SECURITIZATION AND

SUBPRIME MORTGAGE CRISIS

SECURITISATION A TOOL TO MODERN FINANCING

EXECUTIVE SUMMARY
The objective of this study is to understand the concept of Securitisation, its
history, and its importance in the field of financing in an ever booming global
economy. Securitisation is the process of conversion of existing assets or future
cash flows into marketable securities. In other words, securitisation deals with
the conversion of assets which are not marketable into marketable ones. The
meaning of "Securitisation" is to create a multiple assets generation at
a lower Cost of Capital while protecting the Beneficial Interest of the
Investors. It is a financial instrument for various investment projects.
Securitisation in simple words can be defined as "Structured Project Finance.
Thus it can be said with ease that the objective of "True Securitisation" is to
create a multiple assets generation at a lower Cost of Capital while protecting
the Beneficial Interest of the Investors. The study also gives an overview on
the Indian experience of securitisation, its help in financing infrastructure
projects & building credit off stake for banks and its importance and future in
the Indian economy Provision of quality infrastructure services at a reasonable
cost,

is

necessarycondition for achieving sustained economic growth. In fact, one of th

e major challenges being faced by the Indian economy is to enhance infrastruct
ureinvestment and to improve the delivery system and quality of services.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

There

is

huge critical

importance

of

the

infrastructure

sector and high priority for development of various infrastructure is being

given these days.
Investments in these sectors involve high risk, low return, lumpiness of huge
investment, high incremental capital/output ratio, long payback periods, and
superior technology. The Infrastructure Sector, it is the biggest Capital Deficit
Sector

of

Indian

Economy;

it

Financial Engineering and Innovations to Fund the Infrastructure

requires
Projects.

One of best the solutions to this problem is "Securitisation."The need of

securitisation is not only felt by the infrastructure sector but also
the banking sector. Other than freeing up the blocked assets of banks,
Securitisation can transform banking in other ways as well - it helps in the
growth of credit off stake of banks thus funding for release of more loans. This
will benefit investors as they will have a claim over the future cash flows. The
Originator will also benefit as loan obligations will be met from cash flows
generated. The reasons why Securitisation gains over other forms is its low
capital costs for high asset generation, an alternative source of fund and
minimal risks involved. Therefore Securitisation can be viewed as a major tool
for financing the various projects over different sectors in the present as well as
for the years to come.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

INTRODUCTION TO SECURITISATION
"Securitisation will be the major financial instrument for the next decade,"-by
ICICI chairman K V Kamat.
Recent years have witnessed the wide spread of Western financial innovations
into developing markets. Globalization and integration of capital markets,
started in the1990s, have made it possible for such big global players as India
to adopt new financial strategies which allow increasing liquidity and
accelerating development of the capital markets. One of these financial
innovations is securitisation, the process of transformation of illiquid assets
into a security which can be traded in the capital markets. Securitisation is the
buzzword in today's World of Finance. It's not a new subject to the developed
economies. It is certainly a new concept for the emerging markets like India.
The Technique of Securitisation definitely holds great promise for a
Developing Country like India. Funds of a firm get blocked in various types of
assets

such

as

loans,

advances,receivables etc. To meet its growing funds requirements, a firm has to

raiseadditional funds from the market while the existing assets continue to
remain on its books. This adversely affects the capital adequacy and debt
equity ratio of the firm and may also raise its cost of capital. An alternative
available is to use the existing illiquid assets for raising funds by converting
them into negotiable instruments. E.g. a housing loan finance company, which
has a portfolio of loan advances having periodic cash flows, may convert
this portfolio to instant cash. Though the end result of securitisation is
financing, it is not financing as such since the firm securitizing its

