INDEX

Particulars

Sr. No

Pg. No

1.

Introduction

2.

Meaning & Definition

3.

Quick Guide to Jargon

11

4.

The Securitization Process

14

5.

Key Players

23

6.

Merits & Demerits

27

7.

Securitization in India

32

8.

US Sub Prime Mortgage Crises

a. Introduction
b. Background and timeline of events
c. Causes of Crisis
d. Implications

37

9.

Conclusions

52

10.

Bibliography

54
1

INTRODUCTION
Technological advancements have changed the face of the world of
finance. It is today more a world of transactions than a world of relations. Most
relations have been transactionalized.
Transactions mean coming together of two entities with a common
purpose, whereas relations mean keeping together of these two entities. For
example, when a bank provides a loan of a sum of money to a user, the transaction
leads to a relationship: that of a lender and a borrower. However, the relationship is
terminated when the very loan is converted into a debenture. The relationship of
being a debenture holder in the company is now capable of acquisition and
termination by transactions.
"Securitization" in its widest sense implies every such process which
converts a financial relation into a transaction.
Securitization is the financial practice of pooling various types of
contractual debt such as residential mortgages, commercial mortgages, auto loans
or credit card debt obligations and selling said consolidated debt as bonds, passthrough securities, or collateralized mortgage obligation (CMOs), to various
investors. The principal and interest on the debt, underlying the security, is paid
back to the various investors regularly. Securities backed by mortgage receivables
are called mortgage-backed securities (MBS), while those backed by other types of
receivables are asset-backed securities (ABS).
Critics have suggested that the complexity inherent in securitization
can limit investors' ability to monitor risk, and that competitive securitization
markets with multiple securitize may be particularly prone to sharp declines in
underwriting standards. Private, competitive mortgage securitization is believed to
have played an important role in the U.S. subprime mortgage crisis.
In addition, off-balance sheet treatment for securitizations coupled
with guarantees from the issuer can hide the extent of leverage of the securitizing
2

firm, thereby facilitating risky capital structures and leading to an under-pricing of

credit risk. Off-balance sheet securitizations are believed to have played a large
role in the high leverage level of U.S. financial institutions before the financial
crisis, and the need for bailouts.
The granularity of pools of securitized assets is a litigant to the credit
risk of individual borrowers. Unlike general corporate debt, the credit quality of
securitized debt is non-stationary due to changes in volatility that are time - and
structure-dependent. If the transaction is properly structured and the pool performs
as expected, the credit risk of all tranches of structured debt improves; if
improperly structured, the affected tranches may experience dramatic credit
deterioration and loss.
Securitization has evolved from its beginnings in the late eighteenth
century to an estimated outstanding of $10.24 trillion in the United States and
$2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance
amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole
Business Securitization) arrangements first appeared in the United Kingdom in the
1990s, and became common in various Commonwealth legal systems where senior
creditors of an insolvent business effectively gain the right to control the company.
Securitization started as a way for financial institutions and
corporations to find new sources of fundingeither by moving assets off their
balance sheets or by borrowing against them to refinance their origination at a fair
market rate. It reduced their borrowing costs and, in the case of banks, lowered
regulatory minimum capital requirements.
For example, suppose a leasing company needed to raise cash. Under
standard procedures, the company would take out a loan or sell bonds. Its ability to
do so, and the cost, would depend on its overall financial health and credit rating.
If it could find buyers, it could sell some of the leases directly, effectively
converting a future income stream to cash. The problem is that there is virtually no
secondary market for individual leases. But by pooling those leases, the company
can raise cash by selling the package to an issuer, which in turn converts the pool
of leases into a tradable security.
3

MEANING & DEFINITION

I. Definition
Below are some of the ways to define Securitization: 1. The process through which an issuer creates a financial instrument
by combining other financial assets and then marketing different tiers of the
repackaged instruments to investors. The process can encompass any type of
financial asset and promotes liquidity in the marketplace.
2. Securitization is the process of taking an illiquid asset, or group of
assets, and through financial engineering, transforming them into a security.
3. Securitization is a process by which a company clubs its different
financial assets/debts to form a consolidated financial instrument which is issued to
investors. In return, the investors in such securities get interest.
4. A securitization is a financial transaction in which assets are pooled
and securities representing interests in the pool are issued.

II. Meaning and Explanation

History of evolution of finance, and corporate law, the latter being
supportive for the former, is replete with instances where relations have been
converted into transactions. In fact, this was the earliest, and by far unequalled,
contribution of corporate law to the world of finance, viz., and the ordinary share,
which implies piecemeal ownership of the company. Ownership of a company is a
relation, packaged as a transaction by the creation of the ordinary share. This
earliest instance of securitization was so instrumental in the growth of the
corporate form of doing business, and hence, industrialization, that someone rated
it as one of the two greatest inventions of the 19th century -the other one being the
steam engine. That truly reflects the significance of the ordinary share, and if the
4

same idea is extended, to the very concept of securitization: it as important to the

world of finance as motive power is to industry.
Other instances of securitization of relationships are commercial
paper, which securitizes a trade debt.
However, in the sense in which the term is used in present day capital
market activity, securitization has acquired a typical meaning of its own, which is
at times, for the sake of distinction, called asset securitization. It is taken to mean a
device of structured financing where an entity seeks to pool together its interest in
identifiable cash flows over time, transfer the same to investors either with or
without the support of further collaterals, and thereby achieve the purpose of
financing. Though the end-result of securitization is financing, but it is not
"financing" as such, since the entity securitizing its assets it not borrowing money,
but selling a stream of cash flows that was otherwise to accrue to it.
Mortgage-backed securities are a perfect example of securitization.
By combining mortgages into one large pool, the issuer can divide the large pool
into smaller pieces based on each individual mortgage's inherent risk of default and
then sell those smaller pieces to investors.
The process creates liquidity by enabling smaller investors to
purchase shares in a larger asset pool. Using the mortgage-backed security
example, individual retail investors are able to purchase portions of a mortgage as
a type of bond. Without the securitization of mortgages, retail investors may not be
able to afford to buy into a large pool of mortgages.
This process enhances liquidity in the market. This serves as a useful
tool, especially for financial companies, as its helps them raise funds. If such a
company has already issued a large number of loans to its customers and wants to
further add to the number, then the practice of securitization can come to its rescue.
The simplest way to understand the concept of securitization is to take
an example.
5

III. Example
1. An example would be a financing company that has issued a large
number of auto loans and wants to raise cash so it can issue more loans. One
solution would be to sell off its existing loans, but there isn't a liquid secondary
market for individual auto loans. Instead, the firm pools a large number of its loans
and sells interests in the pool to investors. For the financing company, this raises
capital and gets the loans off its balance sheet, so it can issue new loans. For
investors, it creates a liquid investment in a diversified pool of auto loans, which
may be an attractive alternative to a corporate bond or other fixed income
investment. The ultimate debtorsthe car ownersneed not be aware of the
transaction. They continue making payments on their loans, but now those
payments flow to the new investors as opposed to the financing company.
2. Let's start with a 10-year mortgage. (It's easier to see the chart with
a 10-year mortgage than a 30-year mortgage, but it works the same way with any
maturity). The mortgage consists of 12 payments a year, for 10 years. Let's group
the payments together by year, so each box on the following chart constitutes 12
monthly payments.

Now let's throw four such mortgages together. They look like this:

Now let's pool those into one. Think of it this way. Each
payment is represented by a coupon. The lender has 120
coupons for each mortgage. He throws all the coupons for four
mortgages into one box. The he starts sorting the coupons
according to the year that the payment will be made.
He takes all of the coupons for payments in the first
year; he staples them together, and calls them "Tranche A." Then
he takes all the coupons for payments in the second year, staples
them together, and calls them "Tranche B." In the chart below,
each tranche has its own color.

When we started this explanation, before securitization, we thought

the natural grouping of coupons was to put all the coupons from one borrower
together. However, after securitization, all the coupons for one year are put
together. The buyer of this tranche gets coupons from different home-owners, but
all the coupons are to be paid in the same year.
This is a highly simplified example, because we haven't talked about
who gets what if the mortgage is paid off early, or what happens if one borrower
does not pay. Add these rules, and you have a mortgage-backed security,
consisting of 10 tranches. Each tranche can be sold individually.

3. A diagrammatic representation of an example of Securitization

Thus, the present-day meaning of securitization is a blend of two

forces that are critical in today's world of finance: structured finance and capital
markets. Securitization leads to structured finance as the resulting security is not a
generic risk in entity that securitizes its assets but in specific assets or cash flows of
such entity. Two, the idea of securitization is to create a capital market product that is, it results into creation of a "security" which is a marketable product.
9

This meaning of securitization can be expressed in various dramatic

words:
i.

