The role of securitization in

the global financial crisis

 LEWIS RANIERI
SALOMON BROTHERS
It all began 50 years ago

https://www.cnbc.com/id/41735500
 Securitization

 Technique by which illiquid assets (e.g. financial receivables) can be transformed

into negotiable securities on a secondary market

 Born in the United States in the seventies - In 1977 a team of experts from
Salomon Brothers and Bank of America structured the world's first securitization
transaction

 In Italy, regulatory recognition of securitization only with law 130 in 1999

 Securitization
How it works….

Asset Sales ABS

Borrowers Special
Originating Investors
Purpose
Lender
Proceeds Vehicle Proceeds

Loan Payments Collect Payments for

the SPV (there may be a Payments
servicer)

Initial payments/proceeds
After the initial payments
Securitization
How it works….
 The protagonists of the securitization transaction

 Originator of the securitized assets which can be a bank, a non-bank financial intermediary
or a non-financial enterprise

 Special Purpose Vehicle (SPV) - transferee: which issues the securities (ABS - asset backed
securities) in which the transferred receivables are incorporated

 Investors in ABS

 Servicer: service company specializing in the management of the transferred credit portfolio
and in the management of collection and payment flows (collects the cash flows originating
from the transferred assets and honors the payment of coupons for ABS subscribers)

 Arranger (investment bank) who takes care of the structural aspects of the transaction;

 Rating company: which assesses the risk of the transaction and assigns a rating to the
securities issued (credit trancing)
Credit RATING

The term credit rating refers to a quantified

assessment of a borrower's creditworthiness in
general terms or with respect to a particular debt
or financial obligation.
A credit rating can be assigned to any entity that
seeks to borrow money—an individual, a
corporation, a state or provincial authority, or a
sovereign government.

Credit RATING Agencies

 Asset Backed Securities

 Main assets sold (generating cash flows):

 performing loans of any nature (i.e. mortgage loans, deriving from credit cards, consumer
loans, leasing contracts)
 Non-performing loans (NPLs)
 Real estate (residential, commercial)

 The securities issued are usually called Asset Backed Securities (ABS) and have a bond nature

 They take on specific names depending on the type of underlying:

 CMBS (Commercial Mortgage Backed Securities)
 RMBS (Residential Mortgage Backed Securities) MBS
 Pre-crisis Market: Europe vs. US

ABS Issuance in billion of EUR

Europe USA
Advantages and disadvantages of
securitization
 Advantages and disadvantages of securitization

 Objectives of the securitization transaction for a bank:

 Transfer / manage risks
 Improve asset quality
 Outsourcing of problematic credit management
 Liquidity creation (alternative funding source) - Diversify funding sources
 Reduce the Balance the maturities of assets and liabilities
 “Saving” of regulatory capital
 Advantages and disadvantages of securitization

 Securitization implies a separation between the origination functions and the credit portfolio
management functions limits the incentive for a bank to screen and monitor

Originate-to-hold (OTH) vs. Originate-to-distribute (OTD)

 Downside aspects of the OTD model

 Reduction of responsibility of originator banks
 Banks' vulnerability to insolvency of borrowers is not eliminated but only mitigated by
the securitization of risky assets.

 Increased market interconnections and contagion effects between markets and

banking systems
PROTAGONISTS of The BIG SHORT

( MARK BAUM ) ( JARED VENNETT ) ( CHARLIE GELLER e JAMIE SHIPLEY

Insolvency rates
 SUBPRIME Credit
 SUBPRIME Mortgages
A subprime mortgage is one that’s normally issued to borrowers with low credit ratings.
Borrowers with FICO credit scores below 640 will often be stuck with subprime mortgages and their
corresponding higher interest rates.

Since 2003, American

banks have significantly
increased their
Bn of dollars

mortgages (especially
subprime)
SUBPRIME and credit score
 CDS
Credit Default Swap

An agreement between a buyer (protection buyer) and a seller (protection

seller) through which the seller undertakes, against the installment
premium paid by the buyer, to make a certain payment in the event of a
specific event (credit event), which is typically the default of the third party
debtor.
 Credit Default Swaps (CDS) European Banks

9,00% 350
8,00%
300
7,00%
250
6,00%
5,00% 200

4,00% 150
3,00%
100
2,00%
50
1,00%
0,00% 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Mean BVE/TA Mean MVE/TA Mean CDS 5 Yrs