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

assets is not borrowing money, but selling a stream of cash flows that are
otherwise to accrue to it.
Securitisation is "Structured Project Finance". The financial instrument is
structured or tailored to the risk-return and maturity needs of the investors,
rather than a simple claim against an entity or asset. The popular use of the
term Structured Finance in todays financial world is to refer to such financing
instruments where the financier does not look at the entity as a risk: but tries to
align the financing to specific cash accruals of the borrower. The actual and a
current meaning of securitisation is a blend of two forces that are critical in
today's world of Finance: Structured Project Finance and Capital Markets. The
process of Securitisation creates a strata of risk-return and different
maturitysecurities and is marketable into the capital markets as per the needs of
theinvestors. The basic idea is to take the outcome of this process into the
market, the capital market. Thus, the result of every securitisation process,
whatever might be the area to which it is applied, is to create certain
instruments, which can be placed in the market.
Securitisation is the process of de-construction of an entity:
If one envisages an entitys assets as being composed of claims to various cash
flows, the process of securitisation would split apart these cash flows into
different buckets, classify them, and sell these classified parts to different
investors as per their needs. Thus securitisation breaks the entity into various
sub-sets.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

Securitisation is the process of integration and differentiation

: The entity thatsecuritizes its assets first pools them together into a common
hotchpot assuming it isnot one asset but several assets. This is the process of
integration. Then, the poolitself is broken into instruments of fixed
denomination. This is the process of differentiation

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

MEANING
Securitization is the process of homogenizing and packaging financial instruments into a
new fungible one. Acquisition, classification, collateralization, composition, pooling and
distribution are functions within this process
As defined by
The Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002:
Securitisation means acquisition of financial assets by any securiti
sationcompany or reconstruction company from any originator, whether by
raising

of

funds

by

such

securitization

company

or reconstruction company from qualified institutional buyers by issue of security

receipts representing undivided interest in such financial assets or otherwise
Securitizations is the process by which, financial assets such as household mortgages,
credit card balances, hire-purchase debtors and trade debtors, etc., are
transformed

into

securities

by

the

owner

(the

Originator)

in return for an immediate cash payment and/or deferred consideration

through a Special Purpose Vehicle (SPV) created for this purpose. The pooling
standard prescribes that the asset portfolio has to be homogeneous in
terms of underlying financial asset, maturity and risk profile
.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

This ensures an efficient analysis of the credit risk of the asset portfolio and
a common payment pattern. It means only one type of asset (e.g. car loans)
of similar duration (e.g. 20 to24 months) having uniform risk (whose repayment is
continuous during the first 10to 12 months of the loan) will be bundled for creating one
securitized instrument. The Special Purpose Vehicle finances the assets transferred to it by
the issue of debt securities such as loan notes or Pass through Certificates, which
are generally monitored by trustees. Pass through Certificates are certificates
acknowledging a debt where the payment of interest and/or the repayment of principal
are directly or indirectly linked or related to realizations from securitized assets.
Let us consider some examples:
1) Suppose Mr X wants to open a multiplex and is in need of funds for the same.
To raise funds, Mr X can sell his future cash flows (cash flows arising from sale of
movie tickets and food items in the future) in the form of securities to raise
money. This will benefit investors as they will have a claim over the future cash
flows generated from the multiplex. Mr X will also benefit as loan obligations will
be met from cash flows generated from the multiplex itself.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

2) A finance company with a portfolio of car loans can raise funds by selling
these loans to another entity. But this sale can also be done by securitizing its
car loans portfolio into instruments with a fixed return based on the maturity
profile (the period for which the loans are given). If the company has Rs 100
crore worth of car loans and is due to earn 17 per cent income on them, it can
securitize these loans into instruments with 16 % return with safeguards
against defaults. These could be sold by the finance company to another if
it needs funds

before

these

loan

repayments

are

due. The principal and interest repayment on the securitisedinstruments are met
from the assets which are securitized, in this case, the car loans.
Selling these securities in the market has a double impact.
One, it will provide the company with cash before the loans mature. Two, the assets (car
loans) will gout of the books of the finance company, a good thing as all risk is removed.