Securitization is the process of commoditization. The basic

idea is to take the outcome of this process into the market, the
capital market. Thus, the result of every securitization process,
whatever might be the area to which it is applied, is to create
certain instruments which can be placed in the market.

ii.

Securitization is the process of integration and

differentiation. The entity that securitizes its assets first pools
them together into a common hotchpots (assuming it is not one
asset but several assets, as is normally the case). This process of
integration. Then, the pool itself is broken into instruments of
fixed denomination. This is the process of differentiation.

iii.

Securitization is the process of de-construction of an entity.

If one envisages an entity's assets as being composed of claims
to various cash flows, the process of securitization would split
apart these cash flows into different buckets, classify them, and
sell these classified parts to different investors as per their
needs. Thus, securitization breaks the entity into various subsets.

10

QUICK GUIDE TO JARGON

There is a great deal of terminology that is specific to Securitization.
Though there is a complete terminology appended, this section will help the reader
to quickly get familiarized with the essential securitization jargon.
The entity that securitizes its assets is called the originator: the name
signifies the fact that the entity was responsible for originating the claims that are
to be ultimately securitized. There is no distinctive name for the investors who
invest their money in the instrument: therefore, they might simply be called
investors.
The claims that the originator securitizes could either be an existing
claim, or existing assets (in form of claims), or expected claims over time. In other
words, the securitized assets could be either existing receivables, or receivables to
arise in future. The latter, for the sake of distinction, is sometimes called future
flows securitization, in which case the former is a case of asset-backed
securitization.
In US markets, another distinction is mostly common: between
mortgage-backed securities and asset-backed securities. This only is to indicate
the distinct application: the former relates to the market for securities based on
mortgage receivables, which in the USA forms a substantial part of total
securitization markets, and securitization of other receivables.
Since it is important for the entire exercise to be a case of transfer of
receivables by the originator, not a borrowing on the security of the receivables,
there is a legal transfer of the receivables to a separate entity. In legal parlance,
transfer of receivables is called assignment of receivables. It is also necessary to
ensure that the transfer of receivables is respected by the legal system as a genuine
transfer, and not as mere eyewash where the reality is only a mode of borrowing. In
other words, the transfer of receivables has to be a true sale of the receivables, and
not merely a financing against the security of the receivables.

11

Since securitization involves a transfer of receivables from the

originator, it would be inconvenient, to the extent of being impossible, to transfer
such receivables to the investors directly, since the receivables are as diverse as the
investors themselves. Besides, the base of investors could keep changing as the
resulting security is essentially a marketable security.
Therefore, it is necessary to bring in an intermediary that would hold
the receivables on behalf of the end investors. This entity is created solely for the
purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or
a special purpose entity (SPE) or, if such entity is a company, special purpose
company (SPC). The function of the SPV in a securitization transaction could
stretch from being a pure conduit or intermediary vehicle, to a more active role in
reinvesting or reshaping the cash flows arising from the assets transferred to it,
which is something that would depend on the end objectives of the securitization
exercise.
Therefore, the originator transfers the assets to the SPV, which holds
the assets on behalf of the investors, and issues to the investors its own securities.
Therefore, the SPV is also called the issuer.
There is no uniform name for the securities issued by the SPV as such
securities take different forms. These securities could either represent a direct
claim of the investors on all that the SPV collects from the receivables transferred
to it: in this case, the securities are called pass through certificates or beneficial
interest certificates as they imply certificates of proportional beneficial interest in
the assets held by the SPV.
Alternatively, the SPV might be re-configuring the cash flows by
reinvesting it, so as to pay to the investors on fixed dates, not matching with the
dates on which the transferred receivables are collected by the SPV. In this case,
the securities held by the investors are called pay through certificates. The
securities issued by the SPV could also be named based on their risk or other
features, such as senior notes or junior notes, floating rate notes, etc.

12

Another word commonly used in securitization exercises is

bankruptcy remote transfer. What it means is that the transfer of the assets by the
originator to the SPV is such that even if the originator were to go bankrupt, or get
into other financial difficulties, the rights of the investors on the assets held by the
SPV is not affected. In other words, the investors would continue to have a
paramount interest in the assets irrespective of the difficulties, distress or
bankruptcy of the originator.

13

THE SECURITIZATION PROCESS

Securitization is a complex procedure that involves several actors. The
diagram below, taken from the IMF website, illustrates the basic mechanism for
transferring assets and creating securities:

The entity that originally holds the assets (the originator) initiates the
process by selling the assets to a legal entity, an SPV (Special Purpose Vehicle),
specially created to limit the risk of the final investor vis--vis the issuer of the
14

assets. An SPV is also referred to as a conduit. Then, depending on the situation,

the SPV either issues the securities directly or resells the pool of assets to a trust
that, in turn, issues the securities (the trust is actually used for several
securitization transactions and therefore oversees several SPVs).
An SPV is more of a legal framework than an element that plays an
active part in the transaction. The most important role is played by the arranger,
typically a bank, who sets up the transaction and evaluates the pool of assets,the
way in which it will be fed, the characteristics of the securities to be issued, and the
potential structuring of the fund.
The object of the structuring is to model the characteristics of the
securities such that they correspond to the needs of the final investor. Instead of
simply paying the final investor the revenue generated by the assets, the
amortization rules for the security are defined in advance.
Some ABSs are able to be topped up, meaning that the pool of
assets can be reefed during the life of the security. This makes it possible to
refinance short-term debts (such as credit-card debt) with long-term bonds.
Finally, the arranger plays an important role in distributing the
securities to the final investors (distribution). Quite often, the securities are not
issued on an exchange, but are distributed over-the-counter to a small number of
investors.
The trio of actors comprising the originator, SPV, and arranger
constitutes the Originate-to-Distribute model, which has thrived over the
course of the past few years.
An important distinction must be made between traditional
securitization, where the assets are actually sold to the SPV (true sale), and what
is known as synthetic securitization, where the originator retains ownership of
the assets and transfers only the risk to the SPV, via a credit derivative. This
transaction brings no liquidity to the assignor, but enables him to externalize the
risk associated with holding the securitized assets.

15

A diagrammatic presentation on the Securitization Process: -

16

Thus, the process of Securitization can be summarized as below: -

I. Pooling and Transfer

The originator initially owns the assets engaged in the deal. This is
typically a company looking to either raise capital or restructure debt or otherwise
adjust its finances. Under traditional corporate finance concepts, such a company
would have three options to raise new capital: a loan, bond issue, or issuance of
stock. However, stock offerings dilute the ownership and control of the company,
while loan or bond financing is often prohibitively expensive due to the credit
rating of the company and the associated rise in interest rates.
The consistently revenue-generating part of the company may have a
much higher credit rating than the company as a whole. For instance, a leasing
company may have provided $10m nominal value of leases, and it will receive a
cash flow over the next five years from these. It cannot demand early repayment on
the leases and so cannot get its money back early if required. If it could sell the
rights to the cash flows from the leases to someone else, it could transform that
income stream into a lump sum today (in effect, receiving today the present value
of a future cash flow). Where the originator is a bank or other organization that
must meet capital adequacy requirements, the structure is usually more complex
because a separate company is set up to buy the assets.
A suitably large portfolio of assets is "pooled" and transferred to a
"special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust
formed for the specific purpose of funding the assets. Once the assets are
transferred to the issuer, there is normally no recourse to the originator. The issuer
is "bankruptcy remote", meaning that if the originator goes into bankruptcy, the
assets of the issuer will not be distributed to the creditors of the originator. In order
to achieve this, the governing documents of the issuer restrict its activities to only
those necessary to complete the issuance of securities.
Accounting standards govern when such a transfer is a sale, a
financing, a partial sale, or a part-sale and part-financing. In a sale, the originator is
allowed to remove the transferred assets from its balance sheet: in a financing, the
17

assets are considered to remain the property of the originator. Under US accounting
standards, the originator achieves a sale by being at arm's length from the issuer, in
which case the issuer is classified as a "qualifying special purpose entity" or
"QSPE".
Because of these structural issues, the originator typically needs the
help of an investment bank (the arranger) in setting up the structure of the
transaction.

II. Issuance
To be able to buy the assets from the originator, the issuer SPV issues
tradable securities to fund the purchase. Investors purchase the securities, either
through a private offering (targeting institutional investors) or on the open market.
The performance of the securities is then directly linked to the performance of the
assets. Credit rating agencies rate the securities which are issued to provide an
external perspective on the liabilities being created and help the investor make a
more informed decision.
In transactions with static assets, a depositor will assemble the
underlying collateral, help structure the securities and work with the financial
markets to sell the securities to investors. The depositor has taken on added
significance under Regulation AB. The depositor typically owns 100% of the
beneficial interest in the issuing entity and is usually the parent or a wholly owned
subsidiary of the parent which initiates the transaction. In transactions with
managed (traded) assets, asset managers assemble the underlying collateral, help
structure the securities and work with the financial markets in order to sell the
securities to investors.
Some deals may include a third-party guarantor which provides
guarantees or partial guarantees for the assets, the principal and the interest
payments, for a fee.