Notes: Market value over total assets (MVE/TA) and CDS spreads are arithmetic means for the 25 top European banks.
Source: Bloomberg.
Credit Default Swap «Naked»
 ABX Index
The ABX index is a synthetic
tradable index referencing a
basket of 20 subprime mortgage-
backed securities.

if the index increases it means

that there are less risks with
subprime mortgages and vice
versa

https://www.markit.com/Documen
tation/Product/ABX
 Securitization and risk reduction for investors
 In order to reduce the risks for the investor, to increase the rating of the issue and to reduce
the rate of return required by the market, it is possible to improve the quality of the
underlying portfolio through forms of internal guarantees - provided directly by the
originator. - or external, i.e. provided by third parties.

 Internal guarantees (the originator does not entirely transfer the credit risk to the transferee,
but bears part of it)
 overcollateralisation: to guarantee the issue, an amount of underlying assets exceeding the market value of
the securities issued is transferred;

 Credit line by the originator granted to the SPV that can be used if the securities issued were not fully
repaid due to the insolvency of the assigned debtors;

 Credit tranching: the securities are issued in several classes or tranches, each of which is characterized by a
different order of priority in the distribute on of cash flows.
 credit traching

 The securities issued are divided into groups (tranches) characterized by a decreasing level of priority in the
allocation of financial flows (seniority).
 The ABS tranches have different rating, risk and return levels for investors with different risk appetites

Three main tranche classes:

1. Senior: highest rating level and highest priority in

the payment of coupons and final capital;

2. Mezzanine: intermediate level of subordination;

3. Junior (equity tranche) the most subordinate: the

last to be repaid. They are generally withheld by
the originator (bank)
 CREDIT TRANCHING
An example

Senior tranche -Rating AAA

Face Value 70
Interest rates/coupons:
SPV issues 3 thanches of • Senior 4%
Mezz. tranche -Rating BB
ABS • Mezzanine 6%
Face Value 10 • Junior (residual interest)
Junior tranche – No Rating
Face Value 20
 CREDIT TRANCHING
An example

Mortgages Sold
(Face value = 100)

SPV receives the mortgage payments which on average are equal to 5% of the face value

The net inflow of 5 will be divided as follows:

•Senior tranche 2,8 (70 x 4%)
•Mezz. Tranche 0,6 (10 x 6%)
•Junior 1,6 (which corresponds to a yield of 8% (1,6/20))
 CREDIT TRANCHING

What if the debtors start not paying ???

If half of them don't pay anymore ??

Default rate of 50%  the SPV will receive 2.5 and will be divided as follows:
•Senior tranche 2,5
- Mezz. Tranche 0
-Junior 0
CDO (collateralized debt obligation)
 CDO

or sold to the
financial market

CDO2 , CDO3…
 Securitization and financial crisis

 Macroeconomic factors at the origin of the crisis:

 Expansive monetary policy of the US Federal Reserve (so-called "era Greenspan")
 Very low interest rates achieved from 2001 to 2004
 Global economic growth  Strong credit demand from borrowers

Lenders Borrowers/investors

Search for high returns Strong increase in the use of debt

and consequently more risky => increase in real estate investments
(sub prime customers) and consumption

Prices increase:
creation of a gigantic US REAL ESTATE BUBBLE
 Case-Schiller index: US
Indice Case-Schiller: housing
Prezzi market
delle Case USA
prices

Foreclosure
and resale
of the House
Mortgage
origination
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008
 The US "housing bubble"

Case-Schiller index: US
Indice Case-Schiller: housing
Prezzi market
delle Case USA
prices
the real estate
bubble bursts
Foreclosure
and resale
of the House
Mortgage
origination
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008
 Securitization and financial crisis

Prices of housing and loans demanded by borrowers

are rising

How the banking system could manage to cope with the intense
and rapid expansion of credit to households
and to businesses?

Recourse to techniques of
securitization also "innovative"
(via alternative to traditional funding): ABS, MBS and CDO
Synthetic CDO
 SOME NUMBERS OF THE CRISIS. . .
In the USA

- $ 5 Trillion in Pensions Burned;

- 401 million of real estate, securities and investments;

- 8 million people lost their jobs;

- 6 million people lost their homes.

1 euro = 121,5 JPY

1 JPY = 0,0082 euro

10.000 euro = 1.215.000 JPY

If the exchange rate

becomes

1 JPY = 0,009 euro?

My debt will be
10935!!!
(1,215,000 x 0,009)