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

HISTORY
Securitization in its present form originated in the mortgage markets in USA. It
was promoted with the active support of the government. The government
wanted to promote secondary markets in mortgages to allow liquidity for
mortgage finance companies. Government National Mortgage Association
(GNMA) was the first one to buy mortgages from mortgage companies and to
convert them into pass through securities - this was 1970. GNMA were passing
through securities backed by Mortgage insured by FHA.
These pass through have the full credit and the backing of the US government,
since GNMA has guaranteed both the repayment of the principal and timely
payment of the interest. The 1970 program (GNMA -I) is still in operation. In
1983, GNMA launched another pass through program called GNMA - II.
These programs are further classified based on the type of mortgages pooled
therein, such as single family (SF) loans, mobile home (MH) loans, project
loans (PL) etc.
Other US government agencies, FNMA and Freddie Mac jumped in later. The
first FNMA Mortgage Backed Securities (MBS) was issued in 1981. The
agency played a crucial role in promoting securitisation of Adjustable-Rate
Mortgages (ARMs) and Variable Rate Mortgages (VRMs). FHLMC was
created in 1970 to promote an active national secondary market in residential
mortgages and has been issuing mortgage-backed securities since 1971.
The first securitisation of receivables outside the mortgage markets happened
in1975 when Sperry Corporation securitised its computer lease receivables.
Another mortgage funding device, slightly different from the US-type Pass
through Certificates, has existed in Europe for almost two centuries in the past.
9

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

In Denmark, for example, mortgage bonds are more than 200 years old.
Germany also has a long history of mortgage bonds and it is stated that there
have been no defaults on these instruments for all these years. Other countries
in Europe have been relatively slow starters, though regulatory and legislative
changes in Germany, France, Belgium and Spain have been fashioned to assist
development of securitisation. In Japan, the securitisation market was not well
developed until recently; the Government had restricted securitisation to the
assets of leasing, consumer loans and credit card companies. The Government
has, however, amended laws to allow full-scale securitisation in May 1997.
India
The first widely reported securitisation deal in India occurred in 1990 when
auto loans were secured by Citibank and sold to the GIC mutual fund.
However, the sound legal framework for securitisation was not drafted until
2002 when the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Ordinance (Ordinance) was promulgated by the
president of India. According to this law, securitisation was defined as
acquisition of financial assets by any securitisation company or reconstruction
company from any originator, whether by raising funds by such securitisation
or reconstruction company from qualified institutional buyers by issue of
security receipts representing undivided interest in such financial assets or
otherwise. The notion of financial assets for the above definition is stated as
any debt or receivables. Non-surprisingly, it follows that the definition of
securitisation in India is very close to that of western countries, especially
taking into account that the experience of the UK is of special relevance to
India

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

MAJOR PLAYERS
The major "players" in the securitization game, all of whom require legal
representation to some degree, are as follows (this terminology is typical, but
different terms are used; for example the "originator" is often referred to as the
"issuer" or "seller"):

1. Originator - the entity that either generates Receivables in the ordinary

course of its business, or purchases and assembles portfolios of Receivables
(in that sense, not a true "originator"). Its counsel works closely with
counsel to the Underwriter/Placement Agent and the Rating Agencies in
structuring the transaction and preparing documents and usually gives the
most significant opinions. It also retains and coordinates local counsel in
the event that it is not admitted in the jurisdiction where the Originator's
principal office is located, and in situations where significant Receivables
are generated and the security interests that secure the Receivables are
governed by local law rather than the law of the state where the Originator
is located.

2. Issuer - the special purpose entity, usually an owner trust (but can be
another form of trust or a corporation, partnership or fund), created pursuant
to a Trust Agreement between the Originator (or in a two step structure, the
Intermediate SPE) and the Trustee, that issues the Securities and avoids
taxation at the entity level. This can create a problem in foreign
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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

Securitizations in civil law countries where the trust concept does not exist
(see discussion below under "Foreign Securitizations").

3. Trustees - usually a bank or other entity authorized to act in such capacity.

The Trustee, appointed pursuant to a Trust Agreement, holds the
Receivables, receives payments on the Receivables and makes payments to
the Security holders. In many structures there are two Trustees. For
example, in an Owner Trust structure, which is most common, the Notes,
which are pure debt instruments, are issued pursuant to an Indenture
between the Trust and an Indenture Trustee, and the Certificates,
representing undivided interests in the Trust (although structured and
treated as debt obligations), are issued by the Owner Trustee. The Issuer
(the Trust) owns the Receivables and grants a security interest in the
Receivables to the Indenture Trustee. Counsel to the Trustee provides the
usual opinions on the Trust as an entity, the capacity of the Trustee, etc.

