other institu- and after heavy criticism, the various granted to the agency.
tional investors, resulting in an unsuc- credit rating agencies started taking b. The quasi-regulatory role of the
cessful security issue.
Securitization and the develop-
ment of complex structured credit in-
struments have undeniably improved
access to credit. However, they may
also have contributed to greater (and
now in hindsight clearly unnecessary,
unwarranted and unsubstantiated)
aggregate risk-taking and, instead of
resulting in an efficient dispersion of
risks, have led to a destabilizing shift of
risks toward institutions that could not
adequately manage them. Moreover
it has had a counter effect, presently
and dramatically seen in the rever-
sion of some of these risks to banks
that had supposedly offloaded them,
and to much more uncertainty about
the actual distribution of risks among
market participants. In addition,
both banks and the off-balance-sheet
Special-Purpose Vehicles created in
the securitization process have come to
rely excessively on wholesale funding
markets, thus incurring maturity mis-
matches without adequate consider-
ation of the risks of such funding, that

66 | 2009 APRIL
International Financing

rating agencies in Basel II should be elimi- consumer protection with maintaining the stitutions on non-bank lenders and loan
nated or amend. viability of the securitization model. brokers that are regulated at the state level;
such initiatives also rely on consistent
c. The customer wishing to have his When considering future policy state-level enactment and enforcement.
company, country or instrument rated changes, regulators and lawmakers need The U.S. Federal Reserve should review
does not pay the rating agency, ex-ante to balance carefully the need to limit future its powers to regulate mortgage transac-
or ex-post. Instead he pays the regulator, predatory lending excesses, while preserv- tions and tighter restrictions, especially
who then allocates/auctions the individual ing a model that has successfully dispersed concerning the clarity of disclosures to
rating activity among the population of losses from higher-risk mortgages away borrowers and the availability of the riski-
competing rating agencies. from the banking system and maintaining est loans, appear warranted.
the ability of stretched but viable subprime
d. Rating agencies should be paid in borrowers to refinance when confronted The introduction of Asset Securitiza-
part in the securities they are rating. Such with reset payment shock. This is a chal- tion, and its evolution over three decades,
securities should be held to maturity and lenging task within a regulatory and legal has had a profound impact on consumers
cannot be hedged by the rating agency. framework ill-suited to provide consumer and financial institutions as an innovative
protection in an originate-to-securitize product and no doubt, it will continue to
Conclusion financial system. remain so. In the light of recent events it
is clear that more and better regulatory
Asset securitization made the finan- Federal banking regulators should approaches must be instituted in order to
cial system more resilient at the expense of tighten guidance on nontraditional and ensure that the original model and some of
undermining the effectiveness of consum- hybrid mortgage lending. It is absolutely its innovative iterations reconstitute to the
er protection regulation. In recent months, necessary to address the very fragmented original power and value they provided.
lending standards have tightened and rat- nature of the U.S. financial regulation sys- In this manner, the markets will reset,
ings models are being strengthened, but tem where such standards are not uniform consumers will benefit and Asset Securiti-
subprime credit is still readily available—at in observance and enforcement. zation can regain its rightful perch as one
a price. Potential solutions to the manage- of the most valuable products and financial
ment of this trade-off should be explored. Regulators should establish and
enforce compliance by their regulated in- instruments in banking history. IFM
Policy response should balance greater

This is an English-translated reprint of an article from International Finance Magazine - April, 2009.

2009 APRIL | 67