18

The securities can be issued with either a fixed interest rate or a

floating rate under currency pegging system. Fixed rate ABS set the coupon
(rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills.
Floating rate securities may be backed by both amortizing and non-amortizing
assets in the floating market. In contrast to fixed rate securities, the rates on
floaters will periodically adjust up or down according to a designated index such
as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate
(LIBOR). The floating rate usually reflects the movement in the index plus an
additional fixed margin to cover the added risk.

III. Credit Enhancement

Unlike conventional corporate bonds which are unsecured, securities
generated in a securitization deal are "credit enhanced", meaning their credit
quality is increased above that of the originator's unsecured debt or underlying
asset pool. This increases the likelihood that the investors will receive cash flows
to which they are entitled, and thus causes the securities to have a higher credit
rating than the originator. Some securitizations use external credit enhancement
provided by third parties, such as surety bonds and parental guarantees (although
this may introduce a conflict of interest).
Individual securities are often split into tranches, or categorized into
varying degrees of subordination. Each tranche has a different level of credit
protection or risk exposure than another: there is generally a senior (A) class of
securities and one or more junior subordinated (B, C, etc.) classes that function
as protective layers for the A class. The senior classes have first claim on the
cash that the SPV receives, and the more junior classes only start receiving
repayment after the more senior classes have repaid. Because of the cascading
effect between classes, this arrangement is often referred to as a cash flow
waterfall. In the event that the underlying asset pool becomes insufficient to make
payments on the securities (e.g. when loans default within a portfolio of loan
claims), the loss is absorbed first by the subordinated tranches, and the upper-level
tranches remain unaffected until the losses exceed the entire amount of the
subordinated tranches. The senior securities are typically AAA rated, signifying a
19

lower risk, while the lower-credit quality subordinated classes receive a lower
credit rating, signifying a higher risk.
The most junior class (often called the equity class) is the most
exposed to payment risk. In some cases, this is a special type of instrument which
is retained by the originator as a potential profit flow. In some cases the equity
class receives no coupon (either fixed or floating), but only the residual cash flow
(if any) after all the other classes have been paid.
There may also be a special class which absorbs early repayments in
the underlying assets. This is often the case where the underlying assets are
mortgages which, in essence, are repaid every time the property is sold. Since any
early repayment is passed on to this class, it means the other investors have a more
predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two
separate "waterfalls" because the principal and interest receipts can be easily
allocated and matched. But if the assets are income-based transactions such as
rental deals it is not possible to differentiate so easily between how much of the
revenue is income and how much principal repayment. In this case all the income
is used to pay the cash flows due on the bonds as those cash flows become due.
Credit enhancements affect credit risk by providing more or less
protection to promised cash flows for a security. Additional protection can help a
security achieve a higher rating, lower protection can help create new securities
with differently desired risks, and these differential protections can help place a
security on more attractive terms.
In addition to subordination, credit may be enhanced through:

A reserve or spread account, in which funds remaining after expenses such

as principal and interest payments, charge-offs and other fees have been
paid-off are accumulated, and can be used when SPE expenses are greater
than its income.
20

 Third-party insurance, or guarantees of principal and interest payments on

the securities.
Over-collateralization, usually by using finance income to pay off principal
on some securities before principal on the corresponding share of collateral
is collected.
Cash funding or a cash collateral account, generally consisting of short-term,
highly rated investments purchased either from the seller's own funds, or
from funds borrowed from third parties that can be used to make up
shortfalls in promised cash flows.
A third-party letter of credit or corporate guarantee.
A back-up servicer for the loans.
Discounted receivables for the pool.

IV. Servicing
A servicer collects payments and monitors the assets that are the crux
of the structured financial deal. The servicer can often be the originator, because
the servicer needs very similar expertise to the originator and would want to ensure
that loan repayments are paid to the Special Purpose Vehicle.
The servicer can significantly affect the cash flows to the investors
because it controls the collection policy, which influences the proceeds collected,
the charge-offs and the recoveries on the loans. Any income remaining after
payments and expenses is usually accumulated to some extent in a reserve or
spread account, and any further excess is returned to the seller. Bond rating
agencies publish ratings of asset-backed securities based on the performance of the
collateral pool, the credit enhancements and the probability of default.

21

When the issuer is structured as a trust, the trustee is a vital part of the
deal as the gate-keeper of the assets that are being held in the issuer. Even though
the trustee is part of the SPV, which is typically wholly owned by the Originator,
the trustee has a fiduciary duty to protect the assets and those who own the assets,
typically the investors.

V. Repayment Structures
Unlike corporate bonds, most securitizations are amortized, meaning
that the principal amount borrowed is paid back gradually over the specified term
of the loan, rather than in one lump sum at the maturity of the loan. Fully
amortizing securitizations are generally collateralized by fully amortizing assets
such as home equity loans, auto loans, and student loans. Prepayment uncertainty
is an important concern with fully amortizing ABS. The possible rate of
prepayment varies widely with the type of underlying asset pool, so many
prepayment models have been developed in an attempt to define common
prepayment activity. The PSA prepayment model is a well-known example.
A controlled amortization structure is a method of providing investors
with a more predictable repayment schedule, even though the underlying assets
may be non amortizing. After a predetermined revolving period, during which
only interest payments are made, these securitizations attempt to return principal to
investors in a series of defined periodic payments, usually within a year. An early
amortization event is the risk of the debt being retired early.
On the other hand, bullet or slug structures return the principal to
investors in a single payment. The most common bullet structure is called the soft
bullet, meaning that the final bullet payment is not guaranteed on the expected
maturity date; however, the majority of these securitizations are paid on time. The
second type of bullet structure is the hard bullet, which guarantees that the
principal will be paid on the expected maturity date. Hard bullet structures are less
common for two reasons: investors are comfortable with soft bullet structures, and
they are reluctant to accept the lower yields of hard bullet securities in exchange
for a guarantee.

22

Securitizations are often structured as a sequential pay bond, paid off

in a sequential manner based on maturity. This means that the first tranche, which
may have a one-year average life, will receive all principal payments until it is
retired; then the second tranche begins to receive principal, and so forth. Pro rata
bond structures pay each tranche a proportionate share of principal throughout the
life of the security.

KEY PLAYERS

The KEY "players" in the securitization process, all of whom require legal
representation to some degree, are as follows:

I. Originator
The entity that either generates receivables in the ordinary course of
its business or purchases or assembles portfolios of receivables (in that sense, not a
true "originator"). Its counsel works closely with counsel to the
Underwriter/Placement Agent and the Rating Agencies in structuring the
transaction and preparing documents and usually gives the most significant
opinions. It also retains and coordinates local counsel in the event that it is not
admitted in the jurisdiction where the Originator's principal office is located and in
situations where significant Receivables are generated and the security interests
that secure the Receivables are governed by local law rather than the law of the
state where the Originator is located.

II. Issuer
The special purpose entity, usually an owner trust (but can be another
form of trust or a corporation, partnership or fund), created pursuant to a Trust
Agreement between the Originator (or in a two step structure, the Intermediate
SPE) and the Trustee, that issues the Securities and avoids taxation at the entity
level. This can create a problem in foreign Securitizations in civil law countries
where the trust concept does not exist (see discussion below under "Foreign
Securitizations").
23

III. Trustees
Usually a bank or other entity authorized to act in such capacity. The
Trustee, appointed pursuant to a Trust Agreement, holds the Receivables, receives
payments on the Receivables and makes payments to the Securityholders. In many
structures there are two Trustees. For example, in an Owner Trust structure, which
is most common, the Notes, which are pure debt instruments, are issued pursuant
to an Indenture between the Trust and an Indenture Trustee, and the Certificates,
representing undivided interests in the Trust (although structured and treated as
debt obligations), are issued by the Owner Trustee. The Issuer (the Trust) owns the
Receivables and grants a security interest in the Receivables to the Indenture
Trustee. Counsel to the Trustee provides the usual opinions on the Trust as an
entity, the capacity of the Trustee, etc.

IV. Investors
The ultimate purchasers of the Securities. Usually banks, insurance
companies, retirement funds and other "qualified investors." In some cases, the
Securities are purchased directly from the Issuer, but more commonly the
Securities are issued to the Originator or Intermediate SPE as payment for the
Receivables and then sold to the Investors, or in the case of an underwriting, to the
Underwriters.

