How securitization led to total uncertainty

Securitization is often cited as one of the main factors that caused the financial crisis.

Securitization (from “security” - a security) is often cited as one of the main factors that caused the financial crisis. It certainly contributed a lot, but if I had to label it, I would rather call it a “technical prerequisite” than a cause. Without claiming to be exhaustive, in this presentation I will try to summarize and explain what securitization implies, as well as why things ultimately got out of hand.

By definition, it is a process by which an issuer (e.g. an investment bank) creates a financial instrument by combining other financial assets (e.g. loans, bonds and their derivatives). The issuer offers different parts of the newly created financial instrument (securities) to investors in the financial markets. In this way, through the intermediary of the issuer , the ownership of the original assets, the subject of the securitization, is effectively transferred from their owners (e.g. commercial banks) to the investors. However, in addition to the ownership, the risk is also transferred.

I would like to clarify that according to the Bulgarian Law on Special Investment Purpose Companies (SIPCC), the definition of securitization includes both rights to monetary (including future) receivables and real rights to real estate, which, materialized in securities, are offered publicly.

Here I will focus on the securitization of financial assets and future receivables, since this area is more murky and susceptible to speculation. The result of the process is a soup of letters and abbreviations (CDOs, CMOs, CLOs, MBSs, etc.), which we could very well classify as elements of the periodic table.

Нека вземем за пример ценни книги, обезпечени с ипотеки (MBS – mortgage backed security). По същество това са обединени в голям фонд ипотечни вземания, които търговските банки са продали на инвестиционния посредник.  Последният, в общия случай, комбинира продадените му бъдещи вземания и разделя фонда на малки дялове. Критерии за разграничение между различните дялове е рискa от неплатежоспособност на длъжника по първоначалното задължение. Колкото по-малък е рискът задължението да не бъде изплатено, толкова по-висок рейтинг има съответния MBS. Същото важи и за всички останали буквени комбинации, които са създадени на база различни видове дълг.

One of the main tricks here is actually the assessment of this risk. On the one hand, this is done by the institutions that provided the initial funding, and on the other, when the fund has already been created and divided into units, by the credit rating agencies.

Before 2008, intoxicated by the growing trend in the markets and "victim" of some political influences, lenders opened their purse strings and generously granted increasingly risky loans, even giving them the humorous label NINJA (No Income, No Job, No Assets Loans). The situation was as follows:

1. The main activity of financial intermediaries is to make loans, which they do willingly when there is a cheap monetary resource (a large money supply in circulation and a low base interest rate).

In addition, in November 2007, two government agencies in the United States, Fannie Mae and Freddy Mac, with the aim of facilitating access to financing for low-income families, began the process of securitization in its purest form. The main idea of the agencies is to provide these families with " the opportunity to obtain a 30-year loan with a fixed interest rate". One does not need to be an expert in banking and the time value of money to realize how absurd this is. Moreover, in order to increase the money supply for lending, these loans (low-risk and high-risk) are combined into common funds, which are subsequently offered to investors in the financial markets (the already described MBS).

2. By selling credit and other obligations to investment intermediaries, banks and other financial institutions realize an immediate profit without having to wait the next 30 years to eventually receive what is owed to them (interest and principal). Moreover, such a step favors the granting of even more loans, since it allows for the manipulation of balance sheets.

3. Once the wheel is turned, the perception that these loans will be sold and realized on the financial markets in the form of financial instruments with exotic names allows financial institutions to ignore their otherwise strict risk assessment rules. And they have started to do so.

In the name of progress, in addition to loans and mortgages, securitization involved bonds and all other future receivables, along with their derivatives. The most aerobatics among which are the so-called CDOs (collateralized debt obligations). In reality, no one knew what was behind the profitable image of CDOs except for a handful of mathematicians who invented the formulas. However, they were indifferent to who would buy them and why. Naturally, the moment came when investors realized that they were not aware of how much what they were buying was worth and the bubble burst. And those who, by an unfavorable turn of events, remained the last hole in the cauldron, went bankrupt.

Instead of adhering to the principles of the economic system, Western politicians schizophrenically rolled up their sleeves and handed out bailouts that they collected from taxpayers. At the end of this entire cycle, many financial institutions that should have been allowed to fail remained unscathed. However, they will pay the moral price for public discontent and the progressive impoverishment of people for a long time. To quote John Fowles: “Wealth in itself is innocent. The rich in itself is innocent. But wealth and the rich, surrounded by poverty and the poor, are guilty,” and they will probably remain so for a long time in the public consciousness – the circulatory system of the economy, bleeding society.

Investor distrust, fear, panic, market crashes, public discontent, movements like “Occupy Wallstreet”, “Indignados”, “Occupy London” and others in the last few years have been quite sobering for both the political elite and the economic actors. I am not painting an apocalyptic picture, I am summarizing what the price we pay for our greed and naivety is.

Let us not forget that it is precisely investor sentiment and market psychology that determine economic growth in the long term. Confidence in the markets will not return with guarantees that banks will not be allowed to fail. It will only stabilize with guarantees that processes will be driven by natural rules and a regulatory framework that assumes that banks and other financial institutions that make bad business decisions will bear the consequences of them.

Efforts should not be aimed at "patching up" the situation, but at creating a stable, sustainable and transparent political and economic system, guided by clear rules and based on market mechanisms.

Did you like it? Take a minute to support the EKIP on Patreon!