HYPOTHESIS TESTING

Ho : Securitization cannot reduce the risk. H1: Securitization can reduce the risk.
Does credit securitization reduce bank risk? Evidence from the European CDO market by Dennis N. Hansel & Jan-Pieter Krahnen

Model on Securitization
This study claims different effects of credit securitization on the risk exposure of the originator. On the one hand, banks are seizing the advantage of an improved risk management, and may choose higher risk exposures, for instance, by operating with greater financial leverage. As a consequence, the equity yield may rise, together with the systematic risk of the originator. On the other hand, securitizations will allow the bank to transfer risk to investors, thereby decreasing systematic risk.

Claims
Securitization is boon for banking industry, and it used to mimic banking activities outside the regulatory framework for banks. Assumption: Securitization was designed to benefit lenders, investment bankers, and investors. Lenders earned fees for originating and selling loans. Investment banks earned fees for issuing mortgagebacked securities. Securitization diversify the risk, but it can't reduce the risk.
Securitization was diversifying the risk, said Lindsey, the former Fed governor.But it wasnt reducing the risk. . . .

Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks paid handsome fees to the rating agencies to obtain the desired ratings. Banks that wanted to shed assets and transfer risk, investors ready to put their money to work, securities firms poised to earn fees, rating agencies ready to expand, and information technology capable of handling the job the securitization market exploded. Securitization was not just a boon for commercial banks; it was also a lucrative new line of business for the Wall Street investment banks, with which the commercial banks worked to create the new securities. Quantitative analysts, called quants. ------to develop models to predict how markets or securities might change. Eg Value at Risk model(VaR) by JP Morgan These models purported to predict with at least certainty how much a firm could lose if market prices changed. But models relied on assumptions based on limited historical data; for mortgage-backed securities, the models would turn out to be woefully inadequate. Once banks began selling instead of holding the loans they were making, they would care less about loan quality. The regulators increasingly relied on the banks to police their own risks.

The regulators failed to appreciate the complexity of the new financial instruments and the difficulties that complexity posed in assessing risk.
By Vincent Reinhart, a former director of the Feds Division of Monetary Affairs

Securitization was diversifying the risk, said Lindsey, the former Fed governor.But it wasnt reducing the risk. . . .

THE GROWTH OF DERIVATIVES: BY FAR THE MOST SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE

Derivatives Financial contracts whose prices are determined by, or derived from, the value of some underlying asset, rate, index, or event. Purpose Hedge business risk or for speculating on changes in prices, interest rates. They may be based on commodities , interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures. The derivatives markets are organized as exchanges or as over-the-counter (OTC) Markets. The oldest U.S. exchange is the Chicago Board of Trade, where futures and options are traded. OTC derivatives are traded by large financial institutions.

 Regulation Commodity Exchange Act of 1936, a new federal independent agency, the Commodity Futures Trading Commission (CFTC), to regulate and supervise the market. In 1993, the CFTC sought to address these concerns by exempting certain nonstandardized OTC derivatives from that requirement and from certain other provisions of the Commodity Exchange Act, except for prohibitions against fraud and manipulation. As the OTC market grew following the CFTCs exemption, a wave of significant losses and scandals hit the market.