Asset Securitization is Too Big to Fail

S.G. Badrinath

Professor of Finance

San Diego State University

and

S. Gubellini

Assistant Professor of Finance

San Diego State University

First Draft

May 2010

Please do not quote.

ABSTRACT

This paper explores the evolution and the current state of asset securitization. It begins with a

brief review of securitization and how structured finance enabled the management of interest-rate

and credit risks. It describes the role of credit default swaps in credit risk transfer. It documents

the close historical relationship between securitization and various pieces of rule-making--

FASB, Basel I and II, bankruptcy law, derivatives regulation and the role of rating agencies. It

discusses the financial crisis from the perspective of the shadow banking system that emerged

over the last few decades. It concludes with an assessment of the welfare implications of the

various proposals for financial reform that are presently being contemplated.

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1. Introduction

Over the last 18 months, a tremendous amount of intellectual fire-power has been expended on

attending to and then attempting to reform the Western financial system.1 Financial stability

reports from central banks around the globe, reports from regulatory entities, IOSCO, FDIC,

FASB, BIS, congressional inquiry commissions, and presidential reform agendas dominate the

public policy space. One of the many concerns is the state of markets for asset securitization and

the various practices by which interest rate and credit risk have been transferred through the

global financial system.

As Figure 1 shows large portions of this market have essentially stopped functioning since the

Fall of 2008. During the intervening two years, this market has been kept on life-support by the

FHA’s government backed programs and the US Federal Reserve purchases of nearly $1.25

trillion in mortgage backed securities. The latter program is scheduled to wind-down in the

Spring of 2010. Market participants are understandably reluctant to enter into securitization

arrangements without any clarity in terms of the legal, accounting and financial reforms that are

being proposed. This paper surveys the landscape from a historical perspective and extracts

lessons for both developed and developing markets alike.

Media references to the financial crisis and its aftermath are focused on the failure of credit and

accounting standards, of abusive practices by banks, investment banks, GSE’s, insurance

companies and rating agencies. This court of public opinion simultaneously vilifies the roles

played by these entities as well as the actions of those who came to their rescue and are now

attempting to regulate them. In this telling, the common theme that emerges is one of excess, of

testing and stretching the boundaries of prudent practice in adhering to credit standards,

accounting conventions and legal constructions. What is rarely recognized in such forums is that

securitization lies at the intersection of many evolving practices in the banking and financial

1 The financial crisis is often referred to as the sub-prime crisis, but the growth in sub-prime mortgage securitizations was mostly in the middle of the last decade and the performance failures in this asset class began in early 2007, well before the financial panic spread to other, ostensibly unconnected financial markets and securities.

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system and that there has historically been a very direct connection between government

policies, regulation and securitization.

Accordingly, the paper commences by describing the evolution of securitization and its attempts

to first manage interest rate risk and then subsequently credit risk. In this process the paper traces

the development of CDOs and credit default swaps. It views securitization as the middle ground

in a risk continuum that has bank lending with 100% risk retention at one end and 100%

origination and distribution of loans at the other. The former extreme is exemplified by

traditional banking where the lender holds the loan to maturity and manages the associated risks

of default and interest rate changes. In the latter extreme, the lender only serves as an

intermediary and private investors would absorb borrower and market risks in their entirety. In

the middle, the lender retains a portion of the loan and securitizes the rest. With partial risk

retention, intermediaries can signal the quality of the loan portfolio that is being securitized in

the sense of Leland and Pyle (1977).2 The extent of this retention is masked by the complexity of

the underlying instruments, the certification role of the rating agencies, the reluctance to regulate

and the opaqueness of over-the-counter locations where many of these transactions are

conducted. The paper continues to describe the benefits of securitization by examining the

economic interests of consumers, lenders, and banks. It then addresses the growth of the shadow

banking system and describes the causes for the recent financial panic.

Next, the paper examines the centrality of securitization activities in the web of regulations and

guidelines that have evolved over the last several decades. It highlights the tensions between

securitization and FASB accounting standards, the bankruptcy code, the Basel Accords, credit

derivative reform and the role of the rating agencies. As becomes evident, several of the rules

devised by various institutions-FASB, FDIC, the Treasury, the SEC, the CFTC, Bankruptcy

Law, and the Basel Accords- have their origins in periodic attempts to rein in extreme lending

practices while attempting to preserve the essence of securitizations.

The consequences of a multi-decade thrust towards deregulation become evident along with the

hubris in the power of market solutions and the innovations that accompany them. The general 2 A recent proposal by the SEC suggests risk retention by requiring that the sponsor retain 5% of each tranche of ABS securitizations. This distorts the quality signal that ownership of the most risky tranche would send.

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thrust of the reform proposals from the same rule-making agencies echoes similar sentiments.

The piecemeal solutions to improve transparency, reduce excessive risk taking and complexity

that are being proposed for the various affected parts of the financial system also raise some

concerns about regulatory fragmentation. Still, informed market participants and regulators are

working very hard behind the scenes to make the markets for asset securitization regain some

semblance of normalcy. In other words, securitization is perceived as too big to fail. At the most

basic level though, the ability to repackage cash flows and make them appear less risky is a

market imperfection and the profits from exploiting that imperfection has become a social cost.

The obvious benefits are home ownership, easy access to credit for borrowers, and an arguably

lower cost at which banks are able carry out lending activities. To us it seems vital that such a

cost-benefit analysis and how it generates welfare gains be central to any and all discussions of

the political economy of securitization.

The rest of the paper is as follows. Section 2 describes the various aspects of securitization.

Section 3 briefly reviews the events in financial markets and the bailout of shadow banking over

the past three years. Section 4 discusses the historical importance of regulatory trends in

supporting securitization activities and the efforts at financial reform. Section 5 discusses

alternative approaches and welfare implications and Section 6 concludes.

2. The characteristics of securitization.

In its most elementary form, securitization refers to the process by which illiquid individual

claims (loans) originated by financial institutions are transformed into securities and distributed

to investors. While most of the media coverage addresses the fallout from commercial and

residential real estate mortgages, the affected securitizations also involve loans, bonds, and a

wide range of receivables and other cash-flow generating financial assets. However, the

mortgage provides a useful starting point for describing and understanding the securitization

process. Imagine a continuum, at one end of which loan funding remains essentially a primary

market activity. Traditional thrift institutions would originate the loan, service the loan, fund it

with deposits and assume the associated interest rate risk as well as the risk of default of the

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individual borrower.3 At the other conceptual extreme, is a scenario where all the interest rate

and credit risk is distributed in the secondary market to investors. In such a situation, there is no

informational asymmetry as the lender does not have a stake in the quality of the loan. On this

risk continuum, securitization occupies a middle ground where loans are bundled, risk is

unbundled, and some of it is retained, with the entire structure being closely monitored. There is

a three-step process. First, originated loans are pooled together into mortgage-backed securities

enabling a diversification of borrower risk. Second, these assets are transferred in a true-sale to a

special purpose vehicle (SPV) so that the cash flows from these assets cannot be attached in the

event of originator bankruptcy.4 Third, the SPV issues different tranches or slices of bonds where

the cash flow is passed through from the original mortgages comprising the pool according to

different rules of priority. Typically, the senior and the largest tranches are paid first and bear the

least risk. The lowest or equity tranche is the first to be affected by default in the underlying

collateral pool. In this manner, securitization provides access to funding sources from secondary

capital markets.

