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First we get to introduce the term securitization and its advantages leading to the discussion of its
spiraling utilization and incentivization of the securitization due to transfer of default risk to the
Then we discuss its backdrop as to how its relevant organizations came into being catering to the
mortgage market investors and their idiosyncratic risk appetites.
Then we will go at length about how securitization phenomenon emerged and the cataclysm that
followed post the year 2007 and 2008, the factors that caused them, the bane of collateralized
mortgage obligations and credit default swaps and how it swept away the liquidity from the
American markets, the antecedents for the housing bubble with its incessant increases registered
day by day and its burst, and the impact on TED spreads that continued to rise out of control
causing general liquidity problems and credit issues.

Let us first get started by defining the term securitization and discuss its salient features and
applications prior to expounding its impact on the American financial crisis of 2008.
Securitization is defined as:
the process of transforming otherwise illiquid financial assets (such as residential
mortgages) into marketable capital markets securities 1
The securities have greater liquidity as compared to the relatively illiquid, high risk assets. Its
existence is thus, attributable to advances on both information and transactions technology. The
ability to acquire information at a low cost has enabled to make the trading more liquid and
tradable. The low transaction cost is possible due to the feasibility and easiness with which the
loans can be bundled together without incurring much cost. The loans are given to the mortgagee
(in case) and the interest and principal amount collected thus can be paid out to the third parties
i.e. the investors. The standardized amounts of loans are then made up from a portfolio of loans
and the resultant claims on the interests and the principal payments are then transferred to the
investors or third parties in the form of mortgage-based securities. The standardized amount of
those loans makes them liquid securities. The fact that they are composed of a number of loans
helps diversify risk, making them desirable. The financial institution making the loans, while
paying principal and interest payment earned from borrowers, makes revenue by receipt of fees
for their servicing charges.2
Thus, the securitization phenomenon begot the notion of catering to variegated appetites of the
investor requirements i.e. it was tailored towards providing payment streams that was deemed
suitable for individual investors. Collateralized mortgage obligations is one such example in

Financial Markets, Institutions and Money by Frederic S. Mishkin, pg.272

Financial Markets, Institutions and Money by Frederic S. Mishkin pg.272

which payments are arranged into tranches or layers of returns with senior securities paid
preferentially by virtue of their lower credit risk and then sequentially the ones with the higher
credit risk are paid later.3
Though, securitization works best in condition in which packaged loans are homogenous so that
the risk is better distributed and is predictable and thus, some of the newer loans being
considered for packaging, such as loans for boats and motorcycles being considered can prove
complicating for the predictability assessment.4
The advantages of securitization is increasing liquidity, lowering the cost of capital to the
borrowers and increasing the efficiency of the financial markets.5


The homeowners were financed in USA and to facilitate lower income groups,
two organizations were formed to carry out the needful i.e. the Federal
Housing Administration and Veteran Administration Loans. FHA and VA
required lower down payments and lower mortgages than conventional
mortgages due to guarantee on former.
The New Deal of Roosevelt introduced Fannie Mae (the Federal National Mortgage Association)
in 1938 to purchase and securitize government-sponsored FHA and later VA mortgages. In 1970,
the Freddie Mac (the Federal Home Loan Mortgage Corporation) was created to provide for
conventional mortgages the same securitization that Fannie provided for government-backed
Though the risk was uncertain in securitization but it was well-compensated by the higher
interest rates levied on the payment streams.

It addresses the factors or aspects of securitization that caused financial crisis and how
securitization caused various aspects of the economy to tumble, the CMOs and their domino
effect on the fall of the great American economy cataclysm post 2006.

The data have been collected from a number of sources i.e. the Internet, Research articles and
Financial Management books. It is a secondary research derived from these aforementioned

Financial Markets, Institutions and Money by Frederic S. Mishkin, page 273
Financial Management Theory and Practice, 10th edition by Eugene F. Brigham and
Michael C. Ehrhardt pg. 775

sources. These material were read, comprehended and reproduced and summarized as a result of
general understanding of the topic.

