Global Financial Crises and the Future of Securitization

Case Study 5:

Global Financial Crises and the future of securitization

XUN YIN 25654373

Introduction:

This case explained in details the causes and role played by structure finance typically financial securitization in the past four global financial crises, especially during the 2007 to 2010 crises period. It also describes and analyses how securitization and structured products work and the value they add to finance, Finally, it proposes some new regulations set on securitization that may reduce the associated risks. Based on the case study and the relevant questions given, this report will explain the future trend of securitization covering the improving standards of regulations, credit enhancement and credit rating agencies. Then in the conclusion part, whether investors will return to the securitization market will be concluded.

Analysis:

The future trend of securitization is still promising as long as the following problems are solved gradually. Firstly, the originate-and-hold model requires originators to increase the quality of loans. Also the issuers should retain some proportion of their products which may require issuers to monitor their products carefully. Secondly, the increasing supervision of rating agencies regulated by the government indicate that the credit rating agencies are requested to enhance disclosure concerning the procedures and methodologies they use in rating structured finance products as well as in the surveillance of these ratings according to the tightening regulations. (Schwarcz,S.L.,2010).Noticeably, another point is to secure enough competition in rating industry. With the tightening regulations and the better surveillance as well as fair competition among rating industry, the investors will have a better knowledge of the rating procedure and the conflicts of interest will be reduced. Thirdly, the credit enhancements are indeed to be used to restore investors’ confidence and reduce risks. Credit enhancement measures can be divided into two categories internal credit enhancement and external credit enhancement. For the internal credit enhancement, the most commonly used measure is subordination which means that the class of highest seniority has the first right on the available principle cash flows. Overcollateralization is another measure which means that the face value of the underlying loan portfolio is larger than the security it backs, if some payments from underlying loans are late or default, principle and interest payment can still be made. Reserve account is created to reimburse the issuing trust for losses up to the amount allocated to the reserve. While for external credit enhancement the measures such as letter of credit, cash collateral account and wrapped securities are generally used in practice.

On the one hand, the increasing regulation will secure higher safety on securitized products. However, on the other hand, the effects of those regulations will reduce the usefulness of securitization. For originators, they are always in a need of financing and increasing their liquidity. However, it is not easy to sell their loans to a SPV at a high volume because the quality of loan should be highly considered. Only those high quality loans can be sold to SPV, because SPV will be required to have a proportion in the issued securitized product. If the loans have a high probability of default, those SPV will stop issuing them due to the counterparty risks and reputation risks. For issuers, if their issuing behaviors are stringently regulated by the government and their interests are highly associated with the securitized products, then their issuing behaviors will be gradually recognized by investors. However, investors have been affected by the bad name of securitization during the financial crisis. Thus, it needs a long time to restore customers’ confidence. In words, the increased regulations will reduce the volume of securitization but improve the quality of securitization. Originators and issuers should not only rely on securitization to finance but also search for some other alternatives to financing.