As the structures are designed by the SPV, an iterative process with rating agencies is used to

determine the type of credit rating that the different tranches can garner. The SPV engages an

asset manager to trade the assets in the pool, a guarantor to provide credit guarantees on the

performance of that pool, a servicer to process the cash flows generated from the pool and

transferring them to the owners of the tranches and a trustee to oversee the activities of the SPV.

Figure 2 provides a pictorial representation of the entire process.

As comfort with securitization products and structures grew, numerous variations emerged over

the years. In addition to the usual individual fixed-rate and adjustable-rate mortgages and

mortgage backed securities (MBS), the assets pooled into the securitization began to include

loans and leveraged loans, high-yield corporate bonds as well as asset-backed securities (ABS).

3 One of the primary reasons for the Savings and Loan Crisis of the 1980’s was the funding mismatches caused by borrowing short (via deposits) and lending long (to 30-year fixed rate mortgages). In addition to maturity mis-matches, the Regulation Q ceiling on interest payable to depositors was kept artificially low, causing them to move to alternative interest bearing investments such as money market funds.

4 These entities have been variously described as special purpose entities (SPE), structured investment vehicles (SIV), or Asset Backed Commercial Paper (ABCP) conduits. While there are differences in the way the different entities operate, their common feature is that they all are bankruptcy remote.

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Thus the early collateralized mortgage backed obligation (CMO), were augmented by

collateralized loan obligations (CLO), then by collateralized bond obligations (CBO), and later

their aggregated version- the collateralized debt obligation (CDO). Once the securitization

infrastructure was in place at most banks, new product development even involved the re-

securitization of the lower (and more risky) CDO tranches into CDO-squared structures. Demand

from private investors seeking yield in an environment of low interest rates began to mean that

every conceivable cash flow stream was prone to being securitized.

2.1 Securitization and interest rate risk.

On the risk continuum described above, the S&L crisis can be viewed as failure of the traditional

model of concentrating risk in one set of entities. Indeed, after that crisis, mortgage securitization

received a significant impetus with the government sponsored enterprises (GSE’s) taking on a

more increased role in the mortgage market.5 Home ownership has been a cornerstone of public

policy in the US and the GSE’s mandate was to provide liquidity, stability and affordability to

this market.6

The typical view of securitization is one where the GSE’s attempted to manage interest rate risk

by selling tranched securities rather than issuing debt to finance their purchase. This was done by

prioritizing the cash flows to the tranches. Some tranches received only interest or only principal.

Others allocated fixed rate payments to a floating rate and an inverse floating rate tranche, with

different exposures to interest rate risk. Still others had explicit planned payment schedules,

similar to a sinking fund to reduce uncertainty in payment times caused by variation in the speed

at which mortgages are pre-paid.

5 This was not however, the starting point for securitization. Goetzmann and Newman (2009) point to a complex real estate market in the 1920’s with arrangements resembling securitization well before the GSE’s were created.

6 This mission is conducted by holding mortgages and MBS as well as guaranteeing other MBS issues. Loans that meet underwriting and product standards are purchased from the lenders and then pooled and sold to investors as MBS. The GSE’s received a fee for guaranteeing the performance of these securities. Second, they held some of the loans they purchase from banks for portfolio investment. Some of the holdings in the investment portfolio were themselves MBS issued by private firms (many of which have been subprime). Funding for the former is obtained from investors and funding for the latter is obtained by issuing agency debt creating moral hazard problems.

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However, as part of that mandate to promote home ownership, Fannie Mae initially issued its

own debt and retained the interest rate risk rather than passing it through to investors. Typically,

the debt issued to finance the mortgage acquisition was of a shorter duration than the mortgage

that it finances. Declines in interest rates triggered refinancing by borrowers in fixed-rate

mortgages. Although the mortgage gets prepaid, the financing must still pay off at the higher

original rate causing a loss to Fannie Mae. If interest rates rise, the borrower retains the mortgage

and Fannie Mae still bears the loss of having to refinance its loan at the new higher rate. This

feature of mortgages is curiously referred to as negative convexity. The bank-like behavior of the

GSE has inevitably resulted in the bank-like consequences of maturity mismatch that plagued the

S&Ls. In response, the GSE’s initially increased the issuance of callable debt to counter the

impact of interest rate changes and later to access the over-the-counter interest rate swap market

to accomplish maturity transformation. Ironically, the SPV’s that were structured as ABCP

conduits became subject to similar maturity mis-match problems in 2009 when money market

funds lost confidence in the safety of that paper. 7

2.2 Securitization and credit risk.

Credit risk was initially managed by the GSE’s by strictly adhering to loan size, conformity and

underwriting standards. As the mortgage market expanded, the guarantee business became a

larger part of GSE operations. Loans that were bundled and sold as MBS came with a guarantee

that the unpaid balances to security holders on individual mortgage defaults would be paid by the

GSE. The GSE would then attempt to recover that amount through the foreclosure process.

Therefore, the security holder would not have any exposure to credit risk.

The Collateralized Debt Obligation (CDO) became a common way in which credit risk was

tranched to investors in much the same way that mortgage pre-payment risk was distributed in a

CMO. Although it is often mistakenly described as a credit derivative, a CDO is essentially a

multi-class bond where tranche investors receive cash flows from reference assets in a collateral

7 Kacperczyk and Schnabl (2009) document the characteristics of the asset-backed commercial paper during the financial crisis.

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pool according to strict definitions of priority. Demand for securitized product from such

investors is part of what contributed to the financial meltdown of recent years.