4. Investors - the ultimate purchasers of the Securities. Usually banks,

insurance companies, retirement funds and other "qualified investors." In
some cases, the Securities are purchased directly from the Issuer, but more
commonly the Securities are issued to the Originator or Intermediate SPE as
payment for the Receivables and then sold to the Investors, or in the case of
an underwriting, to the Underwriters.

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

5. Underwriters/Placement Agents - the brokers, investment banks or banks

that sell or place the Securities in a public offering or private placement.
The Underwriters/Placement Agents usually play the principal role in
structuring the transaction, frequently seeking out Originators for
Securitizations,

and

their

counsel

(or

counsel

for

the

lead

Underwriter/Placement Agent) is usually, but not always, the primary

document preparer, generating the offering documents (private placement
memorandum or offering circular in a private placement; registration
statement and prospectus in a public offering), purchase agreements, trust
agreement, custodial agreement, etc. Such counsel also frequently opines on
securities and tax matters.

6. Custodian - an entity, usually a bank, that actually holds the Receivables as

agent and bailee for the Trustee or Trustees.

7. Rating Agencies - Moody's, S&P, Fitch IBCA and Duff & Phelps. In
Securitizations, the Rating Agencies frequently are active players that enter
the game early and assist in structuring the transaction. In many instances
they require structural changes, dictate some of the required opinions and
mandate changes in servicing procedures.

8. Servicer - the entity that actually deals with the Receivables on a day to day
basis, collecting the Receivables and transferring funds to accounts

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

controlled by the Trustees. In most transactions the Originator acts as

Servicer.

9. Backup Servicer - the entity (usually in the business of acting in such

capacity, as well as a primary Servicer when the Originator does not fill that
function) that takes over the event that something happens to the Servicer.
Depending upon the quality of the Originator/Servicer, the need and
significance of the Backup Servicer may be important. In some cases the
Trustee retains the Backup Servicer to perform certain monitoring functions
on a continuing basis.

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

PROCESS OF SECURITISATION

The basis process of Securitisation is explained in the following steps:

1) Selection and Pooling of homogeneous assets& estimation of the Cash Flows:
15

SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

Securitization in its basic form consists of the pooling of a group of

homogeneous assets. Homogeneity is necessary to enable a cost efficient
analysis of the credit risk of the pooled asset and to achieve a common
payment pattern. The originator estimates the cash flows from the underlying
assets. The payment of interest and principal on the securities is directly
dependent on the cash flows arising from the underlying pooled assets. For this
purpose, the originator uses his historical data. Appropriate and accurate
calculations are done keeping in view of the pre payment rates, amortization,
etc for estimation of the cash flows.
2) Creation of SPV:
The next step is to create an SPV. The basis logic behind the creation of an
SPV is
a)To isolate the underlying assets from the originator. This is an important step
in the whole process as the ultimate result of this is "Bankruptcy Remoteness"
from the Originator.
b)Aggregation of the underlying assets into a Pool. Thus the assignment of the
cash flow to the SPV is done in this manner.
3) SPV issues securities/notes to the Investors:
The SPV formed(Trust / MF / Corporate Form)now issues securities/notes
tothe investors to invest in the securitised exercise done by the originator.
4) Investors - Proceeds of the issue of securities to SPV

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

The collection from the investors for their investment in the securitised
instrument is forwarded to the SPV. The SPV, in turn, channelises these
proceeds to the Originator.
5) Collections and Servicing from the Obligors:
The Originator generally performs this function. In some cases, specialized
servicing agents are appointed to collect and service from the loan obligors.
6) Pass Over to the SPV:
In this step the Servicing agent passes the collected payments from the obligors
to the SPV less his fees.
7) Reinvestment of Cash Flows:
The SPV if permitted reinvests the proceeds from the Servicing agent
(Generally in the Pay through Structures) and in turn receives the reinvestment
proceeds also. If the structure of the instrument is the Pass Through Structure
then Step no. 8 is followed directly after Step no. 6.
8) Payment to the Investors:
The Investor earns on his investments by receiving the proceeds from the SPV.
Depending upon the structure of the Instrument the payment of the investment
is made to the Investors.
9) Originators Residuary Profit:
After the payments are made to the Investors if any residue is left, it is passed
on the Originator as his residuary profit, which is generally maintained, by the
originator for the over-collaterisation and guarantee purpose.

