TB0257Copyright © 2010 Thunderbird School of Global Manage.docx

TB0257
Copyright © 2010 Thunderbird School of Global Management.
All rights reserved. This case was prepared by Drs. F. John
Mathis
and Frank Tuzzolino, Professors of Global Finance at
Thunderbird, and Mr. Venkat Ramaswamy, Managing Director
of Srinidhi
Capital Management in India, and a practicing expert in
structured finance for the purpose of classroom discussion only,
and not
to indicate either effective or ineffective management.
F. John Mathis
Frank Tuzzolino
Venkat Ramaswamy
Global Financial Crises and the
Future of Securitization
Background
Rajani Ramaseshan, an outstanding graduate of an MBA
program at a major U.S. university, was a global finance
specialist. Before he graduated, Rajani had spent a summer on
an internship at Citibank (now called Citi) in
their asset-backed securities area learning about the structuring
of mortgage-backed securities. Rajani’s career
goal was to secure a position structuring securitized products at
a major global bank’s capital markets area or at
an investment bank.1 Rajani took every graduate course he
could on structured finance, with a focus on securi-
tization. He had studied global capital and equity markets, and

learned about the new instruments impacting
both corporate treasury and global investment management. He
had also studied global portfolio management
to better understand the changing trends in what investors
wanted and why.
He landed a position with one of the top structured finance
shops on Wall Street after graduation. In 2003,
Rajani was recruited by HSBC Americas to work in New York
as an associate and, after a two-year rotation pro-
gram, he joined the global corporate lending division covering
major multinational corporations headquartered
on the east coast of the United States.
In his new position, Rajani was pitching ways for major
corporations to benefit from using securitized
financial instruments to better market their products globally,
gain market share, and grow their corporations
competitively. Securitization reduced companies’ cost of
funding, gave them immediate cash for their sales, pro-
vided some tax benefits, and reduced their receivables. Within
two years, Rajani was promoted to vice president,
and his career was accelerating rapidly. He honed his skills in
marketing securitized products in support of the
strong growth in corporate profits driven by the continuing
global economic expansion. All seemed well.
Then, in late January 2007, the major financial newspapers
began reporting on problems in the U.S.
housing industry and fears that the four-year growth bubble in
housing prices might burst. Mortgage-backed
securities were a major segment of the structured finance
market, and there was growing concern on Wall Street,
at the Federal Reserve, and the U.S. Treasury of a possible
shock to this part of the financial market. Rajani had
developed a close working relationship with the head of the

structured finance area at HSBC, and both were
increasingly concerned about the viability of subprime
mortgages in the mortgage-backed securities market. As
Rajani called his colleagues at Citi and JPMorgan/Chase on
several occasions over the next couple of months, he
learned that they also had growing anxiety about what was
happening in this massive and still rapidly expanding
segment of the capital market.
By June 2007, financial markets were in a state of turmoil, and
the picture was deteriorating rapidly day by
day. Rajani’s corporate clients, who had used securitized
products so effectively to boost sales and profits, were
1 Securitization involves the pooling of assets and the
subsequent sale to investors of claims on the cash flows backed
by
these asset pools.
For the exclusive use of A. Contreras, 2020.
This document is authorized for use only by Ashley Contreras in
FINA 5330/MBA 5330-International Finance-1 taught by
SIDIKA BAYRAM, University of St Thomas - Houston from
Nov 2019
to May 2020.
2 TB0257
calling regularly, and Rajani did not know what to tell them
other than that the structured finance market was
not functioning well because of the increasing subprime
defaults. Neither Rajani nor anyone else knew what
would happen next. Until the crisis was resolved, the structured

finance market would likely remain closed to
even the best corporate transactions. But no one seemed to
know how long that would take. Rajani was not sure
what his corporate customers would do in the meantime.
Furthermore, Rajani worried about the longer-term
viability of the structured finance market. What had gone
wrong, and could it be corrected?
A more fundamental concern to the bank and Rajani’s clients
was the use of securitized products in the
future. Would government regulations make it so costly that
they would no longer be used? See Exhibit 1 for
recent activity as reported by IMF.2
Rajani was assigned by his direct report to allocate a couple of
days to researching recent financial crises
in order to acquire a deeper understanding of the factors that
had caused the 2007-2009 crisis and how past
crises had been resolved. Thereafter, Raja was requested to
prepare an analysis and report on the future viability
of securitization. He identified three major recent crises prior to
the current one: the Asian foreign debt crisis
in mid-1997; the collapse of Long Term Capital Management in
1998-2000; and the technology equity bubble
in 2000.3
What is Structured Finance?
Structured finance is a process of changing the structure of cash
flows and distributing default risk by aggregat-
ing debt instruments in a pool. The pool is then divided into
portfolio tranches (differing amounts of risk in a
deal), and then the tranches are securitized and issued as new
securities backed by various forms of credit and
liquidity enhancements. Structured finance began to emerge in
the 1970s building on an old practice of dis-

2 See International Monetary Fund, Global Financial Stability
Report: Sovereigns, Funding, and Systemic Liquidity, October
2010.
3 Rajani did a Google search and found summary briefs of the
crises in Wikipedia and Investipedia, which have been further
condensed in this case to provide a summary perspective on the
crises and their causes. Nicholas Dunbar, Inventing Money,
Wiley, 2000, is also an excellent reference source for more
detailed insights.
Exhibit 1. Dramatic Decline in Structured Product Market
CDO = collateralized debt obligation; CDO2 = collateralized
debt obligation-squared and CDOs
backed by asset-backed securities (ABS) and residential
mortgage-backed securities (RMBS).
Source: IMF staff estimates based on data from JPMorgan
Chase & Co.; Board of Governors of
the Federal Reserve System; and Inside Mortgage Finance.
Nov 2019
to May 2020.
TB0257 3
counting, factoring, and forfeiting of receivables and trade
finance. It was modified following the global foreign
debt crisis in the mid-1980s when securitization was added as a

way to convert debt into equity. Then, in the
1990s, structured finance evolved further by incorporating
financial engineering to structure products to fit the
risk and cash flow preferences of investors. Complex asset
diversification structures emerged, including a variety
of credit and liquidity enhancement techniques. In addition,
Credit Default Swaps (CDS) were incorporated to
customize the end security to suit the cash flow needs and risk
appetite of an expanding investor base. In 2007,
more than $1 trillion in structured credit was issued and, at its
peak, the estimated outstanding amount of the
market exceeded $4 trillion in the U.S. and $1 trillion in
Europe.
During the 2000s, the focus of structuring products shifted to
volume and achieving economies of scale
in order to lower the overall cost of originating loans. This
drove the need to expand the sources of cash flow
to include more types of assets beyond mortgages, autos, and
credit cards. It also promoted the development of
synthetic products. What emerged was a variety of very
complex financial instruments employing sophisticated
credit risk models to determine how to structure the pooled
assets to achieve the desired risk profile and cash
flow to the investors. In what is often called the Cash Flow
Waterfall mechanism (because of its cascading effect
between asset classes), if losses begin to rise, the flow through
the tranches threatens the lower rated equity and
mezzanine tranches first. For example, normally in a
Collateralized Debt Obligation (CDO) structure, if 7%-8%
losses occur then securities below a Ba rating are wiped out;
13%-15% losses wipe out all Baa and below-rated
securities, and 11%-14% losses on subprime mortgage-backed
securities wipe out everything from single A
tranches down.

