Global Financial Crises and the Future of Securitization

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
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