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

1.1 INRUDUCTION TO SUBPRIME PRIME MORTGAGE

MARKET
Before discussing what is Subprime mortgage crisis, first will
understand what does meant by subprime mortgage
Usually financial institution classifies the borrower into 3 types
1. Prime borrower
2. Subprime borrower
3. Equity class borrower
Subprime lending
Subprime lending (also known as B-paper, near-prime, or second chance
lending) is the practice of making loans to borrowers who do not qualify for
the best market interest rates because of their deficient credit history. The
phrase also refers to banknotes taken on property that cannot be sold on the
primary market, including loans on certain types of investment properties and
certain types of self-employed persons.
Subprime lending is risky for both lenders and borrowers due to the
combination of high interest rates, poor credit history, and adverse financial
situations usually associated with subprime applicants. A subprime loan is
offered at a rate higher than A-paper loans due to the increased risk. Subprime
lending encompasses a variety of credit instruments, including subprime
mortgages, subprime car loans, and subprime credit cards, among others. The
term "subprime" refers to the credit status of the borrower (being less than
ideal), not the interest rate on the loan itself.
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SECURITIZATION AND
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Subprime lending is highly controversial. Opponents have alleged that

subprime lenders have engaged in predatory lending practices such as
deliberately lending to borrowers who could never meet the terms of their
loans, thus leading to default, seizure of collateral, and foreclosure. There have
also been charges of mortgage discrimination on the basis of race. Proponents
of subprime lending maintain that the practice extends credit to people who
would otherwise not have access to the credit market.
The controversy surrounding subprime lending has expanded as the result of an
ongoing lending and credit crisis both in the subprime industry, and in the
greater financial markets which began in the United States. This phenomenon
has been described as a financial contagion which has led to a restriction on the
availability of credit in world financial markets. Hundreds of thousands of
borrowers have been forced to default and several major American subprime
lenders have filed for bankruptcy.
Background Subprime lending evolved with the realization of a demand in the
marketplace and businesses providing a supply to meet it. With bankruptcies
and consumer proposals being widely accessible, a constantly fluctuating
economic environment, and consumer debt loan on the rise, traditional lenders
are more cautious and have been turning away a record number of potential
customers.[citation needed] Statistically, approximately 25% of the population of the
United States falls into this category.
In the third quarter of 2007, Subprime ARMs only represent 6.8% of the
mortgages outstanding in the US, yet they represent 43.0% of the foreclosures
started. Subprime fixed mortgages represent 6.3% of outstanding loans and
12.0% of the foreclosures started in the same period.
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SECURITIZATION AND
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Definition
While there is no official credit profile that describes a subprime borrower,
most in the United States have a credit score below 723. Fannie Mae has
lending guidelines for what it considers to be "prime" borrowers on
conforming loans. Their standard provides a good comparison between those
who are "prime borrowers" and those who are "subprime borrowers." Prime
borrowers have a credit score above 620 (credit scores are between 350 and
850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income
ratio (DTI) no greater than 75% (meaning that no more than 75% of net
income pays for housing and other debt), and a combined loan to value ratio of
90%, meaning that the borrower is paying a 10% down payment. Any
borrower seeking a loan with less than those criteria is a subprime borrower by
Fannie Mae standards.
Subprime borrowers
Subprime offers an opportunity for borrowers with a less than ideal credit
record to gain access to credit. Borrowers may use this credit to purchase
homes, or in the case of cash out refinance, finance other forms of spending
such as purchasing a car, paying for living expenses, remodeling a home, or
even paying down on a high interest credit card. However, due to the risk
profile of the subprime borrower, this access to credit comes at the price of
higher interest rates. On a more positive note, subprime lending (and
mortgages in particular), provide a method of "credit repair"; if borrowers
maintain a good payment record, they should be able to refinance back onto
mainstream rates after a period of time. Credit repair usually takes twelve
months to achieve; however, in the UK, most subprime mortgages have a two
or three-year tie-in, and borrowers may face additional charges for replacing
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SECURITIZATION AND
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their

mortgages

before

the

tie-in

has

expired.