The Role of Structured Finance in Financial Crises
Four significant global financial crises have occurred since
1997, during which time the widespread use and de-
velopment of structured products expanded rapidly. What
follows is a brief review of the causes, what happened,
the role of securitization if any, and what was done to end the
crises.
Asian Financial Crisis—The Asian financial crisis hit most of
Asia in 1997 and raised concerns that it would
become a global crisis. The crisis was primarily the result of
excessive foreign debt levels and rising foreign debt
service payments which spilled into the domestic economy with
excess leverage ratios supporting real estate
speculation. The turning point was triggered in Thailand with
the collapse of the Thai baht as the government
depegged its currency from the U.S. dollar. The collapse of the
Thai currency was driven by the accumulation of
foreign debt with short maturities which could not be serviced.
Contagion carried the crisis to Southeast Asia and
Japan, resulting in depreciating currencies, devalued equity
markets, and falling asset prices. The International
Monetary Fund (IMF) intervened with a $40 billion currency
stabilization policy for South Korea, Thailand,
and Indonesia. It came with conditions, of course. The IMF’s
restrictive economic policy required a reduction
in government spending in order to reduce deficits, an increase
in interest rates, and encouraged governments
to allow bank failures. This caused a worsening of the crisis as
governments failed to service their foreign debts.
After a period of significant financial, economic and political
restructuring, and major high-growth sector
bankruptcies, the economies gradually recovered after 1999
from the serious growth disruption, but the coun-
tries involved offered strong criticism of IMF policies. Their
governments began to follow a policy of building

international reserves to avoid any future need to have to rely
on IMF support. This crisis had nothing to do
with structured finance.
Long Term Capital Management (LTCM)—LTCM was founded
in 1994 by John Meriwether, the former vice-
chairman and head of bond trading at Salomon Brothers.4 The
members of the Board of Directors of LTCM
included Myron Scholes and Robert C. Merton, who jointly
received the 1997 Nobel Prize in Economics.
Meriwether chose to start a hedge fund to avoid the financial
regulation imposed on more traditional invest-
ment vehicles. LTCM was initially very successful, achieving
annualized net returns less management fees of
more than 40%.
4 John Meriwether headed Salomon Brothers’ bond trading desk
until he was forced to resign in 1991 when his top bond
trader, Paul Mozer, admitted to falsifying bids on U.S. Treasury
auctions. Though Meriwether was not directly implicated,
calls for his ouster rose within the company, and he resigned
before he was to be let go. See Nicholas Dunbar, Inventing
Money: The Story of Long-Term Capital Management and the
Legends Behind It, New York: Wiley, 2000.
Nov 2019
to May 2020.
4 TB0257

The fund’s operation was designed to have extremely low
overhead; trades were conducted through a
partnership with Bear Stearns, and client relations were handled
by Merrill Lynch.5 The company used complex
mathematical models to take advantage of fixed income
arbitrage deals (termed convergence trades), usually
with U.S., Japanese, and European government bonds.
Government bonds are a “fixed-term debt obligation,”
meaning that they will pay a fixed amount at a specified time in
the future.6 For instance, differences in the
bonds’ present value are minimal, so, according to economic
theory, any difference in price will be eliminated
by arbitrage. To note, price differences between a 30-year
Treasury bond and a 29-and-three-quarter-year-old
Treasury bond should be minimal—both will see a fixed
payment roughly 30 years in the future. However, small
discrepancies arose between the two bond types because of a
difference in liquidity.7 By essentially buying the
cheaper 29-and-three-quarter-year-old bond and shorting the
more expensive, but more liquid, 30-year bond
just issued by the U.S. Treasury, it would be possible to make a
profit, as the difference in the value of the bonds
narrowed when a new bond was issued.
As LTCM’s capital base grew, its managers felt pressed to
invest that capital, but had run out of good bond-
arbitrage bets which led LTCM to undertake more aggressive
trading strategies. By 1998, LTCM had extremely
large positions in areas such as merger arbitrage and S&P 500
options (net short long-term S&P volatility).
LTCM had become a major supplier of S&P 500 Vega, which
had been in demand by companies seeking to
essentially insure equities against future declines.8 Because
these differences in value were minute—especially for
the convergence trades—the fund needed to take highly

leveraged positions to make a significant profit.
At the beginning of the year, the firm had equity of $4.72
billion, and had borrowed more than $124.5
billion with assets of around $129 billion, for a debt-to-equity
ratio of about 25 to 1. It had off-balance sheet
derivative positions with a notional value of approximately
$1.25 trillion, most of which were in interest rate
derivatives such as interest rate swaps. The fund also invested
in other derivatives such as equity options.
Factors giving rise to the downfall of the fund were rooted in
the 1997 East Asian financial crisis, which
had a role in precipitating the subsequent Russian financial
crisis later in 1998. In May and June 1998 returns
from LTCM had declined to -6.42% and -10.14% respectively,
reducing their capital by $461 million. This was
further aggravated by the exit of Salomon Brothers from the
arbitrage business in July 1998. Such losses were
accentuated because of the Russian financial crisis in August
and September 1998, when the Russian government
defaulted on its government bonds. Panicked investors sold
Japanese and European bonds to buy U.S. Treasury
bonds. The profits that were supposed to occur as the value of
these bonds converged became huge losses as the
value of the bonds diverged. By the end of August, the fund had
lost $1.85 billion in capital.
After LTCM failed to raise more money on its own, it became
clear that it was running out of alternatives.
In September, Goldman Sachs, AIG, and Berkshire Hathaway
offered to buy out the fund’s partners for $250
million, to inject $3.75 billion, and to operate LTCM within
Goldman’s own trading division. The low offer
was not accepted.9 With no other offers available, the Federal
Reserve Bank of New York organized a bailout of

$3.6 billion from the major creditors to avoid a wider collapse
in the financial markets.10
The contributions from the various institutions were as
follows:11 $300 million from each of the following—
Bankers Trust, Barclays, Chase, Credit Suisse First Boston,
Deutsche Bank, Goldman Sachs, Merrill Lynch, JP-
Morgan, Morgan Stanley, Salomon Smith Barney, UBS; $125
million from Société Générale; and $100 million
from Lehman Brothers and Paribas. Bear Stearns declined to
participate. In return, the participating banks got a
90% share in the fund and a promise that a supervisory board
would be established. LTCM’s partners received a
10% stake, still worth about $400 million, but this money was
completely consumed by their debts. The partners
once had $1.9 billion of their own money invested in LTCM, all
of which was wiped out.12
5 Both Bear Stearns and Merrill Lynch would have to be taken
over by other banks to prevent their collapse in the subprime
loan crisis in 2007-2009.
6 Dunbar, p. 80.
7 Ibid., p. 98.
8 Roger Lowenstein, When Genius Failed: The Rise and Fall of
Long-Term Capital Management, Random House, 2000, pp.
124-125.
9 Ibid., pp. 203-204.
10 Frank Partnoy, Infectious Greed: How Deceit and Risk
Corrupted the Financial Markets, Macmillan, 2003, p. 261.
11 Wall Street Journal, September, 25, 1998; and, on the same
day, bloomberg.com:exclusive news report.
12 Lowenstein, pp. 207-208.