As CDOs and other private lenders entered the securitization space, various types of credit

enhancements began to proliferate.8 The quality of the collateral asset pool and concerns

regarding adverse selection by pool originators resulted in several assurances, both internal and

external.9 Internal guarantees include a cash reserve from setting aside a portion of the

underwriting fee for creating the collateralized structure, or a portion of the interest received

from the collateral assets, after paying interest on the tranches, or even by deliberate over-

collateralization where the volume of collateral assets placed in the structure is greater than the

volume of liabilities, thereby providing a layer of protection when some assets default. In

addition to credit guarantees from the GSEs issuing the MBS, external guarantees were obtained

from the sponsor and by the direct purchase of credit insurance from mono-line insurance

companies or over-the-counter insurance through credit default swaps.10

2.3 Securitization and credit risk transfer-the credit derivatives market.

The credit default swap (CDS) has emerged as the primary vehicle through which credit risk is

transferred and traded.11 Simply stated, a CDS is a put option on credit risk.12 Buyers of

protection from a credit event pay a periodic premium. If there is a relevant credit event that

affects the value of the underlying asset, then the protection buyers are made whole by the

8 Credit enhancement is a wonderful euphemism for loss distribution.

9 If originators have the most information about the quality of the underlying financial claims then it is reasonable to expect adverse selection on their part, only keeping the good loans and selling the bad ones. In the extreme, loan quality will decline across the board as demand for loans from securitizers weakens the incentive for originators to screen the loans This leads to issues of information asymmetry causing rational lenders to demand a lemons-premium, Duffie (2007).

10 Understandably, the level of these credit-enhancements was critical to obtaining a favorable rating from the rating agencies.

11 Although other structures like the Total return swap (TRS) and the Credit-Linked Note (CLN) are also related vehicles, we confine our discussion to the CDS instrument in the interest of brevity.

12 Contract terms and definitions of the credit event are standardized by the International Swap Dealer’s Association (ISDA). More details on the CDS are available at www.isda.org.

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protection seller and in this fashion they have shed the credit risk. Sellers of protection assume

the credit risk in exchange for that periodic premium income. The appeal of the CDS becomes

clear when it is compared with corresponding bond market transactions. Exposure to credit risk

can be achieved either by owning the bond or selling the CDS. Owning the bond requires capital

and also creates interest rate risk exposure while selling the CDS only requires mark-to-market

adjustments and periodic collateral. Likewise, being short credit risk implies being either short

the bond or buying the CDS. Again, the former is difficult to do while the latter is easy. In both

cases, the CDS offers leverage and liquidity and is thus an easy expression of a view on credit in

a manner that has not been possible in the secondary bond market.

This “insurance” product has received considerable notoriety in the media. First, the direct

purchase of a CDS without owning the underlying credit is akin to a short sale.13 Second, owners

of the underlying credit can purchase protection against its possible default- an application

similar to that of a protective put option. 14 Third, from initially insuring the default risk of bonds,

the CDS market soon rapidly expanded to include CDS products on loans, mortgage-backed and

asset-backed securities. Portfolio versions of these known as basket CDS and index CDS

products traded in the middle of the decade. The now notorious ABX and TABX indexes, are

securities that take one or two deals from 20 different ABS programs, with 5 different rating

classes-AAA, AA, AA, BBB, BBB-. The bottom two are further combined into the TABX which

is the most sub-prime and experienced the most rapid declines in value at the beginning of the

financial crisis.15

The synthetic CDO is a special purpose securitization vehicle that makes extensive use of the

CDS instrument. The Bistro structure conceived initially by JPMorgan in 1997 became a

13 Some commentators have urged that this use of a CDS is similar to taking out insurance on some one’s home and then burning it down to realize its value. The criticism here is not of the CDS instrument at all, but more an expression of discontent with the short selling in general.

14 Traditional forms of insurance incorporate the notion of “insurable” interest where the primary purchasers of insurance are those owners of assets who deem it necessary to seek protection against its loss of value. Restricting CDS purchases to this class of market participants is identical to only permitting protective put options to be traded and would thus limit the flexibility of market participants.

15 As an illustration, the ABX.HE.A-06-01 is an index of asset-backed (AB), home-equity loans (HE) assembled from ABS programs originating in the first half of 2006.

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template by which the cash flows to tranches of securitizations were generated from the

premiums received by selling credit default swaps on a portfolio of underlying securitizable

assets. In other words, instead of a pool of assets generating cash flows, the insurance premium

representing their likelihood of default is itself distributed directly to the tranches. Since the rate

of default in the pool of underlying assets governs the amount of the premium that will be

received from credit default swaps sold on those assets, this amounts to essentially the same

bet.16

2.4 The appeal of securitization.

For investors, the appeal of securitization structures is that in normal times, there is a diverse

pool of mortgages and loans which are low in correlation so that in the event of a default, the

senior tranches will continue to be paid out from the cash flows that are not lost in that default.

For borrowers, the appeal of securitization is that it makes credit more easily available and at

better terms.17 For banks and financial institutions that originate these loans, the securitization is

viewed as providing a lower cost method of funding than the typical secured lending activity that

they have historically engaged in. However, Hansel and Krahnen (2007) find that CDO

securitizations actually increase the risk appetites of sponsoring banks when the equity tranche is

retained. Gorton and Souleles (2005) argue that the insulation of the SPV from the bankruptcy of

the sponsor acts to reduce bank bankruptcy costs and is especially relevant for sponsoring banks

that have large risks of bankruptcy. With hindsight, the implicit government guarantee

embodied in “too big to fail” makes this argument somewhat redundant.

3. Securitization, bank runs and the bailout of shadow banking.

16 The charges filed by the SEC in April 2010 against Goldman’s Sachs pertain to their lack of disclosure of information while such a synthetic structure was being created.

17 In a study sponsored by the American Securitization Forum, Sabry and Okongwu (2009) document that a 10 percent increase in securitization activity resulted in decrease of between 4 and 64 basis points on yield spreads, depending on the specific type of the loan. Moreover, a 10 percent increase in secondary market purchases (of loans) increases mortgage loans per capita by 6.43 percent.

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Critics of securitization (Levitin, Pavlov and Wachter, 2009) argue that the securitization process

was corrupted by the emergence of a shadow banking system in the late 1990s. These shadow

banks are mortgage real estate investment trusts, insurance companies, private equity funds, the,

money market funds, mutual funds, pension funds and hedge funds. Investment dollars from

many of these entities served as the “deposits” that the special purpose vehicles, CDOs and the

housing GSE’s employed to fund securitizations. Gorton (2009) argues that this shadow banking

system is really the culmination of several decades of deregulation that facilitated the integration

of the traditional banking system with capital markets. By some measures about 60% of the

credit system is facilitated by shadow banking (Date and Konczal, 2010). Indeed, commercial

banks had little choice but to compete in this arena, since holding loans and funding them with

deposits was not a profitable business for them anymore.18

The financial crisis of the last few years involved a series of runs on this shadow banking system.