V. Underwriters/Placement Agents
The brokers, investment banks or banks that sell or place the
Securities in a public offering or private placement. The Underwriters/Placement
Agents usually play the principal role in structuring the transaction, frequently
seeking out Originators for Securitizations, and their counsel (or counsel for the
lead Underwriter/Placement Agent) is usually, but not always, the primary
document preparer, generating the offering documents (private placement
memorandum or offering circular in a private placement; registration statement and
prospectus in a public offering), purchase agreements, trust agreement, custodial
agreement, etc. Such counsel also frequently opines on securities and tax matters.

VI. Custodian
24

An entity, usually a bank, that actually holds the Receivables as agent

and bailee for the Trustee or Trustees.

VII. Rating Agencies

Moody's, S&P, Fitch IBCA and Duff & Phelps. In Securitizations, the
Rating Agencies frequently are active players that enter the game early and assist
in structuring the transaction. In many instances they require structural changes,
dictate some of the required opinions and mandate changes in servicing
procedures.

VIII. Servicer
The Servicer is the entity that actually deals with the Receivables on a
day to day basis, collecting the Receivables and transferring funds to accounts
controlled by the Trustees. In most transactions the Originator acts as Servicer.

IX. Backup Servicer

The entity (usually in the business of acting in such capacity, as well
as a primary Servicer when the Originator does not fill that function) that takes
over the event that something happens to the Servicer. Depending upon the quality
of the Originator/Servicer, the need and significance of the Backup Servicer may
be important. In some cases the Trustee retains the Backup Servicer to perform
certain monitoring functions on a continuing basis.

25

A diagrammatic representation of various players in the Securitization

process:-

26

MERITS AND DEMERITS

The advantages of Securitization are as follows:

I. The Seller
For the originator, the main reason for securitizing is to reduce (some
might say get rid of) the amount of assigned debt from his balance sheet, which
on the one hand leads to a corresponding reduction in his regulatory capital
requirements under Basel II, and on the other hand enables him to bring in
additional liquidity (which can be used to make new loans).
i.

ii.

iii.

Reduces Funding Costs: Through securitization, a company rated

BB but with AAA worthy cash flow would be able to borrow at
possibly AAA rates. This is the number one reason to securitize a cash
flow and can have tremendous impacts on borrowing costs. The
difference between BB debt and AAA debt can be multiple hundreds
of basis points. For example, Moody's downgraded Ford Motor
Credit's rating in January 2002, but senior automobile backed
securities, issued by Ford Motor Credit in January 2002 and April
2002, continue to be rated AAA because of the strength of the
underlying collateral and other credit enhancements.
Reduces asset-liability mismatch: "Depending on the structure
chosen, securitization can offer perfect matched funding by
eliminating funding exposure in terms of both duration and pricing
basis." Essentially, in most banks and finance companies, the liability
book or the funding is from borrowings. This often comes at a high
cost. Securitization allows such banks and finance companies to create
a self-funded asset book.
Lower capital requirements: Some firms, due to legal, regulatory, or
other reasons, have a limit or range that their leverage is allowed to
be. By securitizing some of their assets, which qualifies as a sale for
accounting purposes, these firms will be able to remove assets from
27

their balance sheets while maintaining the "earning power" of the

assets.
iv.

v.

vi.

vii.

Locking in profits: For a given block of business, the total profits

have not yet emerged and thus remain uncertain. Once the block has
been securitized, the level of profits has now been locked in for that
company, thus the risk of profit not emerging, or the benefit of superprofits, has now been passed on.
Transfer risks (credit, liquidity, prepayment, reinvestment, asset
concentration): Securitization makes it possible to transfer risks from
an entity that does not want to bear it, to one that does. Two good
examples of this are catastrophe bonds and Entertainment
Securitizations. Similarly, by securitizing a block of business (thereby
locking in a degree of profits), the company has effectively freed up
its balance to go out and write more profitable business.
Off balance sheet: Derivatives of many types have in the past been
referred to as "off-balance-sheet." This term implies that the use of
derivatives has no balance sheet impact. While there are differences
among the various accounting standards internationally, there is a
general trend towards the requirement to record derivatives at fair
value on the balance sheet. There is also a generally accepted
principle that, where derivatives are being used as a hedge against
underlying assets or liabilities, accounting adjustments are required to
ensure that the gain/loss on the hedged instrument is recognized in the
income statement on a similar basis as the underlying assets and
liabilities. Certain credit derivatives products, particularly Credit
Default Swaps, now have more or less universally accepted market
standard documentation. In the case of Credit Default Swaps, this
documentation has been formulated by the International Swaps and
Derivatives Association (ISDA) who have for long time provided
documentation on how to treat such derivatives on balance sheets.
Earnings: Securitization makes it possible to record an earnings
bounce without any real addition to the firm. When a securitization
takes place, there often is a "true sale" that takes place between the
Originator (the parent company) and the SPE. This sale has to be for
28

viii.

ix.

the market value of the underlying assets for the "true sale" to stick
and thus this sale is reflected on the parent company's balance sheet,
which will boost earnings for that quarter by the amount of the sale.
While not illegal in any respect, this does distort the true earnings of
the parent company.
Admissibility: Future cash flows may not get full credit in a
company's accounts (life insurance companies, for example, may not
always get full credit for future surpluses in their regulatory balance
sheet), and a securitization effectively turns an admissible future
surplus flow into an admissible immediate cash asset.
Liquidity: Future cash flows may simply be balance sheet items
which currently are not available for spending, whereas once the book
has been securitized, the cash would be available for immediate
spending or investment. This also creates a reinvestment book which
may well be at better rates.

II. The Investor

Securitization present an opportunity to invest in asset classes that are
not accessible in the markets and that offer a risk/return profile that is, in principle,
attractive.
i.

ii.

iii.

Opportunity to invest in a specific pool of high quality assets: Due

to the stringent requirements for corporations (for example) to attain
high ratings, there is a dearth of highly rated entities that exist.
Securitizations, however, allow for the creation of large quantities of
AAA, AA or A rated bonds, and risk adverse institutional investors, or
investors that are required to invest in only highly rated assets have
access to a larger pool of investment options.
Portfolio diversification: Depending on the securitization, hedge
funds as well as other institutional investors tend to like investing in
bonds created through securitizations because they may be
uncorrelated to their other bonds and securities.
Isolation of credit risk from the parent entity: Since the assets that
are securitized are isolated (at least in theory) from the assets of the
29

originating entity, under securitization it may be possible for the

securitization to receive a higher credit rating than the "parent,"
because the underlying risks are different. For example, a small bank
may be considered more risky than the mortgage loans it makes to its
customers; were the mortgage loans to remain with the bank, the
borrowers may effectively be paying higher interest (or, just as likely,
the bank would be paying higher interest to its creditors, and hence
less profitable).
The disadvantages and drawbacks of Securitization are as follows:-

I. The Seller
i.

ii.

iii.
iv.

May reduce portfolio quality: If the AAA risks, for example, are
being securitized out, this would leave a materially worse quality of
residual risk.
Costs: Securitizations are expensive due to management and system
costs, legal fees, underwriting fees, rating fees and ongoing
administration. An allowance for unforeseen costs is usually essential
in securitizations, especially if it is an atypical securitization.
Size limitations: Securitizations often require large scale structuring,
and thus may not be cost-efficient for small and medium transactions.
Risks: Since securitization is a structured transaction, it may include
par structures as well as credit enhancements that are subject to risks
of impairment, such as prepayment, as well as credit loss, especially
for structures where there are some retained strips.

II. The Investor

i.

Credit/default: Default risk is generally accepted as a borrowers

inability to meet interest payment obligations on time. For ABS,
default may occur when maintenance obligations on the underlying
collateral are not sufficiently met as detailed in its prospectus. A key
indicator of a particular securitys default risk is its credit rating.
Different tranches within the ABS are rated differently, with senior
30

ii.

classes of most issues receiving the highest rating, and subordinated

classes receiving correspondingly lower credit ratings. Almost all
mortgages, including reverse mortgages, and student loans, are now
insured by the government, meaning that taxpayers are on the hook
for any of these loans that go bad even if the asset is massively overinflated. In other words, there are no limits or curbs on over-spending,
or the liabilities to taxpayers.
Prepayment/reinvestment/early amortization: The majority of
revolving ABS is subject to some degree of early amortization risk.
The risk stems from specific early amortization events or payout
events that cause the security to be paid off prematurely. Typically,
payout events include insufficient payments from the underlying
borrowers, insufficient excess spread, a rise in the default rate on the
underlying loans above a specified level, a decrease in credit
enhancements below a specific level, and bankruptcy on the part of
the sponsor or servicer.

iii.