Nov 2019
to May 2020.
TB0257 5
The fear was that there would be a chain reaction as the
company liquidated its securities to cover its debt,
leading to a drop in prices, which would force other companies
to liquidate their own debt, creating a cycle.
Some industry officials said that the Federal Reserve Bank of
New York’s involvement in the rescue, however
benign, would encourage large financial institutions to assume
more risk, in the belief that the Federal Reserve
would intervene on their behalf in the event of trouble. The
Federal Reserve Bank of New York actions raised
concerns among some market observers that it could create
moral hazard.13
In all, LTCM lost about $4.6 billion in less than four months in
the market turmoil that preceded Russia’s
default on its debt, because of its highly leveraged investments
in high-risk instruments and in Russia. LTCM
went out of business in early 2000. What did these extremely
bright experts miss, or was this an example of
misdirected greed? This crisis had nothing to do with structured
products.
The Technology Equity Price Bubble—The tech, or dot-com,
bubble occurred during 1998-2000 and peaked
on March 10, 2000, with the NASDAQ hitting an all-time high
of 5,132.52. Equity markets in industrialized
nations experienced a rapid price rise from growth in the “new”

Internet sector and Web technology-related fields
in the 1990s.
A combination of rapidly increasing stock prices, market
confidence that the companies would turn future
profits, individual speculation in stocks, and widely available
venture capital funding created an environment in
which many investors were willing to overlook traditional
performance metrics such as price-to-earnings ratio
in favor of unsubstantiated confidence in sales of technological
advancements.
Venture capitalists saw sharp rises in stock valuations of dot-
com companies. Low interest rates in 1998-99
made it easier for dot-com borrowers to increase the amount of
their start-up capital. Although a number of these
new entrepreneurs had realistic plans and management ability,
many more of them lacked the required business
skills, but were able to sell their ideas to anxious investors with
ready cash to invest.
A basic dot-com company’s business model relied on operating
at a sustained net loss to build potential
market share. These companies expected that they could build
enough brand awareness to charge profitable rates
for their services later. During the loss period, the companies
relied on venture capital, and especially initial public
offerings of stock, to pay their expenses. The novelty of these
tech stocks, together with the difficulty of valuing
these companies, sent many stocks to unrealistic heights,
making the dot-com owners rich on paper in a short
period of time.
Then in 1999 and early 2000, the U.S. Federal Reserve
increased interest rates repeatedly, and the economy
began to slow. The dot-com bubble burst in March, 2000, when

the technology-heavy NASDAQ composite index
peaked at more than double its value just a year before. The
herd effect of investors, funds, and institutions liqui-
dating positions resulted in the index falling by nearly 9%, to
4,580, in one week. In addition, the bursting of the
tech bubble also may have been aggravated by the passing of
the Y2K scare in January 2000 and the poor results
of Internet retailers released in March following the 1999
Christmas season. By 2001, the bubble was deflating
at full speed, and a majority of the dot-coms stopped trading
after burning through their venture capital, with
many having never made a profit. Once again, this crisis was
not the result of the use of structured products.
The 2007-2009 Financial Crisis Hits—Since the 1929 stock
market crash, which led to the Great Depres-
sion, the world had not experienced such a serious financial
market breakdown as that which hit in 2007. High
unemployment and lack of growth devastated global financial
and economic markets.14 The crisis started in the
United States with defaults on subprime loans triggered by the
Fed raising interest rates and tightening credit,
resulting in a bursting of the housing price bubble. This was
followed by the upward adjustment of low teaser
interest rates on adjustable rate mortgage loans to subprime
borrowers who were not able to pay the higher inter-
est rates. Although subprime mortgages accounted for less than
20% of total mortgages in the U.S., delinquen-
cies, defaults, and foreclosures spread rapidly. The decline in
home prices by as much as 30% to 50% in some
13 General Accounting Office, GAO/GGD-00-67R Questions
Concerning LTCM and Our Responses, February 23, 2000.
14 The crisis was so severe that several basic tenets of finance
were violated by the government in order to resolve it. For
example, risk-rating rules were violated regarding the security
of corporate debt as the first claim on corporate assets in the

event of defaults, and the concept of true sale was violated for
securitization.
Nov 2019
to May 2020.
6 TB0257
locations (California, Florida, Nevada, and Arizona),
accompanied by a sharp economic recession and rising
unemployment, amplified the spread of the defaults and
foreclosures beyond subprime loans.
Defaults increased on almost all mortgage loans, and then
spread to commercial real estate and consumer
loans, especially credit card debt. At the same time, equity
prices collapsed as investor recession fears rose, and
they sought liquidity. As the economy rapidly slowed, credit
card delinquencies jumped, followed by a sharp
rise in commercial real estate defaults during 2009. Following
four successive quarters of negative real GDP
growth in 2009, unemployment hit 10% by year-end. What had
started in the U.S. with subprime loans had
now become a worldwide collapse in economic activity.
Exhibit 2 shows the seriousness of the housing price decline and
adjustable interest rate mortgage problem
which resulted in defaults and foreclosures, particularly among
low-income homeowners—but the problem was

not confined to this income class. The interest rate adjustment
problem will continue until 2012 before the
volume of adjustable rate mortgages falls sharply.
Exhibit 2. Large Amounts of Interest Rate Adjustable
U.S. Mortgages Continue into 2012
(First reset in billions of U.S. dollars)
Source: Credit Suisse.
Nov 2019
to May 2020.
TB0257 7
Investigating the details of the failures associated with
subprime loans revealed that there were a number of
causes. The rapid growth that was experienced in the subprime
segment of the mortgage market did not allow
for the diligent training of new hires or the screening and
verification of new employees for their prior experi-
ence. Second, the lend-to-securitize high-volume model did not
demand care, consistency, and due diligence
in processing new borrowers. Third, mortgage originators
convinced themselves—and lenders—that housing
prices would continue to rise, creating positive equity for the
borrower. Fourth, greed drove originators to focus
on volume, not quality, resulting in fraud by some of the
originators to meet their goals. Examples of bad prac-