This was first visible in the asset-back commercial paper (ABCP) market and then in the

repurchase market where institutions obtained short-term financing. The behavior of two key

spreads serves to illustrate the extent of the run on the shadow banks. The first is the 30-day

A2/P2 and AA commercial paper spread which widened to 600 basis points in November 2008

from an average of 10 basis points in quieter times.19 The second is the option-adjusted spread on

the Merrill Lynch AAA Master Asset Backed Securities index which widened from a normal

range of 100-150 to 750 basis points at about the same time.20 Next the failure of the GSE’s

made their implicit government guarantees explicit. The subsequent collapse of AIG whose

aggressive selling of CDS insurance required a federal bailout, was another significant event in

this crisis.

The response of the central banks to this ongoing crisis was coordinated and strong. The

European Central Bank, The Bank of England, Her Majesty’s Treasury, the U.S Federal Reserve,

18 This was one of the motivations behind the Gramm-Leach-Bliley Act of 1999, which relaxed the separation of commercial and investment banking activities that were enshrined in the Depression Era Glass-Steagall Act.

19 A2/P2 Commercial Paper refers to programs that garner at least one short-term credit rating of “2” but noe below it. AA are programs rated “1” or a “1+” but none below.

20 International Monetary Fund, Global Financial Stability Report, 2009.

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The U.S Department of the Treasury initiated several programs whose purpose was to “bail-out”

the shadow banks. Outright purchases of secured commercial paper and GSE obligations, the

acceptance of securitized paper as collateral, the provision of liquidity facilities, capital and

financing to private entities to purchase CMBS and private RMBS as well as non-mortgage MBS

via the PPIP, TALF and TARP programs were some of the steps taken during the Fall of 2008

and Spring of 2009. The thinking behind these bailouts is that the Federal Reserve was better

able to hold these assets either until maturity or until some point where the housing market

recovered. The GSE’s are still requesting supplemental funds and thus far proposals for financial

reform do not address their situation. This socialization of debt with all its welfare implications

continues to this day with the recent events surrounding the PIIGS countries in Europe.

One common theme underlying this shadow banking system was the lack of transparency from

and regulation of several of these pools of capital. Infrequent and limited disclosure is a common

feature in the practices of hedge funds, private equity funds and in the over-the-counter credit

derivatives markets where much of structured credit finance operated. The opacity is often

justified because of the illiquid nature of many of the holdings of these assets, but deterioration

in their values in extreme situations is very hard to track down. To address complexity and

transparency, the Treasury Office of Domestic Finance floated two proposals. The first was the

MLEC Super SIV where the illiquid holdings of banks would be pooled together and held until a

better time to liquidate them rather than to dispose them at the panic-induced fire-sale prices in

the market at that time (Swagel, 2009). However, in the mindset of deregulation, the innovative

activities of these entities were generally regarded as providing liquidity and efficiency to

financial markets. The hope was that the reputational capital of the participating institutions

would constitute an effective deterrent to excessive and abusive practices.

With hindsight, it is easy to recognize that one implication of the diversification benefits that

securitization provides to the senior and super-senior tranches is that it makes them effectively

short correlation. Additionally, mortgage products are well known to exhibit negative convexity

or concavity. Negative convexity essentially implies that they lose value when interest rates fall,

partly because the rush of borrowers to refinance reduces the duration of the bonds. With

correlated defaults, this effect becomes even more severe. At times of financial crisis, all

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correlations tend towards to unity, and it should not be surprising that these tranches that were

rated as “safe” were adversely impaired.21

4. Reforming Securitization.

Reinhard and Rogoff (2009) find that systemic banking crises are typically preceded by credit

booms and asset price bubbles, with significant drops in housing prices, equity prices and output

and significant increases in unemployment and central government debt. In a comforting note,

they state that these major episodes are sufficiently far apart in calendar time for policymakers

and investors to believe that “this time is different.” Indeed, in recent crises like the S&L case,

the same issues of moral hazard, asymmetric information and systemic risk were discussed.

This section examines the implications of the banking crises from the perspective of

securitization and addressing its intersection with accounting practices, bankruptcy law, ratings

agencies, banking regulation and credit markets.

4.1 Securitization and Accounting Principles.

Several guidelines from the Financial Accounting Standards Board (FASB) have sequentially

had direct relevance for asset securitizations. A brief history of the Boards standards in this

regard reveal clearly the rearguard action that the Board performs in attempting to thwart

transgression. The first, titled Accounting for Transfers and Servicing of Financial Assets and

Extinguishments of Liabilities, was issued as FAS 125 in 1996 and has now been completed

superseded. In its 1996 incarnation, FAS 125 articulated that a transfer of assets constituted a

sale if :a) the assets were insulated from sponsor bankruptcy; b) the transferee or a qualified

special purpose entity (QSPE) can pledge or exchange those assets and c) the transferor does not

maintain effective control over those assets. In April 2001, FAS 125 was modified as FAS 140

and clarified the implications of asset transfers during securitization by unequivocally spelling

out that the assets and liabilities of a QSPE do not get consolidated with the financial statements

of the transferor. It also suggested newer disclosure rules for transactions and advocated stress

tests.

21 The assumptions regarding default and correlation in the models used by rating agencies did not anticipate this outcome resulting in a rash of severe ratings downgrades once the effect was noticed.

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In 2003, after Enron’s abuse of FAS 125/140, FASB Interpretation No. 46(R), Consolidation of

Variable Interest Entities was issued to further clarify when consolidation rules applied. Prior to

this rule, the consolidation of SPE financial statements with those of the sponsor was required

when the sponsor had a controlling financial interest, which in turn was broadly measured by

majority voting rights. FASB 46® expanded the definition of the sponsor and of controlling

interest. The financials of entities classified as Variable Interest Entities (VIE) must be

consolidated with those of the primary beneficiary. The primary beneficiary is defined as the

organization that absorbs the majority of the VIE’s expected losses. Sponsors who typically offer

liquidity and default guarantees are deemed primary beneficiaries. Controlling interest of equity

investors in the SPE is measured by their right to residual returns and their obligation to absorb

losses in addition to majority voting rights.22

The latest incarnation of FAS 125/140 now known as FAS 166 was released in June 2009 in

response to the recent financial crisis. It requires more information about transfers of financial

assets, including securitization transactions, and where companies have continuing exposure to

the risks related to those transfers. Specifically, it requires that the transferor of assets consider

whether the transferee would be consolidated by the transferor, It eliminates the concept of a

“qualifying special-purpose entity,” first recognized in FAS 140 which permitted non-

consolidation of financial statements in certain situations. It changes the requirements for

derecognizing financial assets, and requires additional disclosures to aid transparency about

transfers of financial assets and a sponsor’s continuing involvement in them.  

Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest

Entities. FAS 167 strengthens the guidelines in FAS -46R by making consolidation more

directly linked to the entity’s purpose and design and a sponsor’s ability to direct the activities of

the entity that most significantly impact the entity’s economic performance. Taken together,

22 Bens and Monihan (2007) report some reduction in ABCP issuance pursuant to application of the consolidation rules applying to VIEs. To avoid this consolidation, financial institutions came up with a restructuring called an expected loss note. Third party investors in this note take an equity position in the conduit and agree to absorb a majority of the first loss portion. One can think of this note as a “consolidation” derivative and the reason for its creation appears to have been to get around FASB regulations requiring consolidation.

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these standards are another attempt to clarify the extent of originator liability in these

transactions.

These efforts by FASB bring US GAAP accounting more in line with international (IFRS)

standards. However, these stricter rules have caused ratings agencies to express the view that

senior tranches of asset securitizations are “unlikely” to receive AAA ratings. The Treasury and

the Obama administration have lent their support to originator risk retention arguing that

originators should have some “skin in the game.23 The idea of 5% risk retention by originators

appears in various versions of Congressional reform proposals. The concern is that, if

implemented, this rule could limit off-balance sheet securitizations.

4.2 Securitization and Bankruptcy.

What is also not commonly understood is the extent to which securitization has stood in tension

with the bankruptcy code. In a straightforward lending arrangement, secured creditors have an

incentive to monitor the firm and to conduct due diligence on an ongoing basis, in order to

prevent liquidation. In contrast, with a securitization, the assets are turned over to the SPV in a

“true-sale.” True-sale implies that the sponsor sells the assets to the securitizer as an off-balance

sheet transaction, is free from monitoring the assets for performance and no longer carries them

on the books. If met, the true-sale standard implies that cash flows from the underlying assets

cannot be attached in any originator bankruptcy proceeding since they have been “sold.” In this

sense, the securitized assets are said to be bankruptcy-remote and this distance from the

originator is central in marketing the securitized assets to investors.24

This true-sale is supported by a legal opinion that is not always clear and unambiguous, but very

carefully reasoned and buttressed as available by citations from both common-law and case-law.

23 Indeed shortly after the financial crisis started, several banks made public proclamations of their intentions to take several of the offending off-balance sheet entities back on their balance sheets.

24 In 2001, the LTV Steel Company, Inc. challenged its pre-bankruptcy securitization facilities, arguing that the transfers to the SPVs were not true sales and, therefore, that LTV should be able to use the collections of receivables as "cash collateral” by giving adequate protection under bankruptcy law. LTV’s rationale was that, without such use, it might have to cease its operations, thereby jeopardizing employee jobs and retiree benefits and adversely affecting the local economy. The bankruptcy court permitted LTV to use these collections pending resolution of the true sale issue. However, no legal precedent was established as the parties reached a settlement.

16

Issues regarding the type of bankruptcy that the originator may become subject to as well as any

relationships between the two parties are usually spelled out. Many early securitizations before

2000 used two sets of special purpose entities to accomplish bankruptcy-remoteness. This

opinion frequently runs 40-50 pages and essentially passes the buck to a rating agency which

makes a judgment that the opinion is strong enough to consider the transfer of securitized assets

to an SPV as a true-sale so that the resulting tranche structures are deemed worthy of a high

credit rating.

In 2000, the FDIC clarified the “securitization rule” codified as 12 C.F.R. 360.6 which

essentially was a statement that the FDIC would not use its statutory authority to repudiate “true-

sale” contracts entered into during a securitization as long as GAAP principles were met. This

clarification lent further support to the bankruptcy-remote character of securitized assets in the

event of sponsor bankruptcy. In 2005, the Bankruptcy Abuse Prevention and Consumer

Protection Act explicitly amended Section 541 of the Bankruptcy code to exclude assets

transferred in an asset-backed securitization from the debtor’s estate, thus providing a “safe

harbor” for securitization activities.25 While this represented a victory for securitization

advocates, the financial crisis of 2007-09 has created a cloud of uncertainty. GAAP

modifications in 2009 subsequent to the current financial crisis make securitizations via a true-

sale less likely. In March 2010, the FDIC introduced an extension to the 2000 securitization rule

until September 2010 essentially grandfathering securitizations that commenced before these

new GAAP standards were defined.

4.3 Securitization and the Basel Accords.

The evolution of minimum capital standards for banks, proposed in the various Basel accords

were an attempt to globally regulate risk taking in the banking industry. 26 Basel I had overly

broad risk categories and did not tie regulatory capital charges to economic risk. Under Basel II,

25 In the bankruptcy code, the eligible asset-backed securities are referred to as those where “at least one class or tranche of which was rated investment grade by one or more nationally recognized rating organizations when the securities were initially issued by an issuer.” Once again the rating agencies have been granted significant powers. 26 Ironically, Basel I was initiated by the US Federal Reserve and the Bank of England, prompted in part by complaints from domestic banks about undercapitalized foreign banks operating on their turf.

17

banks with deposits of over $250 billion had more stringent requirements which were optional

for the smaller banks. According to Hancock et al. (2005), Basel II capital requirements for GSE

securitized mortgages was actually lower than for loans originated by banks. The differential

regulatory criteria for different banks created an incentive for regulatory capital arbitrage

whereby such banks have “an incentive to sell the credit risk on loans whose regulatory capital

exceeds their economic capital to institutions not bound by the same capital regulations, and also

to hold the credit risk on loans whose regulatory capital is below their economic capital.”

Furthermore, the regulatory capital requirements gave considerable importance to the role of

credit ratings. Capital charges were set at 8% and risk-weighted based on long-term credit ratings

with weights ranging from 20% for AAA ratings to 350% for BB ratings. This implied that a

$100 million loan would require $1.6 million in capital if it was rated AAA and $28 million in

capital if the loan was rated BB. However, with the purchase of a CDS, a BB rated security could

be transformed into a AAA rated one.27 Furthermore, capital requirements carry a zero-risk

weight for CP funding. Bake et al. (2010) document recent modifications to the Basel II capital

requirements regime in response to the financial crisis. These include a treatment of re-

securitization exposures designed to treat CDO structures, better stress testing, a value-at-risk

framework and other operating constraints.