Currency interest rate fluctuations: Like all fixed income securities,

the prices of fixed rate ABS move in response to changes in interest
rates. Fluctuations in interest rates affect floating rate ABS prices less
than fixed rate securities, as the index against which the ABS rate
adjusts will reflect interest rate changes in the economy. Furthermore,
interest rate changes may affect the prepayment rates on underlying
loans that back some types of ABS, which can affect yields. Home
equity loans tend to be the most sensitive to changes in interest rates,
while auto loans, student loans, and credit cards are generally less
sensitive to interest rates.

iv.

Moral hazard: Investors usually rely on the deal manager to price the
securitizations underlying assets. If the manager earns fees based on
performance, there may be a temptation to mark up the prices of the
portfolio assets. Conflicts of interest can also arise with senior note
holders when the manager has a claim on the deal's excess spread.

31

v.

Servicer risk: The transfer or collection of payments may be delayed

or reduced if the servicer becomes insolvent. This risk is mitigated by
having a backup servicer involved in the transaction.

SECURITIZATION IN INDIA
Securitization in India began in the early nineties. It has been of a
recent origin. Initially it started as a device for bilateral acquisitions of portfolios of
finance companies. These were forms of quasi-securitizations, with portfolios
moving from the balance sheet of one originator to that of another. Originally these
transactions included provisions that provided recourse to the originator as well as
new loan sales through the direct assignment route, which was structured using the
true sale concept. Through most of the 90s, securitization of auto loans was the
mainstay of the Indian markets. But since 2000, Residential Mortgage Backed
Securities (RMBS) have fuelled the growth of the market.
Securitization in India began with the sale of consumer loan pools.
Originators directly sold loans to buyers. Originators acted as servicers and
collected installments due on the loans. Creation of transferable securities backed
by pool receivables (known as PTCs) became common in late 1990s.
In 1990s, there were only six or seven issuances per year. Average
issue size was about Rs.450 million. The volume of issuances grew exponentially
beginning in 2000 due to rapid growth of consumer finance. Investors acceptance
of securitized instruments also improved. There were approximately 75 issuances
each year. Average issue size was about Rs.1900 million. There was pressure on
the resources of large originators due to continued growth in consumer credit.
From 2004 to 2005, 40% of vehicle finance was funded through ABS backed by
auto loans.
Citibank completed India's first revolving securitization issuance for
its small and medium enterprises working capital loans in 2004. The fixed rate
issuance of Rs 50 crore comprised two series of pass through certificates with
32

bullet maturity of two years. Strong performance and higher yields also attracted
investors.
The first deal in India was in 1992 when Citibank securitized auto
loans and placed a paper with GIC mutual fund worth about Rs. 16 crores. In 199495, SBI Caps structured an innovative deal where a pool of future cash flows of
high value customers of RSIDC was securitized. ICICI had securitized assets to the
tune of Rs. 2,750 crore in its books as at end March 1999. Another novel move was
by Maharashtra government to securitize sales tax. The Maharashtra Vikrikar
Rokhe Pradhikaran (MVRP) is the SPV to undertake this first of its kind
transaction in the country.

Growth of Indian Securitization Market

140
127

120
100
90
80

Value (in billions)

75

60
40
20

25

0
2002

2003

2004

2005

Source: ICRA Rating Feature

Need for Securitization in India

33

The generic benefits of securitization for Originators and investors

have been discussed above. In the Indian context, securitization is the only ray of
hope for funding resource starved infrastructure sectors like Power3. For power
utilities burdened with delinquent receivables from state electricity boards (SEBs),
Securitization seems to be the only hope of meeting resource requirements. As on
December 31, 1998, overall SEB dues only to the central agencies were over Rs.
184 billion.
Securitization can help Indian borrowers with international assets in
piercing the sovereign rating and placing an investment grade structure. An
example, albeit failed, is that of Air Indias aborted attempt to securitize its North
American ticket receivables. Such structured transactions can help premier
corporates to obtain a superior pricing than a borrowing based on their noninvestment grade corporate rating.
After the merger of Indias largest financial institution ICICI with
ICICI Bank, ICICI, faced with SLR and other requirements, is actively seeking to
launch a CLO to reduce its overall asset exposure. It appears to be only a matter of
time before other Public Financial Institutions merge with other banks. Such
mergers would result in the need for more CDOs in the foreseeable future.

Shortcomings faced by Indian Securitized Markets:

i.

Stamp Duty : One of the biggest hurdles facing the development of

the securitization market is the stamp duty structure. Stamp duty is
payable on any instrument which seeks to transfer rights or
receivables, whether by way of assignment or novation (new clause
added to the contract) or by any other mode. Therefore, the process of
transfer of the receivables from the originator to the SPV involves an
outlay on account of stamp duty, which can make securitization
commercially unviable in several states. If the securitized instrument
is issued as evidencing indebtedness, it would be in the form of a
debenture or bond subject to stamp duty. On the other hand, if the
instrument is structured as a Pass Through Certificate (PTC) that
34

merely evidences title to the receivables, then such an instrument

would not attract stamp duty, as it is not an instrument provided for
specifically in the charging provisions.
Among the regulatory costs, the stamp duty on transfers of the
securitized instrument is again a major hurdle. Some states do not
distinguish between conveyances of real estate and that of receivables,
and levy the same rate of stamp duty on the two. Stamp duty being a
concurrent subject i.e. it is under the concurrent list in Schedule 7 of
the Indian Constitution, specifically calls for a consensual legal
position between the Centre and the States.
ii.

Foreclosure Laws : Lack of effective foreclosure laws also prohibits

the growth of securitization in India. The Existing foreclosure laws are
not lender friendly and increase the risks of Mortgage Backed
Securities by making it difficult to transfer property in cases of
default. Transfer of property laws lacks on this aspect.

iii.

Taxation Issues : Tax treatment of Mortgage Backed Securities, SPV

Trusts and NPL Trusts is unclear. Currently, the investors (PTC and
SR holders) pay tax on the income distributed by the SPV Trusts and
on that basis the trustees make income pay outs to the PTC holders
without any payment or withholding of tax. The view is based on
legal opinions regarding assessment of investors instead of trustee in
their representative capacity. It needs to be emphasized that the
Income Tax Law has always envisaged taxation of an Unincorporated
SPV such as a Trust at only one level, either at the Trust SPV level, or
the Investor/Beneficiary Level to avoid double taxation. Hence, any
explicit tax pass thro regime if provided in the Income Tax Act does
not represent conferment of any real tax concession or tax sacrifice,
but merely represents a position that the Investors in the trust would
be liable to tax instead of the Trust being held liable to tax on the
income earned. Amendments need to be made to provide an explicit
tax pass thought treatment to securitization SPVs and Non Performing
Assets Securitization SPVs on par with the tax pass through treatment
applied under the tax law to Venture Capital Funds registered with
35

SEBI. To make it certain that investors as holders of Mutual Fund

(MF) schemes are liable to pay tax on the income from MF and ensure
that there is no tax dispute about the MBS SPV Trust or NPA
Securitization Trust being treated as an AOP(Association of Persons),
SEBI should consider the possibility of modifying the Mutual Fund
Regulations to permit wholesale investors (investors who invests not
less than Rs. 5 million in scheme) to invest and hold units of a closedended passively managed mutual fund scheme. The sole objective of
this scheme is to invest its funds into PTCs and SRs of the designated
Mortgage Backed Security.
iv.

SPV/NPA Securitization Trust : Recognizing the wholesale investor

and Qualified Institutional Buyers (QIB) in securitization trusts, there
should be no withholding of tax requirements on interest paid by the
borrowers (whose credit exposures are securitized) to the
securitization trust. Similarly, there should be no requirement of
withholding tax on distributions made by the securitization Trust to its
PTC and SR holders. However, the securitization trust may be
required to file an annual return with the Income-tax Department,
Ministry of Finance, in which all relevant particulars of the income
distributions and identity of the PTC and SR holders may be included.
This will safeguard against any possibility of revenue leakage.

v.

Legal Issues : Currently, the Securities Contract Regulation Act

definition of securities does not specifically cover PTCs. While there
is indeed a legal view that the current definition of securities in the
SCRA includes any instrument derived from, or any interest in
securities, the nature of the instrument and the background of the
issuer of the instrument, not being homogenous in respect of the rights
and obligations attached, across instruments issued by various SPVs,
has resulted in a degree of discomfort among exchanges listing these
instruments. To remove any ambiguity in this regard, the Central
Government should consider notifying PTCs and other securities
issued by securitization SPV Trust as securities under the SCRA.