tices included no appraisal, no income verification, sometimes
even no documentation, and loan-to-value ratios
exceeding 100% of an undocumented value of the home.
In securitization, originated mortgages are sold to a structuring
institution, usually a bank, which then
divides the mortgages into tranches based on their structure,
expected performance, location, conforming or
nonconforming, and other criteria. The tranches are then
officially rated by one of the rating agencies. The
rating determines the amount of credit enhancement needed to
elevate the securitized structure to a triple A
(AAA) rating or other rating so that it can be sold to investors
requiring that risk level. The agency’s rating of the
tranche of mortgage cash flows determines the amount the bank
must spend on credit enhancement or default
insurance. So, there is little incentive for a bank to question the
rating agency’s historic approach to setting the
rating, even if the bank is aware that the mortgage loan may be
at a higher risk of default going into the structur-
ing process. Rating agencies, anxious for additional income,
were not diligent in assigning ratings to match the
lax loan conditions, and unquestioningly followed the guidance
of the structurer in setting the tranche rating
in order to generate more income.
Finally, in some cases, the banks involved in securitization
invested in the super-senior tranche, which
had Credit Default Swap (CDS) protection from any possible
risk of loss from default. Because of the explosive
volume of CDSs written by several major insurance companies,
when defaults rose, the insurance providers of
CDSs collapsed. In the case of American Insurance Group
(AIG), the CDS exposure was so large that it had to
be rescued by the U.S. government to prevent a possible
collapse of the global financial system. Banks were also

exposed directly, as noted below:
…because they warehouse assets to be subsequently
restructured into CDOs and SIVs and may have
to take (impaired) assets back on their balance sheets (into
inventory) as funding dries up for their
SIVs. Conduits also have credit lines from various banks
established for such contingencies and, as
these are drawn, banks are further drawn into loan exposure to
troubled entities.15 There is also a
concern that banks have lent to other groups such as hedge
funds (in some cases, they are the bank’s
own hedge funds) to invest in structured products in a levered
way.16
In the case of hedge funds not owned by the banks, but that
borrowed from prime brokers to fund their
purchase of the high-yielding risky CDO tranches, this resulted
in a further negative loss impact on major
commercial and investment banks. Finally, some of these hedge
fund investments had been done on margin. It
is estimated that hedge funds owned almost half of the synthetic
and cash CDOs (estimated at $1.4 trillion),
followed by banks at 25% (estimated at $750 billion).17
Major commercial and investment banks involved in mortgage
securitization sold structured products to
investors to remove loans from their balance sheet. They were
forced to take back these assets onto their balance
sheet to protect their reputation and avoid loss of confidence in
the bank. Thus, overnight, major banks found
themselves short of capital and short of loan loss reserves to
offset the jump in nonperforming loans. As these
banks tried to borrow from each other in the overnight LIBOR
market and from many other sources, liquidity
disappeared and interest rates jumped as confidence in the

banks vanished even among themselves.
Another reason that contributed to failure of major banks is
mark-to-market accounting treatment of assets
which undermined their liquidity. As demand for instruments
decreased, financial institutions refused to sell
these instruments, as the sale at a lower price would force a
write-down of other securities, adding illiquidity to
15 Adrian Blundell-Wignall, “Structured Products: Implications
for Financial Markets,” Financial Market Trends, OECP,
Paris, Volume 2007/2, No. 93, p. 43.
16 Ibid., p. 39.
17 Ibid., pp. 39, 45.
Nov 2019
to May 2020.
8 TB0257
the market. Following the crisis outbreak, the FASB revised and
set aside the mark-to-market requirement when
markets are not actively trading the securities.18
The resulting global banking and insurance liquidity and, in
some cases, solvency crises precipitated a
breakdown of the global capital and credit markets. As a result,
governments around the world took steps to inject
funds to rescue these financial institutions from collapse.

Several major U.S. banking institutions such as Bear
Sterns, Lehman Brothers, Merrill Lynch, Countrywide, and
Washington Mutual failed and were acquired into
other financial institutions with government support. Most of
the remaining major U.S. financial institutions—
including the giants Citi and Bank of America—were forced to
take government assistance, increase their capital,
and build loan loss reserves, as were other banks and investment
banks.
The Causes of the 2007-2009 Financial Crisis
The earlier crises that Rajani reviewed had two common major
characteristics: excessive liquidity, and excessive
leverage. The same causes appear to have precipitated the 2007-
2009 crisis. Financial innovation is often the
result of tax law changes, regulatory changes, excessive
liquidity, and low interest rates, which all tend to sup-
port rising leverage. In the case of the subprime loan crisis,
Congress eased the financing requirements of Fanny
Mae and Freddie Mac to expand home ownership to low-income
families whose real incomes had fallen during
the 1980s.19 There are benefits that resulted during the 2000s
subprime securitization growth period, including
expanded home ownership to lower income households,
corporate restructuring that improved productivity, and
risk transfer and dispersion to those that were better equipped to
hold the risk.20 At the same time, securitization
altered various aspects of risk analysis and management in
credit extension as it spread risk to remote investors.
Loan originators had less incentive to perform due diligence in
evaluating borrowing quality, and repayment
risk was transferred to someone else.21
Most financial market analysts identified three major factors
that triggered the 2007-2009 financial crisis.
First, shoddy and fraudulent practices by untrained and

unregulated mortgage originators. This was supported
by Congress easing the mortgage lending standards of Fannie
Mae and Freddie Mac, which are large U.S.
government-sponsored entities that purchased most conforming
mortgages. Second, failure by the rating agen-
cies to adequately rate the credit tranches that made up the
special purpose vehicles. And third, failure of the
banks that structured the products to adequately communicate
and protect themselves and the investors from
correlation and counterparty risk.
Focusing on specific developments in the U.S., there are two
broad categories of mortgage originators. First,
those that originate and retain the mortgage obligation on their
books as part of their loan portfolio.22 Second,
mortgage originators that originate and sell the mortgage
obligation to an institution which then securitizes
the mortgage-backed security to generate fee income, and
subsequently sells the structure to a Special Purpose
Vehicle (SPV)23 or Special Investment Vehicle (SIV).24
Mortgage originators that sell all they originate are generally
unregulated and not involved in credit risk
analysis. Instead, they normally originate to meet the specific
terms and conditions of the securitization pool or
18 John Heaton, Deborah Lucas, and Robert McDonald, “Is
Mark-to-Market Accounting Destabilizing? Analysis and
Implications for Policy,” Working Paper, University of Chicago
and Northwestern University, 2008.
19 Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still
Threaten the World Economy, Princeton University Press,
2010.
20 Blundell-Wignall, pp. 29-57.
21 Ibid., p. 30.
22 Many small and medium-sized banks like Hudson Bank, for