Generally, subprime borrowers will display a range of credit risk

characteristics that may include one or more of the following:
Two or more loan payments paid past 30 days due in the
last 12 months, or one or more loan payments paid past 90
days due the last 36 months;
Judgment, foreclosure, repossession, or non-payment of a
loan in the prior 48 months;
Bankruptcy in the last 7 years;
Relatively high default probability as evidenced by, for example,
a credit bureau risk score (FICO) of less than 620 (depending on
the product/collateral), or other bureau or proprietary scores with
an equivalent default probability likelihood.

1.2 INRUDUCTION TO SUBPRIME PRIME MORTAGAGE

CRISIS
The diagram explains how new model (i.e. Subprime model)
leads to mortgage crisis
How it went wrong

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SECURITIZATION AND
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Traditionally, banks have financed their mortgage lending

through the deposits they receive from their customers. This
has limited the amount of mortgage lending they could do.
And also Percentage of default and loss suffered by financial
institution could be very minimal and there are only 2 players
Viz, financial institutions and investors

In recent years, banks have moved to a new model where they

sell on the mortgages to the bond markets. This has made it
much easier to fund additional borrowing,

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SECURITIZATION AND
SUBPRIME MORTGAGE CRISIS

But it has also led to abuses as banks no longer have the

incentive to check carefully the mortgages they issue. And the
flow chart looks like multiple layer and number of entity
involved in this system, one Player defaulted whole system get
disturb. In present crisis Subprime borrower defaulted their
payment installment due to fall in the prices of house and
lands what they owned, fall in the price leads to fall in the
bond issued by financial institution which linked to subprime
mortgage so in this way all players who ever involved in this

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SECURITIZATION AND
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new

model

all

are

suffered

huge

loss

Subprime mortgage crisis:

The subprime mortgage crisis was a sharp rise in home foreclosures which
started in the United States in late 2006 and became a global financial crisis
during 2007 and 2008.

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SECURITIZATION AND
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The crisis began with the bursting of the housing bubble in the U.S. and high
default rates on "subprime" and other adjustable rate mortgages (ARM) made
to higher-risk borrowers with lower income or lesser credit history than
"prime" borrowers. Loan incentives and a long-term trend of rising housing
prices encouraged borrowers to assume mortgages, believing they would be
able to refinance at more favorable terms later. However, once housing prices
started to drop moderately in 2006-2007 in many parts of the U.S., refinancing
became more difficult. Defaults and foreclosure activity increased dramatically
as ARM interest rates reset higher. During 2007, nearly 1.3 million U.S.
housing properties were subject to foreclosure activity, up 79% versus 2006.
As of December 22, 2007, a leading business periodical estimated subprime
defaults would reach a level between U.S. $200-300 billion.
The mortgage lenders that retained credit risk (the risk of payment default)
were the first to be affected, as borrowers became unable or unwilling to make
payments. Major banks and other financial institutions around the world have
reported losses of approximately U.S. $140 billion as of February 2008, as
cited below. Due to a form of financial engineering called securitization, many
mortgage lenders had passed the rights to the mortgage payments and related
credit/default risk to third-party investors via mortgage-backed securities
(MBS) and collateralized debt obligations (CDO). Corporate, individual and
institutional investors holding MBS or CDO faced significant losses, as the
value of the underlying mortgage assets declined. Stock markets in many
countries declined significantly.

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SECURITIZATION AND
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Typical model of Subprime crisis in United States Of America :

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SECURITIZATION AND
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2. CAUSES AND RISK OF SUBPRIME CRISIS

The reasons for this crisis are varied and complex. Understanding and
managing the ripple effect through the world-wide economy poses a critical
challenge for governments, businesses, and investors. Due to innovations in
securitization, the risks related to the inability of homeowners to meet
mortgage payments have been distributed broadly, with a series of
consequential impacts. The crisis can be attributed to a number of factors, such
as the inability of homeowners to make their mortgage payments; poor
judgment by either the borrower or the lender; inappropriate mortgage
incentives, and rising adjustable mortgage rates. Further, declining home prices
have made re-financing more difficult.
2.1 RISKS INVOLVED IN THE SUBPRIME CRISIS
There are three primary risk categories involved:
Credit risk: Traditionally, the risk of default (called credit risk)
would be assumed by the bank originating the loan. However,
due to innovations in securitization, credit risk is now shared
more broadly with investors, because the rights to these
mortgage payments have been repackaged into a variety of
complex

