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    What is securitization? How does it contribute to global financial system

    University: Griffith University

    • Unit No: 1
    • Level: Undergraduate/College
    • Pages: 12 / Words 2915
    • Paper Type: Essay
    • Course Code: ECON2070
    • Downloads: 342
    Question :

    This assessment will cover following questions :

    • What is securitization and how it plays a crucial role in creating sustainable financial system?
    • Discuss the socio-economic effects on securitization.
    • How did securitization make increment in stability earlier to the 2007 financial crisis?
    Answer :

    INTRODUCTION

    Securitization can be defined as that financial practice in which pooling is being done which is related to different type of contractual debt. The debt can include such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations. The selling in securitization can be done to third party which is basically investors. Like for example a money market account is an account at a bank used to store cash. Securities can also be defined as financial security. It is one of the most important thing in financial market. It can be re packaged into interest bearing securities.

    1. Explaining the Meaning of Securitization

    Securitization refers to the financial practice in pooling several kinds of the contractual debt like residential mortgages, auto loans, credit card obligation, commercial mortgages and selling the cash flows to the third party by way of securities that might be described as the bonds, collateral obligation, pass through securities etc. Under this investors are been repaid from a principal and an interest cash flows that are been gathered from an underlying debt that is redistributed through capital structure of new financing (Broer, 2018). Securities that are been backed by the mortgage receivables are known as mortgage backed securities whereas those which are backed by other kinds of the receivables are stated as asset-backed securities. The granularity of the securitized assets could help in mitigating credit risk of an individual borrower. Unlike the general corporate debt, quality of the securitized debt is seen as non-stationary because of the changes in the volatility which are dependent on the time and the structure.

    Moreover, the SUBPRIME mortgage crisis that started in the year 2007 facilitates a securitization concept as a bad name. It is the process within which certain assets are been pooled together so that they could be re-packaged into the securities that are interest bearing. The principal and the interest payments from an asset are been passed through purchase of securities. Most of the financial institution applies securitization in transferring credit risk of an asset as it originate from their respective balance sheet with that of other institutions like bank, hedge funds and insurance companies (Helgesson and Mörth, 2019). It is reflected as very cheaper funding sources. Until and unless subprime crisis unfolded, an impact of the securitization has been largely appeared as positive and the benign. However, it is also indicated as compromising an incentives for the originators in respect of ensuring minimum standards of the prudent lending, management of risk and investment at the lower time when the lower returns on the conventional products, default rates resulted below historical experiences (Mordel and TeNyenhuis, 2018). Wide availability of the hedging tools were been encouraging an investors in taking the more and more risk in achieving higher yield.

    The process of securitization includes two main steps that is in the first step, corporation with the loans and the other income producing an asset. Thereafter, originators determines an assets that it wants for removing from balance sheet and in pooling them within the reference portfolio. Then it sells such asset pool to the issuer like SPV. An entity that is set up by the financial institution, particularly for purchasing an asset and realizing its off-balance sheet treatment for the legal and an accounting purposes (Messina, 2019). In the next step or second step, issuer finances an acquisition of pooled assets with issuing a secutrities that bears interest and could be traded which are been sold to the investors in the capital market. An investors receives the floating and the fixed rate payments from the trustee account that is been funded by cash flows which are been gained by reference portfolio.

    Significantly, securitization presents the diversifies and an alternative source of the finance on the basis of transferring credit risk from an issuer to the investors. Initially, securitization eas used for financing simple and self liquidated asset that involves mortgages (Bilan, Degryse, O’Flynn and Ongena, 2019). On the other hand, any kind of the asset with the stable value of cash flow could in structured in principle into the reference portfolio which supports securitized debt. 

    The securitization landscape over the decades has reflected dramatically changed. It is no longer wed to the traditional assets along with the specific terms like bank loans, consumer loans, mortgages etc. Improved level of risk quantification and modelling has encouraged an issuer in considering wider range of the assets such as business loans, lease receivables etc. Moreover, in the mature market, it has been registered for a significant growth in the emerging markets where the large and the companies that are highly rated have opt for using securitization for the purpose of turning their future cash flows from export or remittances into the present cash flows.

    In future, products that are securitized likely to become more and more simpler. After the years of posting virtually for not any capital reserves against the debts that are high rated (Zhang, 2019). Issuers or investors will soon facing with the regulatory changes which will needed in charging higher capital and the comprehensive valuation. Reviving transaction relating to securitization and restoring confidence of an investor may require issuers in retaining an interest in performance of the securitized assets at every level.