example.
23 A Special Purpose Vehicle is a legal entity usually created
by a bank engaged in structured finance into which a portfolio
of assets providing known cash flows are sold (“true sale” or
nonrecourse to the bank), and which then issues and sells
securities to investors backed by the cash flows of the
underlying assets. A Special Investment Vehicle is similar to an
SPV,
but has a greater degree of maturity mismatch between the
underlying assets providing the cash flows (e.g., mortgages) and
the instruments issued to investors (e.g., commercial paper). An
SIV is permanently capitalized and managed by a bank
originator.
24 Most large banks like Citi, HSBC, Bank of America,
JPMorgan Chase, and Deutsche Bank, and larger mortgage
institutions
such as Countrywide, now owned by Bank of America.
Nov 2019
to May 2020.
TB0257 9
SPV loan buyers. During the 1990s, Fannie Mae and Freddie
Mac eased their mortgage requirements to allow
the purchase of subprime, nonconforming loans, and together
their portfolio of securitized mortgages grew to
about $5 trillion. The purchase of these subprime mortgages was
encouraged and approved by Congress for the

purpose of increasing home ownership access to lower-income,
more diverse families. It achieved that objec-
tive, but with catastrophic delinquency results beginning in
2007 because of the impact of upward interest rate
adjustments and falling housing prices on the borrowers.
Mortgage origination became a volume-driven business with
little if any regulation by the federal or state
government. Loan processors were trained on the job with a
target number of weekly mortgages closed set for
each processor. The mortgage processor’s pay was driven by the
number of mortgages completed regardless of
loan quality. Soon, the size of the mortgage loan to home value
ratio exceeded 100% (the historic norm is 80%),
income verification of the borrower was omitted, and home
appraisals were conducted with drive-by inspectors.
Many of the subprime home buyers may not have even
understood that their mortgage payments would auto-
matically jump after the first year or after a certain period of
time.25 Given the number of legal actions taken by
the U.S. Department of Justice against some of the now-defunct
mortgage originators, fraud was also a likely
problem.
A second weak link in the mortgage supply chain was the rating
agencies’ poor assessment of the degree
of risk associated with the mortgages that were pooled into
credit tranches during the securitization process.
The ratings assigned to the credit tranches determined the cost
of credit enhancement for the securitizing bank.
The higher the credit rating, the lower the securitizing cost,
which resulted in a larger profit margin for the
securitizing bank. The rating process did not seem to change,
even as the numbers of subprime or lower quality
mortgage loans were added to the pool of tranched loans. As a
result, the Securities and Exchange Commission

(SEC) placed the rating agencies under investigation for failing
to accurately assess the risk associated with credit
tranches in mortgaged-backed securities. In addition, the SEC
began examining their association with major
banks and corporations in determining the risk of the debt
instruments issued by these entities.
The third commonly identified cause of the financial crisis was
the misuse of complex financial instruments
to boost earnings. Associated with this issue was the
compensation paid to the executives who participated in
activities that increased earnings but simultaneously amplified
risk. Banks that engaged in structured finance
operations took several actions that made them more vulnerable
to risk.
First, banks that decided to participate in structured finance in
order to stay competitive had to do it in
a massive way, and, once the process and support infrastructure
(people and systems) was in place, it was not
easy to shut it down because of its high fixed cost. Thus, the
larger the process, the greater were the economies
of scale. Structuring complex financial instruments better than
the competition would have required hiring very
technically competent executives that understood mathematics,
finance, credit, debt markets, risk management,
and pricing. The outstanding executives with all of these skills
and proven experience were very expensive and
in limited supply. In addition, there were the lawyers,
operations, and technology executives needed to execute
and manage these transactions through to maturity. Finally,
there had to be a sales force sophisticated enough
about the instruments to sell a constantly increasing volume of
customized and very complex instruments to
investors. The sales force also had to learn from investors what
they wanted (in terms of return, cash flow, and

risk level) and relay that information back to the experts that
did the structuring. So, once the securitization
machinery was in place, it had to be operated at full capacity to
achieve economies of scale and maximize profits
for the institution.
Second, some banks also thought that the return on these
assumed near-risk-free instruments made them
desirable investments, and so they were held by the bank. In
some cases, these super-senior instruments, rated
AAA by the rating agencies, were used to build bank capital so
the banks could make more loans. A super-senior
rating usually meant that a credit default swap (CDS) had been
established, so that if there were a credit default
on the underlying asset, the investor in the instrument would
recover lost funds from the buyer of the swap. In
most cases, the buyer was a highly leveraged hedge fund, a
bank, or an insurance company like AIG or other
monocline (single-purpose) insurer such as MBIA, Radian,
AMBAC, PMI, and MGIG. So, the higher return the
structuring bank was receiving depended on a rating agency’s
accurate assessment of the underlying risk, which
was questionable. It also depended on the counterparty risk of
the CDS default insurance provided by insurance
25 Financial illiteracy is estimated to be around 60%-70%, even
in the United States.
Nov 2019
to May 2020.

10 TB0257
companies that became oligopolistic providers of protection. In
effect, it was a case of risk piled upon risk piled
upon risk, all very highly correlated to a decline in housing
prices—the underlying asset and collateral.
Third, another issue for banks was the competitive
compensation packages they used to attract and retain
the executives who were responsible for generating a substantial
share of the bank’s profitability. The more cre-
ative and innovative an executive was in boosting the bank’s
competitive position and profitability, the larger the
bonus. Cash bonuses, as opposed to stock options, were risk
sensitive only in the sense that in a collapse such as
the one experienced in 2007, structured finance experts were
likely to lose their jobs. The CEO’s bonus, on the
other hand, was less risk sensitive because it was based on the
bank’s overall performance. In addition, in the late
1990s, stock options, which were exercisable only over time,
fell victim to regulatory disfavor leading to a cash
bonus approach. This, in effect, separated bonus compensation
from risk. As a result of the bank failures and the
government rescue, a Compensation Czar was created to control
compensation in banks receiving any form of
government support. Seeking higher—and unregulated—bonus
compensation, some bankers left government-
rescued banks and moved to institutions that paid more
generously.
Taking a broader international perspective, the 2007-2009 crisis
can be divided into related macroeco-
nomic and microeconomic causes.26 The macroeconomic causes
include problems associated with the buildup of

imbalances in international claims. The imbalances were a
result of the persistent low savings and large current
account deficits in industrialized countries, and high savings
with current account surpluses in emerging market
countries that created large capital flows from the latter to the
former. A second macroeconomic cause was the
difficulty created by the long period of low interest rates. The
low rates were most likely the result of fear of defla-
tion during the first half of the decade. However, persistent low
interest rates contributed to an underestimation,
and therefore an underpricing of risk.
The microeconomic causes included risk-taking compensation
incentives, inadequate risk measurement,
and lack of oversight, which have already been discussed. The
BIS (Bank for International Settlements) identified
four causes of the large macroeconomic capital flows which
transferred the securitized mortgage risk globally.
First, there was a global savings glut in emerging markets (i.e.,
China). Second, there were widespread investment
opportunities. Third was the fast-growing emerging market
countries’ desire for both international diversifica-
tion and low-risk liquid assets. And fourth, there was the
emerging market economies’ accumulation of foreign
exchange reserves to fight appreciation of their currencies due
to their large current account surpluses.27 There was
also an issue of mispriced risk of assets: “…if one country is
producing assets that are grossly mispriced (relative
to risk) and whose quality is lower than is generally perceived,
they can act as a virus carrying the disease abroad
from the country of issue.”28
The relative size and importance (trade and finance
interlinkages) of the U.S. economy and dominance
of the U.S. dollar in global transactions amplified the impact of
low interest rates in the United States. There