As a result of securitization, asset-backed security was heavily utilized prior to the year 2008,
though as it transpired later, their volume decreased to over 90% downside after the financial
cataclysm of 2008. Thus, the ABS and MBS volumes declined sharply post the financial crisis.6
The securitization boom was witnessed between the years 1970 2008 in USA and became a
leading tool of corporate finance. There was a large growth in mortgage loans, consumer credits,
and trade receivables held by issuers of ABS, peaking at about $3737.4 billion by the end of
2007 with an average annual compounded growth rate of 28% since 1984.7
The securitization, which was the causal agent for the recent global financial crisis of 2008 and
its emergence and explosive growth were responsible for the onset of the crisis. The incentives
that was supposed to be efficient for the well-being of the investors was the reason or the factor
behind the financial crisis of 2008 ironically, due to the fact that transference of credit risk of the
borrower to the creditor became the incentivizing factor for the global financial crisis that was to
ensue post this act.
Also, what was supposed to be the greatest innovation of the 20th century turned out to be a total
fiasco for the hitherto booming economy, since the risk of default was transferred to the security
holder away from the bank by the way of securitization that, in turn, was the consequence of
pooling of securities and selling them as marketable securities to make them more tradable.
The ratings of the rating agencies was skewed in favor of the banks as most of the securities got
good ratings that was another hallmark of the financial cataclysm that was to ensue.
Soaring profits and greed for more resulted in organizations financial to enter into
securitization phenomenon and the hype thus created resulted in organizations to act contrary to
their expertise. Wall Street was the first one to enter these markets while the practice penetrated
deeply throughout USA.
As mentioned earlier, the securitization phenomenon got a boost when the banks relied less on
the individual savers and concentrated more on taking loans from the banks instead, thinking that
the bad loans would be compensated by the lending banks, thus hiding their fault.

The Rise of a Giant; Securitization and the Global Financial Crisis by Dov Solomon,
American Business Law Journal, Vol 49, No. 4 , pg. 859, 2012
The Rise of a Giant; Securitization and the Global Financial Crisis by Dov Solomon,
American Business Law Journal, Vol 49, No. 4 , pg. 859, 2012

Other factors are as follows:

Some banks like Lehman Brothers got into mortgages, buying them for securitization and
later selling them.

The vicious cycle of loans was made on pretext of securitizing them and the total number
of loans made was increased.

Running out of loans meant loans were extended to the poor resulting in sub-prime
mortgages i.e. the riskier loans, after all bad loans meant possession of high-valued assets
and hence the emergence of liars loan took place.

Emergence of Collateralized Debt Obligation (CDO) that spreads the risk often hid the
bad loans.

Even high street banks got into home loans and mortgages without right management, expertise
and control.
The general risk level in the economy grew at an alarming level due to the banks giving loans to
undeserving segments of the society that, ironically, the financial instruments that were designed
to reduce the level of risk, backfired so much.
When the problem was about to take birth, the investor confidence fell dramatically and hence
the house prices fell, urging the lenders to take back their money. With lack of backing from the
borrowers, the lenders asked for their money and due to the aforementioned factor, the banks
registered with lack of liquidity and credit ( due to fall of prices of assets).
Bailouts ensued and the capital injected into these organizations concurrently, sucked the
liquidity out from the economy in general, leading to the financial Armageddon8.
The sub-prime mortgage issue was also the conducive factor for the financial crisis as the
undeserving segments of the society were getting loans, which were unable to pay for the
The major player in CMO was the shadow banking phenomenon that used high leverage and
higher net capital ratio, since they were unregulated. In order to briefly explain the term
Shadow banking, it means it comprised of investment banks, hedge funds , money-market
funds, finance companies and asset-backed conduits (ABC). Hence the collateralized mortgage
obligations was similar to normal mortgages but with a twist. Instead of using a pool of
mortgages as one, they used tranches of payments to pay investors with different risk appetites.
One willing to take lower risk was fitted in the tranche of lower credit risk and hence lower
interests were paid out to them, succeeded by middle tranches and then succeeded by lower