36

US SUBPRIME MORTGAGE CRISIS

The U.S. subprime mortgage crisis was a set of events and conditions
that led to the late-2000s financial crisis, characterized by a rise in subprime
mortgage delinquencies and foreclosures, and the resulting decline of securities
backed by said mortgages.
The percentage of new lower-quality subprime mortgages rose from
the historical 8% or lower range to approximately 20% from 2004 to 2006, with
much higher ratios in some parts of the U.S. A high percentage of these subprime
mortgages, over 90% in 2006 for example, were adjustable-rate mortgages. These
two changes were part of a broader trend of lowered lending standards and higherrisk mortgage products. Further, U.S. households had become increasingly
indebted, with the ratio of debt to disposable personal income rising from 77% in
1990 to 127% at the end of 2007, much of this increase mortgage-related.
After U.S. house sales prices peaked in mid-2006 and began their
steep decline forthwith, refinancing became more difficult. As adjustable-rate
mortgages began to reset at higher interest rates (causing higher monthly
payments), mortgage delinquencies soared. Securities backed with mortgages,
including subprime mortgages, widely held by financial firms, lost most of their
value. Global investors also drastically reduced purchases of mortgage-backed debt
and other securities as part of a decline in the capacity and willingness of the
private financial system to support lending. Concerns about the soundness of U.S.
credit and financial markets led to tightening credit around the world and slowing
economic growth in the U.S. and Europe.

Background and timeline of events:

The immediate cause or trigger of the crisis was the bursting of the
United States housing bubble which peaked in approximately 20052006. High
default rates on "subprime" and adjustable rate mortgages (ARM), began to
increase quickly thereafter. Lenders began originating large numbers of high risk
37

mortgages from around 2004 to 2007, and loans from those vintage years exhibited
higher default rates than loans made either before or after.
An increase in loan incentives such as easy initial terms and a longterm trend of rising housing prices had encouraged borrowers to assume difficult
mortgages in the belief they would be able to quickly refinance at more favorable
terms. Additionally, the increased market power of originators of subprime
mortgages and the declining role of Government Sponsored Enterprises as
gatekeepers increased the number of subprime mortgages provided to consumers
who would have otherwise qualified for conforming loans.

The worst performing loans were securitized by private investment

banks, which generally lacked the GSE's market power and influence over
mortgage originators. Once interest rates began to rise and housing prices started to
38

drop moderately in 20062007 in many parts of the U.S., refinancing became more
difficult. Defaults and foreclosure activity increased dramatically as easy initial
terms expired, home prices failed to go up as anticipated, and ARM interest rates
reset higher. Falling prices also resulted in 23% of U.S. homes worth less than the
mortgage loan by September 2010, providing a financial incentive for borrowers to
enter foreclosure. The ongoing foreclosure epidemic, of which subprime loans are
one part, that began in late 2006 in the U.S. continues to be a key factor in the
global economic crisis, because it drains wealth from consumers and erodes the
financial strength of banking institutions.
In the years leading up to the crisis, significant amounts of foreign
money flowed into the U.S. from fast-growing economies in Asia and oilproducing countries. This inflow of funds combined with low U.S. interest rates
from 20022004 contributed to easy credit conditions, which fueled both housing
and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto)
were easy to obtain and consumers assumed an unprecedented debt load.

39

As part of the housing and credit booms, the amount of financial

agreements called mortgage-backed securities (MBS), which derive their value
from mortgage payments and housing prices, greatly increased. Such financial
innovation enabled institutions and investors around the world to invest in the U.S.
housing market. As housing prices declined, major global financial institutions that
had borrowed and invested heavily in MBS reported significant losses. Defaults
and losses on other loan types also increased significantly as the crisis expanded
from the housing market to other parts of the economy. Total losses are estimated
in the trillions of U.S. dollars globally.
While the housing and credit bubbles were growing, a series of factors
caused the financial system to become increasingly fragile. Policymakers did not
recognize the increasingly important role played by financial institutions such as
investment banks and hedge funds, also known as the shadow banking system.
Shadow banks were able to mask their leverage levels from investors
and regulators through the use of complex, off-balance sheet derivatives and
securitizations. These instruments also made it virtually impossible to reorganize
financial institutions in bankruptcy, and contributed to the need for government
bailouts. Some experts believe these institutions had become as important as
commercial (depository) banks in providing credit to the U.S. economy, but they
were not subject to the same regulations. These institutions as well as certain
regulated banks had also assumed significant debt burdens while providing the
loans described above and did not have a financial cushion sufficient to absorb
large loan defaults or MBS losses.
These losses impacted the ability of financial institutions to lend,
slowing economic activity. Concerns regarding the stability of key financial
institutions drove central banks to take action to provide funds to encourage
lending and to restore faith in the commercial paper markets, which are integral to
funding business operations. Governments also bailed out key financial
institutions, assuming significant additional financial commitments.

40

The risks to the broader economy created by the housing market

downturn and subsequent financial market crisis were primary factors in several
decisions by central banks around the world to cut interest rates and governments
to implement economic stimulus packages. Effects on global stock markets due to
the crisis have been dramatic. Between 1 January and 11 October 2008, owners of
stocks in U.S. corporations had suffered about $8 trillion in losses, as their
holdings declined in value from $20 trillion to $12 trillion. Losses in other
countries have averaged about 40%. Losses in the stock markets and housing value
declines place further downward pressure on consumer spending, a key economic
engine. Leaders of the larger developed and emerging nations met in November
2008 and March 2009 to formulate strategies for addressing the crisis. A variety of
solutions have been proposed by government officials, central bankers, economists,
and business executives. In the U.S., the DoddFrank Wall Street Reform and
Consumer Protection Act was signed into law in July 2010 to address some of the
causes of the crisis.
41

Causes of the Crisis:

The crisis can be attributed to a number of factors pervasive in both
housing and credit markets, factors which emerged over a number of years. Causes
proposed include the inability of homeowners to make their mortgage payments
(due primarily to adjustable-rate mortgages resetting, borrowers overextending,
predatory lending, and speculation), overbuilding during the boom period, risky
mortgage products, increased power of mortgage originators, high personal and
corporate debt levels, financial products that distributed and perhaps concealed the
risk of mortgage default, bad monetary and housing policies, international trade
imbalances, and inappropriate government regulation.
During a period of strong global growth, growing capital flows, and
prolonged stability earlier this decade, market participants sought higher yields
without an adequate appreciation of the risks and failed to exercise proper due
diligence. At the same time, weak underwriting standards, unsound risk
management practices, increasingly complex and opaque financial products, and
consequent excessive leverage combined to create vulnerabilities in the system.
Policy-makers, regulators and supervisors, in some advanced countries, did not
adequately appreciate and address the risks building up in financial markets, keep
pace with financial innovation, or take into account the systemic ramifications of
domestic regulatory actions.
During May 2010, Warren Buffett and Paul Volcker separately
described questionable assumptions or judgments underlying the U.S. financial and
economic system that contributed to the crisis. These assumptions included: 1)
Housing prices would not fall dramatically; 2) Free and open financial markets
supported by sophisticated financial engineering would most effectively support
market efficiency and stability, directing funds to the most profitable and
productive uses; 3) Concepts embedded in mathematics and physics could be
directly adapted to markets, in the form of various financial models used to
evaluate credit risk; 4) Economic imbalances, such as large trade deficits and low
savings rates indicative of over-consumption, were sustainable; and 5) Stronger
regulation of the shadow banking system and derivatives markets was not needed.
42

The U.S. Financial Crisis Inquiry Commission reported its findings in

January 2011. It concluded that "the crisis was avoidable and was caused by:
Widespread failures in financial regulation, including the Federal Reserves failure
to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance
including too many financial firms acting recklessly and taking on too much risk;
An explosive mix of excessive borrowing and risk by households and Wall Street
that put the financial system on a collision course with crisis; Key policy makers ill
prepared for the crisis, lacking a full understanding of the financial system they
oversaw; and systemic breaches in accountability and ethics at all levels.
Three important catalysts of the subprime crisis were the influx of
money from the private sector, the banks entering into the mortgage bond market
and the predatory lending practices of the mortgage lenders, specifically the
adjustable-rate mortgage, 228 loan, that mortgage lenders sold directly or
indirectly via mortgage brokers. On Wall Street and in the financial industry, moral
hazard lay at the core of many of the causes. In its "Declaration of the Summit on
Financial Markets and the World Economy," dated 15 November 2008, leaders of
the Group of 20 cited the following causes:
1. Boom and bust in the housing market: Low interest rates and
large inflows of foreign funds created easy credit conditions for a
number of years prior to the crisis, fueling a housing market boom
and encouraging debt-financed consumption. The USA home
ownership rate increased from 64% in 1994 (about where it had
been since 1980) to an all-time high of 69.2% in 2004. Subprime
lending was a major contributor to this increase in home ownership
rates and in the overall demand for housing, which drove prices
higher. Between 1997 and 2006, the price of the typical American
house increased by 124%. During the two decades ending in 2001,
the national median home price ranged from 2.9 to 3.1 times
median household income. This ratio rose to 4.0 in 2004, and 4.6
in 2006. This housing bubble resulted in quite a few homeowners
refinancing their homes at lower interest rates, or financing
consumer spending by taking out second mortgages secured by the
price appreciation. USA household debt as a percentage of annual
43