investment

mortgage-backed

vehicles,

securities

generally

(MBS)

or

categorized

collateralized

as
debt

obligations (CDO). A CDO, essentially, is a repacking of

existing debt, and in recent years MBS collateral has made up
a large proportion of issuance. In exchange for purchasing the
MBS, third-party investors receive a claim on the mortgage
assets, which become collateral in the event of default.
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SECURITIZATION AND
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Further, the MBS investor has the right to cash flows related to
the mortgage payments. To manage their risk, mortgage
originators (e.g., banks or mortgage lenders) may also create
separate legal entities, called special-purpose entities (SPE), to
both assume the risk of default and issue the MBS. The banks
effectively sell the mortgage assets (i.e., banking accounts
receivable, which are the rights to receive the mortgage
payments) to these SPE. In turn, the SPE then sells the MBS to
the investors. The mortgage assets in the SPE become the
collateral.
Asset price risk: CDO valuation is complex and related "fair
value" accounting for such "Level 3" assets is subject to wide
interpretation. This valuation fundamentally derives from the
collectibility of subprime mortgage payments, which is difficult
to predict due to lack of precedent and rising delinquency
rates. Banks and institutional investors have recognized
substantial losses as they revalue their CDO assets downward.
Most CDOs require that a number of tests be satisfied on a
periodic basis, such as tests of interest cash flows, collateral
ratings, or market values. For deals with market value tests, if
the valuation falls below certain levels, the CDO may be
required by its terms to sell collateral in a short period of time,
often at a steep loss, much like a stock brokerage account
margin call. If the risk is not legally contained within an SPE or
otherwise, the entity owning the mortgage collateral may be
forced to sell other types of assets, as well, to satisfy the terms
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SECURITIZATION AND
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of

the

deal.

In

addition,

credit

rating

agencies

have

downgraded over U.S. $50 billion in highly-rated CDO and

more such downgrades are possible. Since certain types of
institutional investors are allowed to only carry higher-quality
(e.g., "AAA") assets, there is an increased risk of forced asset
sales, which could cause further devaluation.
Liquidity risk: A related risk involves the commercial paper
market, a key source of funds (i.e., liquidity) for many
companies. Companies and SPE called structured investment
vehicles (SIV) often obtain short-term loans by issuing
commercial paper, pledging mortgage assets or CDO as
collateral.

Investors

provide

cash

in

exchange

for

the

commercial paper, receiving money-market interest rates.

However, because of concerns regarding the value of the
mortgage asset collateral linked to subprime and Alt-A loans,
the ability of many companies to issue such paper has been
significantly affected. The amount of commercial paper issued
as of October 18, 2007 dropped by 25%, to $888 billion, from
the August 8 level. In addition, the interest rate charged by
investors to provide loans for commercial paper has increased
substantially above historical levels.

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2.2 CAUSES OF THE CRISIS

The housing downturn
Subprime borrowing was a major contributor to an increase in home ownership
rates and the demand for housing. The overall U.S. homeownership rate
increased from 64 percent in 1994 (about where it was since 1980) to a peak in
2004 with an all time high of 69.2 percent.
This demand helped fuel housing price increases and consumer spending.
Between 1997 and 2006, American home prices increased by 124%. Some
homeowners used the increased property value experienced in the housing
bubble to refinance their homes with lower interest rates and take out second
mortgages against the added value to use the funds for consumer spending.
U.S. household debt as a percentage of income rose to 130% during 2007,
versus 100% earlier in the decade. A culture of consumerism is a factor. In the
early 2000s recession that began in early 2001 and which was exacerbated by
the September 11, 2001 terrorist attacks, Americans were asked to spend their
way out of economic decline with "consumerism... cast as the new patriotism".
This call linking patriotism to shopping echoed the urging of former President
Bill Clinton to "get out and shop" and corporations like General Motors
produced commercials with the same theme.