4.4 Securitization and the role of ratings agencies.

The centrality of rating agencies in the Basel II protocols, in the bankruptcy code and in the

western public consciousness is undisputable. In its final report in July 2009, two of the five

recommendations of the US Dept of the Treasury on reforming asset securitizations pertain to

strengthening the performance of credit rating agencies and reducing over-reliance on these

ratings. This section provides a discussion of their role and critically examines various proposals

that have been put forward.

27 The poster child for this activity was AIG and a quote from their 2007 10-K report states clearly that they sold CDS protection to European banks, “…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”.

18

Rating agencies are closely involved in structured credit finance at many levels. First, they

evaluate the credit risk of the assets being pooled and offered as collateral. Second, they review

the structure, examining the tranches and credit enhancements. The fees levied for these

structured finance ratings accounted for over 40% of the revenues for Moody’s and Fitch and

grew at about 30% annually. The feedback loop between the originators of the deal and its raters

has again raised questions about conflict of interest28. Moreover, these pre-rating criteria are not

shared with investors. Third, they investigate the legal status of the SPE operating the

securitization. Fourth, they evaluate all parties to the transaction—the originators, servicers and

the quality, skill and experience of the asset managers.

Two defenses are commonly offered in support of rating activities. The first is that ratings are

long–term opinions which are intended to reflect expected asset performance over a business

cycle, and not intended to capture shorter-term market volatility. Recent agency downgrades of

credit products belie that assertion. These downgrades have been across all rating classes and

extremely severe with existing ratings being taken down multiple levels. Understandably, these

have been responses to the public outcry to which the raters have been subjected. Nevertheless,

the transition to a short-horizon rating undermines an already beleaguered process. The second is

that the complexity of the structures and transactions being rated requires caution in

interpretation. In that case, one would expect to see ratings that are better distributed around the

mean and also ratings that differ across the agencies29. What one observes is an upward bias,

suggesting flaws in their incentive structure.

Despite these criticisms, it is important to recognize that there will always be consumers for

opinions that rating agencies currently provide. New products will develop in financial markets

and will be more complex. Some subset of market participants will call for and benefit from

certifications for asset quality, credit worthiness and credit risk in evaluating the suitability of an

28 The role played by rating agencies has two close precedents from recent financial history. These are the questions of auditor independence following the Enron and WorldCom accounting scandals and the role of financial analyst recommendations during the technology bubble of the late 1990s. The former resulted in Sarbanes-Oxley.

29 Drucker and Puri (2006) find that covenants are more restrictive when the views of rating agencies differ.

19

investment. Regulators can either work with the rating agencies or become a rater themselves.

Accordingly, several solutions to maintain the arms-length nature of raters have been proposed.

The first is to remove barriers to entry in the ratings market- a step taken in the enactment of the

Credit Rating Agency Reform of Act of 2006. Prior to this, it was not uncommon for prospective

entrants to engage in risky business practices30. A second is to make potential purchasers of the

rated product pay for ratings rather than its sellers. However, the buy side is equally likely to

influence the ratings process as the sell side. It is not hard to imagine a large institutional holder

exerting pressure for favorable ratings on the securities they hold. Making investors pay is also

likely to cause free-rider problems that reduce the incentive for research that generates quality

ratings in the first place31. A third is “to leave it to the market.” Models that use market prices to

extract default probabilities are very appealing but that presumes the existence of liquid

secondary markets for the underlying asset or some proxy of it that permits price discovery.

Credit derivative products are not close substitutes and the market price of a CDO tranche, when

it trades, may not shed much light on the likelihood of default of another. Nevertheless, stale

prices may be better than no prices at all. A fourth is to hold the agencies legally liable and/or

accountable for their ratings. A fifth argues that more disclosure of the processes used by the

rating agencies would enable investors to better evaluate their purchases. Raters should describe

the products that are being rated, the criteria used for rating and acknowledge the shortcomings

in their models32. A sixth proposal that is gaining some traction is an amalgam of the issuer pays

model that addresses some of the problems with conflict of interest and competition. An issuer

desirous of a rating would pay the fee to a regulator (rather than directly to the rating agency)

and the regulator would then assign one of several rating agencies to make the determination of

credit quality. The choice of rating agency could be random or depend upon the complexity of

the transaction and the rater’s ability to deal with that complexity.

30 Dominion Bank Rating Services (DBRS), a Canadian rating agency took 13 years to break into the US ratings market. As part of this process, they rated ABCP trusts in Canada and elsewhere, a rating that the big three, S&P, Moody’s and Fitch declined to provide.

31 Raters do appear to be aware of this possibility and address it by providing free access to some information.

32 See the October 2007 issue of the Financial Stability Report from the Bank of England.

20

Regardless of the eventual outcome of these considerations, it is important to recognize that

concerns about rating agency involvement were also raised during past financial disruptions.

Conflicts of interest among financial intermediaries are a necessary consequence of business and

will continue to pose challenges for the management of resultant financial and reputational risks.

These should be considered carefully in creating an environment for due diligence by investors.

4.5. Securitization and the regulation of derivative contracts.

The reluctance to regulate is visible most clearly in the history of derivatives regulation.

Whether to permit off-exchange activity and how to regulate on-exchange activity has been a

pressing concern throughout this history. Since credit securitizations are so closely linked with

derivatives, this section first provides a brief post-Depression overview.

4.5.1 Regulation prior to 2000.

Regulation of exchange-traded futures contracts on agricultural commodities was the purview of

the Commodity Exchange Act (CEA) of 1936.33 Under the Commodity and Futures Trading

Commission Act of 1974, the CFTC became the new regulator whose role was expanded to

include all exchange-traded futures contracts including financial futures. Off-exchange futures-

type transactions could be deemed illegal. The adoption of a proposal from the U.S Treasury,

called the Treasury Amendment, resulted in the exclusion of forward contracts such as those in

foreign currency markets from regulatory supervision by the CFTC. 34

The subsequent rapid growth of interest rate swaps in the 1980’s gave rise to renewed concerns

about the CFTC’s ability to ban over-the-counter activity in these instruments. This issue of legal

certainty persisted despite several soothing statutory interpretations from the CFTC. A provision

in the Futures Practices Act of 1992 eventually granted the CFTC the right to exempt off-

33 The primary motivation purpose behind this regulation was to dampen price volatility by monitoring speculator ability to manipulate prices.

34 The thinking, summarized nicely in a speech by Federal Reserve Chairman Greenspan in 1997, was that foreign currency markets were different from agricultural markets in that they were deep and difficult to manipulate. Therefore regulating them was “unnecessary and potentially harmful.”

21

exchange transactions between “appropriate persons” from the exchange-trading requirement of

the CEA. This right was almost immediately exercised in the context of interest-rate swaps.