were a number of cascading consequences. First, low rates
resulted in a credit boom in a number of industrial
countries. Second, cheap credit supported the housing boom and
consumer credit expansion. Third, low inter-
est rates also increased the present discounted value of revenue
streams arising from earning assets driving up
asset prices (housing and stock prices). Fourth, with low
interest rates, investors took on more risk to generate
increased returns to create profits, probably because they
undervalued the cost of risk.29 The resulting boom from
these developments made macroeconomic policy management
more difficult because the high growth rates did
not have a solid foundation. High productivity growth in
technology, and then finance, resulted in bubbles be-
ing created in these sectors as well.
The Value and Importance of Structured Finance
In January 1992, a change occurred in how larger commercial
banks were regulated. This change was driven by
the Bank for International Settlements (BIS), an international
organization of the central bankers and ministers
of finance for the major industrial countries. The BIS Basel
Committee of Bank Supervision (Basel I), working
through the central banks of the major industrial countries, set
capital requirements related to credit risk for
26 Bank for International Settlements, 79th Annual Report,
Basel, June 29, 2009, Chapter 1, pp. 4-15.
27 Ibid., p. 5.
28 Ibid.
29 Ibid., p. 6.

Nov 2019
to May 2020.
TB0257 11
commercial banks. Large banks were required to have a
minimum of 8% capital backing their assets (loans).
Well-capitalized institutions normally had more than 10%
capital.
Each loan made by the bank had to be placed in one of four risk
categories. The higher the risk category,
the more capital a bank needed, up to a maximum of 8%. The
five risk categories and the capital required identi-
fied by the BIS were: 0% capital required against cash or claims
on the central government or central bank; 10%
capital on claims on public sector entities; 20% capital on
claims on multilateral banks; 50% on loans secured
by a mortgage on residential property; and 100% for any claims
on the private sector.
As a result of Basel I risk-adjusted capital adequacy rules, bank
profitability was reduced because of the
increased cost of capital associated with private sector lending.
Consequently, banks began to focus on growing
fee-based income or off-balance sheet activities to
accommodate private sector borrowers. From its tentative begin-
nings in the late 1970s, securitization became a vital funding
source with an estimated outstanding debt of more
than $4 trillion in the United States and $1 trillion in Europe as
of the end of 2009. Securitization is a structured
finance process that distributes risk by aggregating debt
instruments in a pool, then issuing new securities backed
by the pool. The debt instruments are sold to a trust via a

special purpose vehicle (SPV). SPVs are bankruptcy
remote, which means that in case a parent company goes
bankrupt, the creditors of a parent company cannot
claim the assets of SPV. The creation of SPV removes debt
instruments from the bank’s balance sheet and frees
up capital to support more loans. The result is an improvement
in the profitability of the bank because banks
earn fees from the securitization process, while at the same time
credit risk to the bank gets reduced. Through
the use of off-balance sheet conduits, securitization spreads the
risk pressures through different channels and
passes income to investors in a form that confers tax
advantages. Securitization also provides the private sector
with additional funding at a lower cost in support of economic
growth and job creation.
Securitization offers a number of benefits to the issuer. It
reduces the cost of funding by enabling the issuer
to borrow at AAA rates. Securitization can also confer a
reduction in the asset-liability mismatch by eliminating
or reducing funding exposure of duration and on a pricing basis.
Because securitization is a true sale of assets
from a legal and an accounting basis, it lowers capital
requirements by removing assets from the balance sheet.
For securitized assets, profits can be locked in for the company,
thereby providing budgeting certainty. Thus,
securitization provides the company with immediate liquidity by
removing the delay due to collections and at a
borrowing cost below what they would otherwise have to pay
based on their credit rating.
Securitization can also transfer various forms of risk to an
investor who desires the risk and is better able to
bear it. This provides the issuer with the opportunity to generate
more profits, and thereby restructure itself into
more profitable lines of business. Securitization does require

large-size transactions, and therefore is generally
not beneficial for smaller or medium-sized businesses.
Finally, if the assets are not securitized properly, then there are
risks to the issuer which include counter-
party risk and reputational risk. Various forms of credit
enhancements and cash flow protection also protect the
investor from specific adverse events. During the 2007-2009
financial crisis, however, an unexpected systemic
risk emerged, affecting both issuer and investors. Despite the
portfolio diversification and the credit and liquidity
enhancements to the securitized assets, there was a general
meltdown of securitization due to external economic
and internal financial market factors. As adjustable rate
mortgages jumped from very low teaser rates, home
prices fell and loan-to-value ratios deteriorated, limiting
refinancing. Then, as people began to be laid off and
lose most of their income, the default rate rose rapidly,
resulting in a movement up the waterfall tranche credit
stairs, until finally the cash flow of even the super-senior CDS-
backed tranche was called into question. Investors
stopped buying the securities sold via SPV or SIV, and the
securitization market came to a standstill, and by the
end of 2010, still had not fully recovered for residential
mortgages.
Uncertain Changes in Financial Services Regulation
With this crisis, the destruction of financial capital was
massive, rapid, and global. How to get out of the crisis
and reduce the probability of future crises is being discussed by
most governments and major international or-
ganizations. The global financial infrastructure and
interconnectedness of financial service providers is a major
issue that involves many interested parties: governments,
central banks, shareholders, taxpayers, bond holders,

Nov 2019
to May 2020.
12 TB0257
and depositors.30 Past solvency crises identify three steps
required to achieve recovery: insure deposits to prevent
runs on banks; remove bad assets from banks; and recapitalize
banks.31
While valuation of the bad assets, including the conduits, is not
easy, two approaches are possible: national-
ization (e.g., Resolution Trust Corporation—RTC), or an asset
management approach in which funds are either
sold in open market auction, bad assets are ring-fenced
(government guarantees a first loss amount), or strong
banks acquire weaker institutions. Some of the key issues faced
in defining future longer-term regulation include
separating high-risk from traditional banking, enlarging bank
capital buffers, adopting more stringent liquidity
requirements, strengthening consumer protection, and
improving financial education.
All approaches have disadvantages, and they all take time, as
has been learned from past banking crises.
Once the impaired assets are dealt with, the banks need to be
recapitalized, including a significant cushion of
adequate liquidity levels. Dynamic provisioning, liquidity
management and capital building are a remedy for

pro-cyclicality issues.32 They may also help control the risk of
cross-border contamination through financial
conglomerates.
Government’s regulatory reform of the financial system is
likely to focus, at a macroprudential level, on
reducing systemic risk and better detection. At the
microprudential level, which examines how financial institu-
tions operate, regulations are likely to focus on:
• preventing excess leverage
• addressing market discipline and information
gaps
• strengthening cross-border and cross-functional
regulation
• improving systemic liquidity management
• clearing facility and earlywarning exercises with
the Financial Stability Board
• reducing funding mismatches
• reducing counterparty risk
• making banks and instruments more transparent
• simplifying financial instruments from the pre-
crises period
Financial institutions will be required to improve risk
management systems and dedicate thorough atten-
tion to governance and remuneration policies.
Detecting systemic risk will require developing standard
financial soundness indicators that must include
forward-looking market data, recognition of the interlinkages
among banking institutions globally, a mechanism
for signaling capacity of proxies for market conditions and risk
appetite, and stress testing to ensure that financial
institutions are adequately prepared.