disposable personal income was 127% at the end of 2007, versus

77% in 1990.
2. Homeowner speculation: Speculative borrowing in residential real
estate has been cited as a contributing factor to the subprime
mortgage crisis. During 2006, 22% of homes purchased (1.65
million units) were for investment purposes, with an additional
14% (1.07 million units) purchased as vacation homes. During
2005, these figures were 28% and 12%, respectively. In other
words, a record level of nearly 40% of homes purchased was not
intended as primary residences. David Lereah, NAR's chief
economist at the time, stated that the 2006 decline in investment
buying was expected: "Speculators left the market in 2006, which
caused investment sales to fall much faster than the primary
market." Housing prices nearly doubled between 2000 and 2006, a
vastly different trend from the historical appreciation at roughly
the rate of inflation. While homes had not traditionally been treated
as investments subject to speculation, this behavior changed during
the housing boom. Media widely reported condominiums being
purchased while under construction, then being "flipped" (sold) for
a profit without the seller ever having lived in them. Some
mortgage companies identified risks inherent in this activity as
early as 2005, after identifying investors assuming highly
leveraged positions in multiple properties.
3. High-risk mortgage loans and lending/borrowing practices: In
the years before the crisis, the behavior of lenders changed
dramatically. Lenders offered more and more loans to higher-risk
borrowers, including undocumented immigrants. Lending
standards particularly deteriorated in 2004 to 2007, as the GSEs
market share declined and private securitizers accounted for more
than half of mortgage securitizations Subprime mortgages
amounted to $35 billion (5% of total originations) in 1994, 9% in
1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006.
A study by the Federal Reserve found that the average difference
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between subprime and prime mortgage interest rates (the

"subprime markup") declined significantly between 2001 and
2007. The combination of declining risk premiums and credit
standards is common to boom and bust credit cycles. Another
example is the interest-only adjustable-rate mortgage (ARM),
which allows the homeowner to pay just the interest (not principal)
during an initial period. Still another is a "payment option" loan, in
which the homeowner can pay a variable amount, but any interest
not paid is added to the principal. Nearly one in 10 mortgage
borrowers in 2005 and 2006 took out these option ARM loans,
which meant they could choose to make payments so low that their
mortgage balances rose every month. An estimated one-third of
ARMs originated between 2004 and 2006 had "teaser" rates below
4%, which then increased significantly after some initial period, as
much as doubling the monthly payment.
4. Mortgage fraud: In 2004, the Federal Bureau of Investigation
warned of an "epidemic" in mortgage fraud, an important credit
risk of nonprime mortgage lending, which, they said, could lead to
"a problem that could have as much impact as the S&L crisis". The
Financial Crisis Inquiry Commission reported in January 2011
that: "...mortgage fraud...flourished in an environment of
collapsing lending standards and lax regulation. The number of
suspicious activity reports reports of possible financial crimes
filed by depository banks and their affiliates related to mortgage
fraud grew 20-fold between 1996 and 2005 and then more than
doubled again between 2005 and 2009. One study places the losses
resulting from fraud on mortgage loans made between 2005 and
2007 at $112 billion. Lenders made loans that they knew borrowers
could not afford and that could cause massive losses to investors in
mortgage securities." New York State prosecutors are examining
whether eight banks hoodwinked credit ratings agencies, to inflate
the grades of subprime-linked investments. The Securities and
Exchange Commission, the Justice Department, the United States
attorneys office and more are examining how banks created, rated,
45

sold and traded mortgage securities that turned out to be some of

the worst investments ever devised. As of 2010, virtually all of the
investigations, criminal as well as civil, are in their early stages.
5. Securitization practices: Securitization and Mortgage-backed
security. The traditional mortgage model involved a bank
originating a loan to the borrower/homeowner and retaining the
credit (default) risk. Securitization is a process whereby loans or
other income generating assets are bundled to create bonds which
can be sold to investors. The modern version of U.S. mortgage
securitization started in the 1980s, as Government Sponsored
Enterprises (GSEs) began to pool relatively safe conventional
conforming mortgages, sell bonds to investors, and guarantee those
bonds against default on the underlying mortgages. A riskier
version of securitization also developed in which private banks
pooled non-conforming mortgages and generally did not guarantee
the bonds against default of the underlying mortgages. In other
words, GSE securitization transferred only interest rate risk to
investors, whereas private label (investment bank or commercial
bank) securitization transferred both interest rate risk and default
risk. With the advent of securitization, the traditional model has
given way to the "originate to distribute" model, in which banks
essentially sell the mortgages and distribute credit risk to investors
through mortgage-backed securities and collateralized debt
obligations (CDO). The sale of default risk to investors created a
moral hazard in which an increased focus on processing mortgage
transactions was incentivized but ensuring their credit quality was
not. A more direct connection between securitization and the
subprime crisis relates to a fundamental fault in the way that
underwriters, rating agencies and investors modeled the correlation
of risks among loans in securitization pools. Correlation modeling
determining how the default risk of one loan in a pool is
statistically related to the default risk for other loans was based
on a "Gaussian copula" technique developed by statistician David
X. Li. This technique, widely adopted as a means of evaluating the
46

risk associated with securitization transactions, used what turned

out to be an overly simplistic approach to correlation.
Unfortunately, the flaws in this technique did not become apparent
to market participants until after many hundreds of billions of
dollars of ABSs and CDOs backed by subprime loans had been
rated and sold. By the time investors stopped buying subprimebacked securities which halted the ability of mortgage originators
to extend subprime loans the effects of the crisis were already
beginning to emerge.
6. Inaccurate credit ratings: Credit rating agencies are now under
scrutiny for having given investment-grade ratings to MBSs based
on risky subprime mortgage loans. These high ratings enabled
these MBSs to be sold to investors, thereby financing the housing
boom. These ratings were believed justified because of risk
reducing practices, such as credit default insurance and equity
investors willing to bear the first losses. However, there are also
indications that some involved in rating subprime-related securities
knew at the time that the rating process was faulty. Between Q3
2007 and Q2 2008, rating agencies lowered the credit ratings on
$1.9 trillion in mortgage-backed securities. Financial institutions
felt they had to lower the value of their MBS and acquire
additional capital so as to maintain capital ratios. If this involved
the sale of new shares of stock, the value of the existing shares was
reduced. Thus ratings downgrades lowered the stock prices of
many financial firms. The Financial Crisis Inquiry Commission
reported in January 2011 that: "The three credit rating agencies
were key enablers of the financial meltdown. The mortgage-related
securities at the heart of the crisis could not have been marketed
and sold without their seal of approval. Investors relied on them,
often blindly. In some cases, they were obligated to use them, or
regulatory capital standards were hinged on them. This crisis could
not have happened without the rating agencies. Their ratings
helped the market soar and their downgrades through 2007 and
2008 wreaked havoc across markets and firms." The Report further
47

stated that ratings were incorrect because of "flawed computer

models, the pressure from financial firms that paid for the ratings,
the relentless drive for market share, the lack of resources to do the
job despite record profits, and the absence of meaningful public
oversight."
7. Government policies: Government over-regulation, failed
regulation and deregulation have all been claimed as causes of the
crisis. In testimony before Congress both the Securities and
Exchange Commission (SEC) and Alan Greenspan claimed failure
in allowing the self-regulation of investment banks. In 1982,
Congress passed the Alternative Mortgage Transactions Parity Act
(AMTPA), which allowed non-federally chartered housing
creditors to write adjustable-rate mortgages. Among the new
mortgage loan types created and gaining in popularity in the early
1980s were adjustable-rate, option adjustable-rate, balloonpayment and interest-only mortgages. These new loan types are
credited with replacing the long standing practice of banks making
conventional fixed-rate, amortizing mortgages. Among the
criticisms of banking industry deregulation that contributed to the
savings and loan crisis was that Congress failed to enact
regulations that would have prevented exploitations by these loan
types. Subsequent widespread abuses of predatory lending
occurred with the use of adjustable-rate mortgages. Approximately
90% of subprime mortgages issued in 2006 were adjustable-rate
mortgages.
8. Policies of central banks: Central banks manage monetary policy
and may target the rate of inflation. They have some authority over
commercial banks and possibly other financial institutions. They
are less concerned with avoiding asset price bubbles, such as the
housing bubble and dot-com bubble. Central banks have generally
chosen to react after such bubbles burst so as to minimize
collateral damage to the economy, rather than trying to prevent or
stop the bubble itself. This is because identifying an asset bubble
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and determining the proper monetary policy to deflate it are

