Global Financial Crises and the Future of Securitization Essay Example

business models.

Credit rating agencies play a crucial role in providing investors with assessments of the credit risk of securitized instruments, expressed as expected loss or probability of default. In the past, these agencies heavily relied on rating revenues from structured finance, potentially leading to the rating of highly complex products with limited historical performance data. Ultimately, investors are typically responsible for exerting discipline on other parties involved in the production process through the price mechanism. Securitization has long been a significant means for banks to obtain long-term funding and improve balance sheet management.

Structured finance securitization is praised for expanding credit access and reducing costs while providing investors with exposure to various sectors. The key benefit of securitization in structured finance lies in its capability to distribute credit risk among a broader, more diverse investor base. Ironically, this resulted in increased risk concentration, leading to substantial losses within the banking sector during the global financial crisis.

Before the financial crisis, banks were permitted to heavily leverage their balance sheets with limited transparency. They concentrated their investment and funding needs in an illiquid asset class during times of financial stress. The decline in banking standards was exacerbated by securitization, leading to a multitude of complex and opaque structured products with vastly underestimated risks. The global liquidity and credit crisis was significantly influenced by the substantial size of the securitization markets.
However, it is crucial to acknowledge that not all structured-finance securitization faced issues like the US subprime mortgage sector did, which made up less than 10% of all US securitized mortgages. In Europe, securitization primarily served as a legitimate means of funding rather than being solely pursued

for capital arbitrage purposes as often observed in the US.

Moreover, European underwriters displayed greater market engagement and financial involvement compared to their American counterparts. Additionally, the underwriting standards and regulations in Europe were deemed more stringent. In contrast to the United States' securitization market, Europe did not encounter credit problems; instead, investors incurred losses due to limited liquidity and declining prices. Consequently, there has been a notable decline in structured-finance securitization issuance as a result of this crisis. Certain sectors of the market continue to rely on government-backed liquidity and asset purchase programs.

Despite the flaws in its structure, structured-finance securitization is anticipated to regain significance in debt markets and potentially assist in global economic recovery. Prior to the global financial crisis, favorable economic and financial conditions resulted in a notable rise in global securitization issuance. Nevertheless, following the crisis, there was a decline in private-label securitization issuance.

In 2010, the European securitization market experienced a resurgence, although some segments still relied on the ECB's liquidity program called "retained" issuance. European banks utilized internally-structured securitizations like Residential Mortgage-Backed Securities (RMBS) as collateral to generate liquidity from the ECB. This allowed them to free up their own balance sheets for additional lending.

EUR88 billion was issued through "placed" issuance in Europe in 2010, primarily consisting of prime residential mortgage-backed securities from the UK and Netherlands. While this marked a significant improvement compared to the EUR25 billion recorded in 2009, it fell significantly short of the EUR460 billion peak seen in 2006. However, there was a positive indication of recovery with an increase in the proportion of "placed issuance" compared to total issuance, rising from 6% in 2009 to 23%

in 2010.

According to SIFMA, in 2006, the United States had almost four times more structured finance securitization issuance than Europe. Presently, federal mortgage agencies such as Freddie Mac, Fannie Mae, and Ginnie Mae fund over 90% of US mortgages. Consequently, this is impeding any potential rebound in private-label issuance for the foreseeable future.

Between 2006 and 2010, the non-agency issuance in the US saw a notable decrease, going from USD2.2 trillion to only USD129 billion. The majority of this decline was observed in the ABS sector, which covers asset-backed securities excluding mortgages. This sector mainly comprised auto loans and student loans.

Deficiencies in Rating Agencies: In the 1970s, during the Penn Central crisis, international rating agencies like S&Ps, Moody's, Fitch, and others provided prime ratings to short-term commercial paper. This allowed companies to sell these securities successfully. However, in several instances, investments were rated by rating agencies without the knowledge of ultimate investors about the underlying bonds. Interestingly, all market players had a motivation to participate in these deals, irrespective of the homebuyers' ability to repay the loan. The aim was for the buyer to earn a quick profit, while real estate agents and mortgage brokers collected their fees.

The banks alleviated much of the implied risk by selling the loan quickly. A criticism against the rating agencies is their consistent slowness in identifying crisis indicators. The credit agencies also failed to warn about the company's extensive exposure. As a response, regulatory institutions worldwide established a voluntary code to address conflicts of interest where agencies were paid by the companies they rated. Additionally, the agencies have faced criticism for providing positive evaluations of investments connected to risky

US home loans.