Concerns about the interest-rate swap market still continued amidst turf battles in 1997-98

between the SEC and CFTC on how to regulate the broker-dealer firms in this market. A

Presidential Working Group was formed comprising the Chairman of the Federal Reserve, the

Chairpersons of the CFTC and the SEC and the Treasury Secretary. At this time, events

pertaining to Long Term Capital Management (LTCM) and their leverage in the OTC derivatives

markets came to light. After multiple hearings and a bailout of LTCM orchestrated by the

Federal Reserve, the Commodity Futures Modernization Act of 2000 was signed into law.35

4.5.2 The Commodity Futures Modernization Act (CFMA) of 2000.

It is well known that under the CFMA, over-the-counter derivative transactions between

“sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act

(CEA) of 1934 or as “securities” under the federal securities laws. This fragmented regulation

implied instead that banks and securities firms who are the major dealers in these products would

instead be supervised under the “safety and soundness” standards of banking law. A new

Section 2(h) of the CEA created the so-called Enron “loophole” that excluded oil and other

energy derivatives from CEA requirements of exchange trading. In addition, Title 1 of the

CFMA specifically excluded financial derivatives on any index tied to a credit risk measure. The

Act provided even further impetus for credit derivatives markets to engage in risk transfer

activities pursuant to securitization.

In August 2009, after the financial crisis and the collapse of securitization, regulation took a 180-

degree turn when the US Treasury proposed legislation that essentially repeals many of the CEA

exemptions above and argues for an exchange-traded credit derivatives market.

4.5.3 Fostering an exchange-traded credit derivatives market.

35 A 2009 documentary on Frontline titled “The Warning” describes the 1997-98 conflicts between Brooksley Born, the Chairwoman of the CFTC and the other members of the Presidents Working Group. The former was in strongly in favor of regulating OTC derivatives but the other members, who were opposed to any regulation, prevailed.

22

The complexity and opacity of over-the-counter credit derivatives markets and their purported

role in several scandals in the headlines makes them obvious candidates for financial reform

agendas. One possible solution with multiple adherents that is currently making its way through

Congress borrows from the Commodity Exchange Act of 1936 which required that futures and

options trade on organized exchanges. The goal is to encourage the development of exchange-

traded derivatives markets for credit.

Exchanges have already created templates for and are making markets in trading credit products.

Credit futures commenced activity in March 2007 with a Eurex credit futures contract. Plans are

under way for NYSE-Euronext to created standardized CDS contracts to facilitate exchange

trading. In June 2007, the Chicago Mercantile Exchange (CME) launched its Credit Index Event

contract which is a fixed recovery CDS product36. Since 2009, the CME offers clearing-only

services for over-the-counter CDS products along with several founding members.37 The obvious

motivations for the exchanges are to profit from the volume of activity in these markets.

Currency derivatives markets also started over-the-counter and now trade in parallel on an

exchange platform and also provide some support for this recommendation.

Making credit derivatives exchange-traded has several advantages. First, by interposing itself

between the buyer and the seller, the clearing-house reduces counterparty risk. As an

independent entity, the clearing-house is also separate from the counterparties, unlike over-the-

counter settings, where presently, investment and commercial banks make a market as well as

take on credit risk exposure. Second, clearing-houses are generally well capitalized and their

credit-worthiness is less likely to be called into question. Third, exchange trading makes it

possible to view market prices clearly. If the underlying securities are complex and hard to value,

then market activity may be light and prices may be stale, but that may be still be preferable to

having no prices at all. Fourth, exchanges impose a settlement or a mark-to-market reconciliation

of the exposures of the two parties on a daily basis. In contrast, mark-to-market practices in OTC

36 Since the CDX and iTraxx products described in 3.3.5 above are branded, the CME has created its own index of underlying reference entities.

37 See CME Group Launches Credit Default Swap Initiative; Begins Clearing Trades, Chicago-PRNewswire-First Call, Dec 15, 2009.

23

derivatives are less frequent and likely to be more contaminated. For instance, hedge funds often

carry leveraged positions at cost. Some OTC desks keep the books on an “accrual” basis38. A

disposition effect comes into play and losses are “accrued” while gains are marked-to-market

immediately. Fifth, the contracts can be standardized, along the lines of the ISDA, but

incorporating default events that may be unique to the legal environment in the local market.

Finally, such an exchange-traded credit derivative market is more likely to preserve the benefits

of securitization along with a much-needed increase in transparency and an observation of

market prices. Indeed it is the last feature that appears to be the sticking point as traders are

reluctant to forego past practices. It should also be noted that crises can and have happened in

exchange traded markets as well.

5. Towards more effective regulation.

Recurring concerns about asymmetric information and systemic risk have always caused society

to fret about banking regulation. Its effectiveness is even more critical in this new world of

mass-produced structured finance technology, credit risk transfer, ratings dependence and hedge

funds. As documented above, this complexity is also reflected in the accounting and regulatory

standards required for effective oversight with rules for determining controlling financial

interest, and Basel II guidelines for determining capital requirements becoming extremely

detailed. Events of the past few years provide the most comprehensive evidence to date that

many of these rules were a day late and several dollars short.

5.1 The Covered Bond Alternative

In Europe, structures similar to securitizations have increasingly been conducted using “covered”

bonds, from thePfandbrief in Germany, the Obligations Foncieres in France and the Cédulas

Hipotecaria in Spain. Simply stated, holders of covered bonds have a preferential claim on the

collateral assets in the event of default of the originator. The claim is supported by a legal regime

created specifically for this purpose. Assets are maintained in separate, easily identifiable pools

38 Anecdotal evidence suggests that, at times, mark-to-market practices are postponed if the transactions will not be unwound until expiration.

24

and remain on the balance sheet of the issuer. Exposure to credit risk is retained with the issuer,

thereby aligning the incentives of the issuer and the investor. While in principle, the covered

bond alternative holds some promise, the escalating situation of government debt in the PIIGS

countries does not provide any solace for this alternative.

5.2. Principles-Based Regulation.

In general, rules enable a checklist mentality towards monitoring compliance and enforcement,

with frequent revisions to existing guidelines and interpretations of current guidelines creating a

vicious cycle. Market participants detect loopholes in existing laws and devise innovative

methods to exploit them39. Regulators step in to remove these loopholes and in the process,

inadvertently create new ones. Indeed it is the very nature of regulation that regulators have to

play catch-up to those they seek to regulate. As Caprio et al. (2007) point out, the profit-

maximization incentive of regulatees will create rapid and creative responses to earlier regulatory

proclamations. In recognition of these dynamics, regulatory agencies in both the UK and

Canada have begun to move towards principles-based or “light-touch” regulation.