matters of debate among economists. Some market observers have
been concerned that Federal Reserve actions could give rise to
moral hazard. A Government Accountability Office critic said that
the Federal Reserve Bank of New York's rescue of Long-Term
Capital Management in 1998 would encourage large financial
institutions to believe that the Federal Reserve would intervene on
their behalf if risky loans went sour because they were too big to
fail. A contributing factor to the rise in house prices was the
Federal Reserve's lowering of interest rates early in the decade.
From 2000 to 2003, the Federal Reserve lowered the federal funds
rate target from 6.5% to 1.0%. This was done to soften the effects
of the collapse of the dot-com bubble and of the September 2001
terrorist attacks, and to combat the perceived risk of deflation.
9. Credit default swaps: Credit default swaps (CDS) are financial
instruments used as a hedge and protection for debt holders, in
particular MBS investors, from the risk of default, or by
speculators to profit from default. As the net worth of banks and
other financial institutions deteriorated because of losses related to
subprime mortgages, the likelihood increased that those providing
the protection would have to pay their counterparties. This created
uncertainty across the system, as investors wondered which
companies would be required to pay to cover mortgage defaults.
Like all swaps and other financial derivatives, CDS may either be
used to hedge risks (specifically, to insure creditors against default)
or to profit from speculation. The volume of CDS outstanding
increased 100-fold from 1998 to 2008, with estimates of the debt
covered by CDS contracts, as of November 2008, ranging from
US$33 to $47 trillion. CDS are lightly regulated, largely because
of the Commodities Futures Modernization Act of 2000. As of
2008, there was no central clearing house to honor CDS in the
event a party to a CDS proved unable to perform his obligations
under the CDS contract. Required disclosure of CDS-related
obligations has been criticized as inadequate. Insurance companies
49

such as American International Group (AIG), MBIA, and Ambac

faced ratings downgrades because widespread mortgage defaults
increased their potential exposure to CDS losses. These firms had
to obtain additional funds (capital) to offset this exposure. AIG's
having CDSs insuring $440 billion of MBS resulted in its seeking
and obtaining a Federal government bailout. The monoline
insurance companies went out of business in 20082009. When
investment bank Lehman Brothers went bankrupt in September
2008, there was much uncertainty as to which financial firms
would be required to honor the CDS contracts on its $600 billion
of bonds outstanding. Merrill Lynch's large losses in 2008 were
attributed in part to the drop in value of its unhedged portfolio of
collateralized debt obligations (CDOs) after AIG ceased offering
CDS on Merrill's CDOs. The loss of confidence of trading partners
in Merrill Lynch's solvency and its ability to refinance its shortterm debt led to its acquisition by the Bank of America.

Implications:
Estimates of impact have continued to climb. During April 2008,
International Monetary Fund (IMF) estimated that global losses for financial
institutions would approach $1 trillion.[270] One year later, the IMF estimated
cumulative losses of banks and other financial institutions globally would exceed
$4 trillion.
Between June 2007 and November 2008, Americans lost more than a
quarter of their net worth. By early November 2008, a broad U.S. stock index, the
S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped
20% from their 2006 peak, with futures markets signaling a 3035% potential
drop. Total home equity in the United States, which was valued at $13 trillion at its
peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late
2008. Total retirement assets, Americans' second-largest household asset, dropped
by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the
same period, savings and investment assets (apart from retirement savings) lost
50

$1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total
$8.3 trillion.

Real gross domestic product (GDP) began contracting in the third quarter of
2008 and did not return to growth until Q1 2010. CBO estimated in February
2013 that real U.S. GDP remained 5.5% below its potential level, or about $850
billion. CBO projected that GDP would not return to its potential level until
2017.

The unemployment rate rose from 5% in 2008 pre-crisis to 10% by late

2009, then steadily declined to 7.6% by March 2013. The number of
unemployed rose from approximately 7 million in 2008 pre-crisis to 15 million
by 2009, then declined to 12 million by early 2013.

Residential private investment (mainly housing) fell from its 2006 pre-crisis
peak of $800 billion, to $400 billion by mid-2009 and has remained depressed
at that level. Non-residential investment (mainly business purchases of capital
equipment) peaked at $1,700 billion in 2008 pre-crisis and fell to $1,300 billion
in 2010, but by early 2013 had nearly recovered to this peak.

Housing prices fell approximately 30% on average from their mid-2006

peak to mid-2009 and remained at approximately that level as of March 2013.

Stock market prices, as measured by the S&P 500 index, fell 57% from their
October 2007 peak of 1,565 to a trough of 676 in March 2009. Stock prices
began a steady climb thereafter and returned to record levels by April 2013.

The net worth of U.S. households and non-profit organizations fell from a
peak of approximately $67 trillion in 2007 to a trough of $52 trillion in 2009, a
decline of $15 trillion or 22%. It began to recover thereafter and was $66
trillion by Q3 2012.

U.S. total national debt rose from 66% GDP in 2008 pre-crisis to over 103%
by the end of 2012. Martin Wolfand Paul Krugman argued that the rise in
private savings and decline in investment fueled a large private sector surplus,
which drove sizable budget deficits.
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CONCLUSION
The subprime mortgage market experienced explosive growth
between 2001 and 2006. Angell and Rowley (2006) and Kiff and Mills (2007),
among others, argue that this was facilitated by the development of private-label
mortgage backed securities, which do not carry any kind of credit risk protection
by the Government Sponsored Enterprises. Investors in search of higher yields
kept increasing their demand for private-label mortgage-backed securities, which
also led to sharp increases in the subprime share of the mortgage market (from
around 8 percent in 2001 to 20 percent in 2006) and in the securitized share of the
subprime mortgage market (from 54 percent in 2001 to 75 percent in 2006).
During the dramatic growth of the subprime (securitized) mortgage
market, the quality of the market deteriorated dramatically. We analyze loan quality
as the performance of loans, adjusted for differences in borrower characteristics
(such as credit score, level of indebtedness, ability to provide documentation), loan
characteristics (such as product type, amortization term, loan amount, interest rate),
and subsequent house price appreciation.
The decline in loan quality has been monotonic, but not equally
spread among different types of borrowers. Over time, high-LTV borrowers
became increasingly risky (their adjusted performance worsened more) compared
to low-LTV borrowers. Securitizers seem to have been aware of this particular
pattern in the relative riskiness of borrowers: We show that over time mortgage
rates became more sensitive to the LTV ratio of borrowers. In 2001, for example,
the premium paid by a high LTV borrower was close to zero. In contrast, in 2006 a
borrower with a one standard deviation above-average LTV ratio paid a 30 basis
point premium compared to an average LTV borrower
In principal, the subprime-prime mortgage rate spread (subprime
mark-up) should account for the default risk of subprime loans. For the rapid
growth of the subprime mortgage market to have been sustainable, the increase in
the overall riskiness of subprime loans should have been accompanied by an
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increase in the subprime mark-up. In this paper we show that this was not the case:
Subprime markupadjusted and not adjusted for changes in differences in
borrower and loan characteristicsdeclined over time. With the benefit of
hindsight we now know that indeed this situation was not sustainable, and the
subprime mortgage market experienced a severe crisis in 2007. In many respects,
the subprime market experienced a classic lending boom-bust scenario with rapid
market growth, loosening underwriting standards, deteriorating loan performance,
and decreasing risk premiums.21 Argentina in 1980, Chile in 1982, Sweden,
Norway, and Finland in 1992, Mexico in 1994, Thailand, Indonesia, and Korea in
1997 all experienced the culmination of a boom-bust scenario, albeit in different
economic settings.
Were problems in the subprime mortgage market apparent before the
actual crisis showed signs in 2007? Our answer is yes, at least by the end of 2005.
Using the data available only at the end of 2005, we show that the monotonic
degradation of the subprime market was already apparent. Loan quality had been
worsening for five consecutive years at that point. Rapid appreciation in housing
prices masked the deterioration in the subprime mortgage market and thus the true
riskiness of subprime mortgage loans. When housing prices stopped climbing, the
risk in the market became apparent.

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BIBLIOGRAPHY
Internet
http://www.wikipedia.org/wiki/Securitization
http://www.icra.in
http://www.valuemoney.com
http://www.rbi.gov.in
Books & Articles
Michael Simkovic - Competition and Crisis in Mortgage
Securitization
Allan Greenspan - Banks Need More Capital
Lynnley Browning - "The Subprime Loan Machine"
Blackburn Robin (2008) - "The Subprime Mortgage Crisis
DiMartino, D., and Duca, J. V. (2007) "The Rise and Fall of
Subprime Mortgages
Documentaries
Too Big To Fail (2011 American Documentary)
Inside Job (2010 American Documentary)
Margin Call (2011 American Film)

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