    2. Representing contribution of securitization in sustaining and creating a global system of financial

    Securitization act as the major financial innovation that contains cost and the benefits attached to it. There are various conditions within which securitization could be a net benefit fro global financial system. As such, securitization acts as the concept that is neither considered as good not counted as bad as the point underscored by variation of market in performance of the various classes of the securitized assets at time and after a global financial crisis (Chiaramonte, 2018). This departure point stands in comparison to some more polarizing views attached with the securitization that were been advanced in aftermath of GFC.

    There exist various channels through which healthy market for the securitization may support both broader economy and the financial system. It includes lower cost for funding and the in economizing the capital for the financial institution. Securitization benefits might passes to the businesses and the consumers as it helps an investors and the issuer in diversifying and transferring risk around the different class of asset, industries, geographies, credit risk and an instruments. By way of transforming pool of an illiquid assets into the securities that are been traded. It also contributes in creating a potentially the most valuable tool in assisting with resumption of the credit flows to the worthy borrowers.

    However, such potential benefits required to be weighted against a potential risk towards a financial system that could arise from a sub-optimally working of the securitization markets. This happens because securitization has capacity in increasing credit flow in or outside the formal system of banking (Alqaisi, 2018). Effect of Financial accelerator results in an excessive increase in the asset prices and the credit growth.

    Global securitization has expanded the markets without causing any type of market or economic disruptions over three decades by leading it to late 1990s during the years preceding to the GFC issuing patterns that changed dramatically. By securitization many of the industry participants had became enforced or involved in the powerful reinforcing cycle that is driven by the misaligned incentives. It is the system which is been consist of the for components that is loan originators, intermediaries, investors and CRAs. Thus, from this it has been interpreted that securitization was not been counted as the principal cause of crisis but resulted as creating and sustaining the global financial system in a better way (Elson, 2019). Overall securitization industry has became stigmatized and many of the securitization markets had performed well over crisis. This helps in restoring the credit flow to the worthy borrowers at present time which have been rendered as uneconomical.

    New developments in the securitization over 2000-2007 period that amplified financial crisis specifically where then US subprime mortgages were been involved. Dealers or the brokers found as the dominant actors on supply side as most of new trends have been emerged within the securitization practices within this period. Against a backdrop of the accommodative monetary policy, irresponsible origination of loan practices and the complex financial products and the feedback loop is ensued where the growing demand for the highly rated products results in an increased demand for the low quality loans for serving as the collateral. Hence, concentration of the risk in financial system seen as magnified.

    3. Explaining the socio-economic implications associated to securitization

    In accordance to the forum, there are various economic and the social benefits had been realised in the markets where the securitization is employed on the broader scale. For instance- Efficient and the liquid secondary securitization markets could reduce a regional and the geographical disparities in availability and cost relating to credit throughout the specific jurisdiction linking to local level of credit extension free samples activity to the national and an increasingly global system of capital market.

    Securitisation contains more pronounced effect on the proxies of supply side of an economy than on the economic growth. This tends to be consistent with the shift from an investment to the consumption by constraining supply side of an economy, however, boosting the demand potentially (Securitization, 2018). As the financial crisis attained in last 20 months depicts that the need in understanding better links between the financial intermediaries, real economy and the financial markets. Considering a fact that most of the economy models had underestimated in emerging problems with respect to the part of the financial links to real economy.

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    Securitization provides for number of the reasons that involves reducing informational asymmetries, reducing a regulatory capital and in reducing the bank, lower cost of the financing sources. It increases risk relating to profile of an institution only in case of most creditworthy assets are been removed from a balance sheet through the securitization. It has also been founded that the securitization reduces bank lending to an external source of the fund availability. On the other side, securitization has potential in making the banks more and more vulnerable to the economic shocks at the time when market for the loans is been disrupted.

    4. Why do banks lend to the Sub-prime Borrowers ?

    Sub-prime lending refers to provision for loans of people who have difficulty in maintaining repayment schedule. Loans were characterized to higher interest rates, quality collaterals and the less favourable terms for compensate for higher credit risks. Large number of sub-prime loans have been packaged into the mortgage-backed securities that ultimately defaulted by contributing to financial crisis of 2008.

    Sub-prime borrower means a person having high credit risks for lender. These borrowers are having low credit scores & have number of negative factors presented in their credibility reports like delinquencies & account rejection. They have shorter credit history, and have no or little activities in credit reports for basing the decision by bank. The credit scores are usually below 670 with negative points. As they find difficulty in getting loans banks are able to charge higher interest rates over the loans.