At the beginning of 2008, new accounting rule SFAS157
required banks to begin dividing assets into three
levels based on:
• Level 1: asset price, trading frequency,
and mark-to-market;
• Level 2: partly traded and mark-to-model;
and
• Level 3: bank judgment, including mortgage
securities,securitized credit card receivables,
LBO bridge
loans, complex derivative products, and the like33
The size of Level 3 assets and its growth would be audited
carefully by national bank supervisors, the BIS,
and IMF.
30 This section draws heavily on several reports that were
issued during 2009 by central banks, international
organizations,
and governments. A good summary of the different discussions
and positions is provided by Adrian Blundell-Wignall,
Paul Atkinson, and Se Hoon Lee, “Dealing with the Financial
Crisis and Thinking about the Exit Strategy,” Financial
Market Trends, OECD Journal, Volume 2009/1, pp. 11-28; and
Gert Wehinger, “The Turmoil and the Financial Industry:
Developments and Policy Responses,” Financial Market Trends,
OECD Journal, Volume 2009/1, pp. 29-60.
31 Ibid., p. 13.
32 Ibid., p. 23.
33 Blundell-Wignall, pp. 46-47.

Nov 2019
to May 2020.
TB0257 13
Reducing systemic risk would require better macroprudential
monetary policy management. This would
mean determining who would be the lead systemic risk
regulator, establishing metrics to define and measure
systemic risk, setting standards for excess capital to deter too-
connected-to-fail scenarios, and defining systemically
important institutions and the perimeter of prudential regulation
to include investment banks. It would also re-
quire assessing the systemic implications of financial linkages,
which might include the following approaches:
• network approach—tracks linkages in the
interbank market
• co-risk model—tracks linkages among financial
institutions under extreme events
• distress dependence matrix—examines pairs of
institutions’ probabilities of distress
• default intensity model—tracks probability of
failures of a largefraction of financial
institutions due to
both direct and indirect systemic linkages
Structured Finance in the Future
The revival and future use of structured products as a risk
transfer and credit expansion instrument depends on
a restoration of investor confidence in them. It also depends on

the costs associated with the changes required to
restore this confidence and implement the new regulations.
There is little doubt of the important role played by
securitization in bank wholesale funding and credit extension
under a capital-constrained system. In the United
States, securitization accounted for about 30% of total credit
outstanding before the 2007-2009 financial crisis.
“Securitization, when done prudently, still presents benefits for
pooling and distributing credit risk and for of-
fering banks an alternative source of financing.”34 It is of vital
importance to the real estate and consumer credit
markets.
Some of the actions taken primarily by the Federal Reserve and,
to a lesser extent, the U.S. Treasury in-
clude:
• liquidity swaps of securitized assets for
treasury collateral
• liquidity and loans to banks to purchase
asset-backed commercial paper (ABCP) from
money market
mutual funds (MMMF)
• liquidity to Fed-sponsored special purpose
vehicles to purchase 3-month commercial paper
• liquidity in the form of loans to investors to
purchase nonmortgage-backed asset-backed
securities (ABS)
and commercial mortgage-backed securities (CMBS)
• purchases of Government-Sponsored Enterprises
(GSE)35 obligations—$200 billion authorized; outright
purchase of GSE mortgage-backed securities (MBS)—$200
billion and $1.25 trillion authorized,

respectively
• capital and financing for private sector
partners to purchase legacy CMBS and private-
label residential
mortgage-backed securities (RMBS)36
Another effort to reduce the legacy asset overhang was to
resecuritize the senior private-label mortgage-backed
security tranches that experienced a rating downgrade. This
process, called RE-REMIC (Resecuritization of Real
Estate Mortgage Investment Conduits), was driven by the need
to maintain the AAA rating required by some
of the investors, but it could also result in capital reduction
requirements for banks. The RE-REMIC process
divided the downgraded security into a new senior AAA tranche
representing about 65% of the original senior
AAA tranche, which usually accounted for about 70% of the
original security. The remaining 5% then become a
new mezzanine tranche which could be sold to a hedge fund.
This meant that only 30% of the original security
needed to be sold at distressed prices. Under new Basel II rules,
a BB rating had a 350% capital requirement,
whereas there was only a 40% capital requirement for tranches
rated under a AAA securitization. 37
34 IMF, “Navigating the Challenges Ahead,” Global Financial
Stability Report, Washington DC, October 2009, p. 32.
35 Such as Fannie May and Freddie Mack-securitized
instruments.
36 Ibid., pp. 32-33.
37 IMF, “Policy Initiatives Aimed at Restarting Sustainable
Securitization,” Global Financial Stability Report, Washington
DC,
October 2009, pp. 77-115. See also in the same source, the “Box
2.4: Covered Bond Primer,” pp. 90-91. Structured covered

bond activity has risen in recent years as an alternative to
securitization. Covered bonds have two sources of protection:
the
obligation to repay, and specific collateral “covered pool”
legally ring-fenced to protect the investor. One major difference
is that they do not come off the balance sheet. See also
http://www.theatlantic.com/business/archive/2009/10/re-remics-
really/27639/.
Nov 2019
to May 2020.
14 TB0257
The main problem behind the loss of confidence was a severe
deterioration of the credit quality of the
underlying assets, aggravated by the loss of confidence in the
financial system with the failure of Bear Sterns and
Lehman Brothers. Subprime and Alt-A mortgages, which
expanded rapidly, accounted for about 20% of the nearly
$4 trillion total outstanding securitized products.38 Steps have
been taken by governments to restore confidence
in the outstanding securitized products, but new securitizations
must be modified to improve investor confidence
before the market will recover. Time is critical to restore
confidence in securitization, given an economic recovery
which may be neither smooth nor quick. Economic recovery will
help restore confidence in banks as they build
capital, as nonperforming loans decline, and as the uncertainty