Both the US and EU have acknowledged that rating agencies did not adequately alert about the sub-prime crisis. Consequently, they are taking measures to enhance the performance of these agencies, closely monitor them, and hold them legally responsible for their actions. The US Financial Services subcommittee on capital markets recently announced plans to host a hearing regarding the involvement of credit rating agencies in the structured finance market, specifically mortgage-backed securities. Additionally, on June 11, 2008, the US Securities and Exchange Commission (SEC) implemented comprehensive rules that address conflicts of interest between rating agencies and issuers of structured securities. These regulations will require credit rating agencies to review information about the underlying assets of a structured product before issuing a rating. They will also prohibit agencies from structuring products they rate and mandate public disclosure of information utilized in determining ratings for structured products, which includes details about underlying assets.

The aim of the final proposed requirement is to enable unsolicited rating agencies to provide ratings for structured securities without being paid by issuers. These rating agencies have recently decreased the ratings of a significant amount of mortgage-backed debt. To address conflicts of interest, they have implemented internal monitoring programs, undergone third-party reviews of their rating processes, and received updates from their board. The US subprime securitization market played a major role in the global financial crisis. Regulatory reforms have been implemented to improve disclosure and transparency for this asset class; however, the full impact of these changes remains uncertain. Once the necessary conditions for recovery are met, it is expected that investor confidence will increase again. This will ultimately allow securitization to regain

its importance as a vital channel for both debt markets and the overall economy in the medium term.

It is necessary for market participants and regulators to assess the pros and cons of regulatory changes pertaining to securitization. If securitization does not rebound, banks may need to seek alternative sources of capital in order to meet redemption schedules. The financial sector depends on a securitization market that functions effectively and prioritizes simplicity, transparency, and disclosure. Implementing appropriate regulations now will ensure the long-term sustainability of the securitization market. However, private-label securitization is unlikely to fully recover until policymakers are confident enough in their economies to withdraw government support from these markets.

Efforts are currently being made to revive the banking sector in developed countries and restore confidence among consumers, investors, and financial participants. One key aspect of achieving this goal is revitalizing the housing market. Additionally, the US Administration has plans to eventually withdraw its government-sponsored agencies from the securitization market and transfer authority to private entities in housing-related securitization markets. This transition is expected to take several years. The issue of financial stability has become increasingly concerning lately; however, despite past crises providing warnings, necessary actions to mitigate future consequences have been implemented slowly.

Despite numerous recommendations from working groups, supervisory committees, and others, there has been limited decisive action taken so far. The use of structured finance instruments offers advantages through increased credit risk distribution. However, recent events have raised doubts about the effectiveness of securitized lending. One concern is that incorporating structured instruments into a bank's portfolio may result in unforeseen risk concentrations. Addressing these risks is challenging due to current market knowledge and the

existing supervisory and regulatory framework. Additionally, rating agencies play a role in structured finance operations.

There are several proposed strategies for action that could result in improved financial stability. These include strengthening national supervisory and regulatory frameworks, enhancing transparency and regulatory disclosure, and adopting an international approach to effectively overseeing and regulating financial activity. Transparency and liquidity are two key challenges that need to be addressed. However, the most difficult task is likely to be mitigating the potential for increased systemic risks due to intense financial innovation.

References

1. Fitch Ratings. A Guide to Global Structured Finance Regulatory Initiatives and their Potential Impact, Global Special Report, April 2011.
2. Yener Altunbas, 2009. Securitization and the Bank Lending Channel, European Economic Review vol. 53, no. 8, pp. 996-1009.

Hans J. Blommestein.

Wikipedia provides information on credit rating agencies and the subprime crisis. [1] Fitch Ratings has published a guide called "A Guide to Global Structured Finance Regulatory Initiatives and their Potential Impact" in April 2011. [2] Altunbas, Y. has written an article titled "Securitization and the Bank Lending Channel" in European Economic Review vol. 53, no. 8, pp.

• 996-1009. [3]
• Blommestein, H. J.
• Grappling with Uncertainty
• The Financial Regulator, Volume 12, No.

4, March 2008.

Quarterly Review, September 2010. [5] Nawas, M., Results of our European Securitisation Investor Survey: Let the Sunshine In, Bishopsfield Capital Partners, June 2010.