    Banks are providing for the loans to sub-prime owners for many reasons. Banks takes benefits from the sub-prime loans as they are given t lenders at higher rates that are greater than prime rates candidates having poor credit scores (Arentsen and et.al., 2015). Along with higher rates of interest they also come with much higher fees. Subprime loan have great variations. Risk based pricing method are used for calculating the mortgage terms and rates. The more worse is the credit of candidate the more it is beneficial for the banks. These loans are generally used for financing mortgages. Banks also prefer these rates as they also include the prepayment penalties which does not allows borrowers in paying off the loans earlier. This makes it expensive and difficult for refinancing or retiring the loans prior to its ending term. Many of the loans come with the balloon maturities that requires larger final payment. This has increased the benefits and opportunities for homes. This helped banks in attracting large number of client who were in meed of loans. Banks for earning higher interest rates provided large number of loans to people. Defaulters and low credit risks individuals were also provided loans for home purchases. Due to easy availability large number of people availed loans from banks for housing.

    Banks were generating high revenues as loans were granted at higher interest rates. After the global recession faced borrowers of loan started defaulting. The defaults were made mainly by the sub-prime lenders who were given loans at higher rates. As number of houses were purchased on loans the resale of houses were not giving the costs of purchase (Foote and Willen, 2016). This dropped the prices of property and all the loans started lapsing. This caused huge losses to banks and many of them became bankrupt (Adelino, Frame and Gerardi, 2017). Default by homeowners also spilled downturn to other streams of economy.

    Main reasons behind the financial crisis was the sub-prime mortgages for earning higher interest rates on loans. The problems were initiated due to the lenders for advancing the loans at poor credits and higher risks of default. When market were flooded by central bank with the capital liquidity it lowered rates of interest and depressed broadly the risk premiums because investors also looked for the riskier opportunities for bolstering their returns on investments. Banks were having ample capital for lending. Banks were having willingness of undertaking the additional risks for increasing the investment returns.

    Banks started lending at an increased speed as demand raised for mortgages. Prices of housing were rising due to substantial drop in interest rates. This made the lenders to see the sub-prime mortgages less riskier than the actual situations. Banks made huge lending as economy of nation was healthy, interest rates were lower and also the people were paying their instalments on time.

    After that situations were made even bad by the investment bankers. Increased use of the secondary mortgage markets by the banks added more lenders for sub-prime loans. Banks in place of holding the mortgages sold them in secondary market for collecting originating fees. This helped in freeing more capitals for lending, that increased the liquidity more (Haughwout, Okah and Tracy, 2016). Higher liquidity attracted more investors.

    5. Case Study

    Owing to global reputations for the receivables financing & assets based lending in form of the trade receivable securitizations, Demica was to be appointed for working with one of the largest manufacturer of Europe in packaging and paper industry. Incumbent management teams together with new equity owners focus immediately their efforts to minimise the interest cost and paying senior debts for reducing the pressure of debt amortisation. Demica with clients worked for paving way for trade receivable securitisations of 260 million in form of 7 year Medium Terms Note receivables. With sale of receivables client was saving four million of annual interest cost by sale of the receivables. Financing receivables allowed the clients in repaying major senior debts. This transformed the risks profile of group post balance sheet statement. Consultants of Demica worked with management team of client and its lawyers for analysing global receivable book of 800 million for assessing the operational, financial, tax and legal issues defining structures of transactions. On the basis of stringent invoices eligibility criterias for AAA rated transactions for ultimately including invoices representing 32.5% of global trade receivables book.

    Special technical skills are required for centralising the invoice tracking across the multiple jurisdiction. Following review of the software system available in market. Proprietary Citadel technology was selected as optimal solutions for running securitisation transactions and existing discounting programme of invoices. Continuous management of internal invoice of discounting programme system was key requirement of client. The critical important point was also integration of IT system across the companies operating at multiple platforms. Asset based lending of Citadel and the trade receivable securitisation solutions fulfilled most of the requirement of client. For finalising financial structure Demica worked with client, investment bank and its lawyers of trade receivables.

    CONCLUSION

    From the above study it has been analysed that securitization has been used by many companies so that mortgages can be converted into liquid assets. It has been analysed that pool of mortgages are been included securitization. Various assets which can be securitized are home equity loans, auto loans, student loans. These loans are given on basis of security. The asset needs to be mortgage in this. Also it has been analysed that if cash has not been given to loan then security can not be relieved by individual. Securitization is merging various financial assets into tranches.

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