in the supply of credit ends.
Restoring investor confidence in securitization may require
several changes in the process. There are four
segments to the securitization process: pooling of assets (cash
or synthetic); delinking of credit risk from the
originator; tranching the liabilities backed by the asset pool;
and the quality and maturity mismatch between the
underlying asset and the product sold to the investor. The main
issues in the tranching process are the priority
ordering of tranches by risk or allocation of losses: equity or
first loss, mezzanine tranches or second loss, and
senior or safest tranches. Although there are currently various
forms of credit support in use, simply estimating
the loss distribution of the asset pool may be insufficient. It
may also be necessary now to model the distribution
of cash flows from the asset pool to the tranches under different
scenarios.39
Securitization involves managing a large number of participants
and tracking the flow of information to all
parties, which is difficult. Greater transparency about the
makeup of the tranche is required, and perhaps only
smaller portions of the portfolios should be securitized. Of
course, transparency is dulled when the structured
tranches contain tranches from other securitizations.40
Furthermore, the compensation incentives should shift
from driving the originate-to-distribute high-volume model to
more selective higher quality parts of the total
portfolio. The credit rating system also needs to improve and be
more forward looking. Again, more transparency
regarding the rating methodologies used and their related risks
and vulnerabilities is required. The issue raised
is whether “…tranching causes ratings of structured securities
to behave differently from traditional corporate
bond ratings.”41 The result could be mispriced and mismanaged

risk. Investors relied on the credit rating to
make a decision, and had too little information about the
structure to be able to ask questions about the risks or
underlying assumptions. However, the lack of transparency as to
who owns what and what losses in a mark-to-
market sense might look like is causing uncertainty for existing
and would-be investors and lenders.42
In order for investors to return to the securitization market, less
complexity is required.43 This may mean
fewer tranches, reduced use of special structural features, more
transparency of the underlying assets in the
tranches, and less complex structures than those developed
during the last decade. This would suggest more
standardization of the information package on the structure and
of the structures themselves. Better ratings of
the tranches are required, along with how they were derived and
their related risk properties. It has been recom-
mended that rating agencies need to be supervised by the
government. Several proposals from the European
Parliament, U.S. Treasury, and International Organization of
Securities Commissions (IOSOC) suggest that the
originator and the structuring body should retain some portion
of the securitization. It is important that the
incentives of originators and end investors be more closely
aligned.
The question is, how much should be retained and in what form
should retention take place to ensure the
greatest impact on restoration of investor confidence. Several
alternatives have been proposed, including requiring
retention of the equity or first-loss tranche. However, the
significance of this measure would depend on the size
of the equity tranche relative to the securitized portfolio. Three
alternatives arise, each with a different sensitivity

38 “Highly-leveraged loans (subprime and Alt-A) are very
desirable for a CDO structure because…high-yield spreads are
necessary for the conduits to pay cash streams to investors and
remain profitable.” Blundell-Wignall, p. 33.
39 Bank for International Settlements, “The Future of
Securitization: How to Align Incentives,” BIS Quarterly
Review, Basel,
September 2009, pp. 29-43.
40 Ibid., p. 32.
41 Ibid., pp. 32-33.
42 Blundell-Wignall, p. 43.
43 The major players in a complex structure include originators,
conduits, investment banks, rating agencies, insurers,
liquidity providers, sales agents, and trusts, and each have many
subplayers to support their function. Blundell-Wignall,
pp. 34-38.
Nov 2019
to May 2020.
TB0257 15
to the business cycle: retention should include a vertical slice,
equity tranche, and mezzanine tranche.44 The size
of the potential loss or the discipline on the originators and
securitizers is a function of the width and size of the
slice retained. For example, if the equity tranche is relatively
small, a wide slice is almost meaningless. If there
is too high a cap placed on retention, then the incentive and

benefits of securitization become questionable to
the structuring bank.45
Some Basel II securitization and resecuritization-related
enhancements have already been enacted. Risk
weights attached to these exposures have been increased
because they were believed to be necessary. Opportuni-
ties for regulatory arbitrage across the trading and banking
books between liquidity facilities with short- versus
long-term maturities and across on- and off-balance sheet
entities have been addressed.46 In addition, in the U.S.,
the Federal Accounting Standards Board (FASB) eliminated the
ability to report the gain-on-sale accounting
treatment that had added to the profitability of securitization.
This will not only remove a benefit to securitizing
bank profits, but will also reduce an immediate compensation
benefit. There is a concern that this new regulatory
structure may make some securitizations too costly to be used
by banks and corporations.
Outcome
Rajani finished his research and was left with many questions
(see below), but it was his feeling that securitization
remained a very useful financial tool and would continue to be
used. Nevertheless, some of the incentives which
supported securitization’s growing use by financial institutions
and corporations would possibly be diminished
because increased regulation raises the cost of issuance. Rajani
now had to return to work and begin contact-
ing his customers to share his arguments for the future of
securitization as a competitive financing instrument.
What should he say? What are the important issues and
arguments? How should Rajani answer these important
questions?
Questions

1. Do you believe that structured products, specifically
securitization, will ever return to its former importance?
What are the pros and cons ethically and functionally? What
will replace its important role of function in
financing?
2. How will the proposed increased regulation (2010) affect
value of structured finance instruments to both
originator and issuer? Would it affect their usefulness as a
source of financing and diversification/transfer of
credit risk? Analyze and explain.
3. What credit enhancements/options can an issuer use in order
to increase buyer confidence and enhance
market liquidity? Discuss and explain.
4. What changes have been proposed and implemented for the
rating agencies, and will these prevent the
deficiencies of the past? Analyze and explain.
5. Will investors return to purchasing financial products back
for the cash flows related to securitized residential
or commercial mortgages? Analyze and discuss.
References
Akerlof, George A., and Robert J. Shiller, Animal Spirits,
Princeton University Press, 2009.
Bank for International Settlements, 79th Annual Report, Basel,
Switzerland, June 29, 2009.
El-Erian, Mohamed A., When Markets Collide, McGraw Hill,
2008.
Fender, Ingo, and Janet Mitchell, “The Future of Securitization:
How to Align Incentives?” BIS Quarterly Review,
September 2009, pp. 27-44.

Goldman Sachs, Effective Regulation: Part 3 Helping to Restore
Transparency, June 2009.
International Organization of Securities Commissions,
Unregulated Financial Markets and Products, May
2009.
44 BIS, pp. 36-41.
45 IMF, p. 96. A summary of Securitization Policy Progress
Report is presented in Table 2.1 in the report.
46 IMF, pp. 98-99.
Nov 2019
to May 2020.

TB0257Copyright © 2010 Thunderbird School of Global Manage.docx

Recommended

Recommended

More Related Content

Similar to TB0257Copyright © 2010 Thunderbird School of Global Manage.docx

Similar to TB0257Copyright © 2010 Thunderbird School of Global Manage.docx (6)

More from bradburgess22840

More from bradburgess22840 (20)

Recently uploaded

Recently uploaded (20)

TB0257Copyright © 2010 Thunderbird School of Global Manage.docx