In this approach, broad principles of governance are articulated, rather than an attempt at micro-

management. The common example that is used to illustrate the difference in these two

approaches is with reference to how driving conduct is regulated. A rules-based approach would

state a speed limit of 65 mph and a traffic officer would issue speeding tickets if a driver was in

violation of that rule. A principles-based approach would merely state that a driver would drive

in a manner that was reasonable and prudent under the circumstances. In the latter context,

factors such as time-of-day, road, traffic and weather conditions, as well as the experience of the

driver would go towards determining prudent conduct. At a legislative level, the goal is one of

promoting prudent driving practices while a lower level works out the details of how those

practices would be implemented.40 In a sense, this is a form of enforced self-regulation.

39 In 2002, J.P.Morgan won three awards for innovation from Risk Magazine-Derivative House of the Year, Interest Rate Derivatives House of the Year and Credit Derivatives House of the Year. The contributions cited include a description of a “FASB-busting” solution to hedge anticipated changes to foreign currency income.

40 In 2001, the Financial Services Authority (FSA) in the UK developed a set of 11 high level Principles of Business that it uses extensively.

25

Most descriptions of principle-based regulation make it appear as if it is the polar opposite of

rules-based regulation. While this may be the correct view if one takes Sarbanes-Oxley as the

epitome of rule making, there is no reason why the two cannot exist at the same time. In the US,

practices that adhere to the Prudent Man Rule and the Business Judgment rule are largely

principles-based. Even in the area of securities regulation, the SEC’s approach relies more on

rules while the CFTC leans towards principles. Furthermore, principles may be more

appropriate for certain types of business but not other types. However, regulator behavior in a

principles-based setting can also become arbitrary and create a tendency to go after entities with

deep pockets. Nevertheless, the promise of a principle-based framework is that it may be less

likely to cause mis-directed innovative activity and let it proceed relatively unhampered.41

5.3 Welfare implications.

Activities of the welfare state are usually taken to imply government spending that supports

education, health, pensions, unemployment and providing social safety nets for citizens of

advanced economies. As the paper documents, securitization activities in the US have been

driven by social policies that include broadening homeownership and easing the credit available

to citizens. In addition, some have argued that the ability of banks to securitize a large portion of

their loans has resulted in lowering their cost of funds. Securitization’s ability to repackage cash

flows and make them appear less risky is, at one level, a market imperfection and the attendant

gains to arbitrage from exploiting them is one of the costs. A larger cost is the government

guarantee to the GSE’s that resulted in their conservatorship in 2008 and the eventual bailout of

the shadow banks. Moral hazard arguments would suggest that these implicit guarantees actually

increased risk taking behavior.

Even if we grant that some of these costs are/were acceptable in normal times, the inescapable

fact is that the “abnormal” collapse of securitization and the subsequent bailout of the many

associated financial institutions resulted in the socialization of these costs with the potential for

41 The SIFMA, the CME group and Treasury Secretary Paulson were all early supporters of some form of principle-based regulation to deal with the financial crisis.

26

their transfer to future generations.42 Simply stated, the issue is really whether the government

should be so closely involved in programs designed to broaden homeownership and access to

credit for its citizens. However, the complexity of the transactions in a securitization has

effectively meant that a broader social conversation of the tradeoffs from securitization can

hardly take place in the public sphere. The inexorable growth of innovation implies that a return

to a simpler regime is highly unlikely. In any event, such a regime will always find opposition

from those quarters that generate wealth from opaqueness. Efforts to reduce complexity and

bring transparency into the “shadow” banking system are laudable first steps.

The role of regulation in enabling these social goals is a little more complicated. One of the main

arguments supporting self-regulation has been that reputational considerations would cause large

institutions to behave themselves. The collapse of Lehman, Bear Stearns, and the recent scandals

with Goldman Sachs suggests that such reliance was misguided. It is equally obvious that the

efforts of rules-based regulation to rein in the excesses of securitization have failed as well. It

could be argued that this failure was unavoidable in an era where the prevailing philosophy has

been one of deregulation. In such an environment, political expediency and the power of the

banking lobby may have resulted in compromises that render these regulations somewhat

toothless. Perhaps in belated recognition of these circumstances, one of the current proposals

being debated in Congress is a clearer specification of the level of risk retention by originators in

securitizations. For such rules to be effective however, they should not be pronounced in

isolation, but rather as part of broad principles with harsher penalties in the event of their

violation. At present, with the rather tenuous state of global financial markets, the focus appears

to be more on firefighting rather than a concerted effort at addressing this big picture.

6. Conclusions.

The paper describes the process of asset securitization and its attempts to manage interest rate

and credit risk as it operates within (and tries to circumvent) the prescriptions of accounting,

legal and banking regulations. The role of securitization to the banking business is viewed from

its location on a lender risk continuum. Securitization was viewed as a middle ground between

42 Of course this depends on the extent to which the hold-to-maturity approach of the Federal Reserve is successful.

27

an extreme banking entity that held all the loans it originated and another extreme entity that

distributed all originated loans. The exact amount of risk retention by securitization sponsors has

been masked in the bankruptcy remote character of true-sale accounting, off-balance sheet

transactions, circumventions around the consolidation of financial statements, and the magic of

ratings. The paper then identifies the different aspects of rules-based regulation that attempted to

rein in the excesses of complex securitizations.

It is clear that securitization activities have greatly benefited by the hubris of the prevailing

political philosophy of deregulation. The concern in those quarters is that the “gains” to market-

based solutions will be reversed due to shifting investor sentiment and their reaction to the

frequency with which vested interests appear able to profit from the system. Whether “this time

is different” or not, the inescapable fact is the significant amount of debt on government balance

sheets and that private debt has been socialized. Any cost-benefit analysis of securitization

should compare the societal benefits of home-ownership and the ease of access to credit with the

cost of this never-ending bailout. Such an analysis will aid in determining the optimal location of

securitization in the conceptual risk continuum described in the paper. The paper urges that a

focus on the political economy of securitization is what is necessary to continue the ongoing

experiment we call capitalism.

28

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31

Figure 1Securitization rates as a proportion of MBS issuance

32

Figure 2

The structure of securitization

Trades Assets Insures Tranches

True-sale assets funds from Bond sales

Funds payments from pool

Collects CF from pool Oversight

INVESTORS

Source: Adapted from Fender and Mitchell (2009)

Originator(sponsor, pools assets)

Asset Manager Man

Guarantor

SPECIAL PURPOSE VEHICLE Assets | Liabilities

Loans

Mort-gages

Bonds

TrusteeServicer

Senior

Mezzanine

Equity

33