tranches that were paid out to those willing to undertake higher levels of risk and hence, higher
incomes were paid to them.9
The housing bubble, furthermore bursted it was growing at an annual rate of 10% that was
more than the inflation. The monetary easing and then the higher interest rates increase also
caused more and more people to default, thus increasing foreclosure rates and hence further
decreasing the prices of the houses, thus popping the bubble.
Collateralized mortgage obligations and the credit default swaps aggravated the problem as the
value for the CMOs were not decidable thus gauging the levels of losses was inaccurate and it
spread its effects to other financial sectors.
Credit default swaps was another thorn in the way of American development as more people
betted on the failure of CMOs and AIG, in order to levy more fees on more people betting on it,
actually incurred losses while it could not pay off people betting against the CMOs and it
affected the whole chain of wagers.
Since private lenders were affected, the whole credit market suffered and while the business runs
on credit, the managers in the corporations or firms were unable to have the required working
capital to run their businesses and payrolls were adversely affected, thus plunging the economy
into recession.
TED market rates increase was another way that markets were plunging in recession. TED rates
means the difference between risk free 3-month Treasury Bills and 3-month LIBOR. The
interbank lending is usually charged 0.5% higher before the crisis as compared to LIBOR.
On August 3 2007, banks were unable to securitize loans but could make loans and hence these
were paid to lower risk taking investors.
Post the losses incurred by BNP Paribas three investment banks unit in Europe and failure of
two Bear Sterns hedge funds, the level of trust between the banks hit the rock bottom and TED
spread remained above 1% for a period of more than 16 months. Thus, the banks were unable to
give loans to each other and increased default on the CMOs resulted in losses in credit default
swaps and it became impossible task for the investment banks to gauge the losses caused due to
Whatever happened in 2007 was a precursor to whatever happened in 2008.

The commercial paper trading also suffered a setback as Reserve Fund had bought it from
Lehman Brothers and it liquidated that resulted in broking off the buck, something that happened
to USA for the second time in their history. It also failed to retain its net asset value at $1.
The trading froze to be revived again after 12 hours, with the credit returning at a higher 8%
from the former 2%. As a consequence, the TED spread increased.
On October 7, the Federal Reserve created the Commercial Paper Funding Facility (CPFF),
enabling issuers of commercial paper to borrow against those assets, to provide liquidity in the
commercial paper market. On the same day, to stem the potential for bank runs, FDIC raised the
deposit insurance limit to $250,000 per depositor.
On October 21, the Federal Reserve Board created the Money Market Investor Funding Facility
(MMIFF) to enable the purchase of CDs, commercial paper and other assets from money market
funds to provide liquidity to cover any withdrawals.
Since mid-October, the TED spread has improved, dropping to 1% in mid-January 2009 and
dropping further to 0.5% in late-May.

Furthermore, later bailouts ensued and Federal Stimulus Plan was launched by Obama to
resuscitate the economy in the aftermath of the financial crisis that was designed to redeem the
economy out of the abyss in which it found itself in.10
No doubt, securitization presents new developments and exciting opportunities. Securitization
allows for more precise targeting of asset liquidation. It can create value for originators and
investors. It can deepen capital markets, thereby providing funds for new borrowers and new
businesses. And it can improve market price discovery for illiquid assets.
When a securitization gets beyond the analytical apparatus of market participants, however, it is
capable of destroying value. The potential harm is greater in globally interconnected markets.
Executives may find it useful to keep in mind the following key ingredients to a successful securitization.

Characteristics of assets to be securitized should be documented well and identified


Transfer of assets to a SPE to form a collateral pool should be a true, bankruptcy-remote


The transformation of collateral pool risks into security risks should be simple enough to
provide clear and robust analysis of the dependence of security risks on collateral

Processes for servicing, and for ongoing monitoring of collateral and security
performance, should be well-defined, with some evidence of success under reliability

Using collateral, securities, and structures with an established history or clear evidence of
success provides greater liquidity in security trading, and more reliable analysis of
collateral performance.

Using opaque and exotic structures requires considerable expertise and comes with
greater risks.


Financial Markets, Institutions and Money by Frederic S. Mishkin

Financial Management Theory and Practice, 10th edition by Eugene F. Brigham and
Michael C. Ehrhardt

The Rise of a Giant; Securitization and the Global Financial Crisis by Dov Solomon