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SECURITIZATION AND
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Existing Homes Sales, Inventory, and Months Supply, By Quarter

Overbuilding during the boom period, increasing foreclosure rates and
unwillingness of many homeowners to sell their homes at reduced market
prices have significantly increased the supply of housing inventory available.
Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior
year. By January 2008, the inventory of unsold new homes stood at 9.8 months
based on December 2007 sales volume, the highest level since 1981. Further, a
record of nearly four million unsold existing homes were available.
This excess supply of home inventory places significant downward pressure on
prices. As prices decline, more homeowners are at risk of default and
foreclosure. According to the S&P/Case-Shiller housing price index, by
November 2007, average U.S. housing prices had fallen approximately 8%
from their 2006 peak. However, there was significant variation in price
changes across U.S. markets, with many appreciating and others depreciating.
The price decline in December 2007 versus the year-ago period was 10.4%. As
of February 2008, housing prices are expected to continue declining until this
inventory of surplus homes (excess supply) is reduced to more typical levels.
THE HOUSING PRICE CRASH

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SECURITIZATION AND
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Graph clearly denote the bursting of the housing bubble and crash of housing
prices

Role of financial institutions

A variety of factors have caused lenders to offer an increasing array of higherrisk loans to higher-risk borrowers. The share of subprime mortgages to total
originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in
1999 , and 20% in 2006. A study by the Federal Reserve indicated that the
average difference in mortgage interest rates between subprime and prime
mortgages (the "subprime markup" or "risk premium") declined from 2.8
percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007.
In other words, the risk premium required by lenders to offer a subprime loan
declined. This occurred even though subprime borrower and loan
characteristics declined overall during the 2001-2006 period, which should

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SECURITIZATION AND
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have had the opposite effect. The combination is common to classic boom and
bust credit cycles.

In addition to considering higher-risk borrowers, lenders have offered

increasingly high-risk loan options and incentives. One example is the interestonly adjustable-rate mortgage (ARM), which allows the homeowner to pay just
the interest (not principal) during an initial period. Another example is a
"payment option" loan, in which the homeowner can pay a variable amount,
but any interest not paid is added to the principal. Further, an estimated onethird of ARM originated between 2004-2006 had "teaser" rates below 4%,
which then increased significantly after some initial period, as much as
doubling the monthly payment.

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Some believe that mortgage standards became lax because of a moral hazard,
where each link in the mortgage chain collected profits while believing it was
passing on risk.

Role of securitization
Securitization is a structured finance process in which assets, receivables or
financial instruments are acquired, classified into pools, and offered as
collateral for third-party investment. There are many parties involved. Due to
securitization, investor appetite for mortgage-backed securities (MBS), and the
tendency of rating agencies to assign investment-grade ratings to MBS, loans
with a high risk of default could be originated, packaged and the risk readily
transferred to others. Asset securitization began with the structured financing
of mortgage pools in the 1970s. The securitized share of subprime mortgages
(i.e., those passed to third-party investors) increased from 54% in 2001, to 75%
in 2006. Alan Greenspan stated that the securitization of home loans for people
with poor credit not the loans themselves were to blame for the current
global credit crisis.

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SECURITIZATION AND
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Borrowing Under a Securitization Structure

Role of mortgage brokers
Mortgage brokers don't lend their own money. There is not a direct correlation
between loan performance and compensation. They have big financial
incentives for selling complex, adjustable rate mortgages (ARM's), since they
earn higher commissions.
According to a study by Wholesale Access Mortgage Research & Consulting
Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the
U.S., with subprime and Alt-A loans accounting for 42.7% of brokerages' total
production volume.
The chairman of the Mortgage Bankers Association claimed brokers profited
from a home loan boom but didn't do enough to examine whether borrowers
could repay.

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SECURITIZATION AND
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Role of mortgage underwriters

Underwriters determine if the risk of lending to a particular borrower under
certain parameters is acceptable. Most of the risks and terms that underwriters
consider fall under the three Cs of underwriting: credit, capacity and
collateral. See mortgage underwriting.
In 2007, 40 percent of all subprime loans were generated by automated
underwriting. An Executive vice president of Countrywide Home Loans Inc.
stated in 2004 "Prior to automating the process, getting an answer from an
underwriter took up to a week. "We are able to produce a decision inside of 30
seconds today. ... And previously, every mortgage required a standard set of
full documentation." Some think that users whose lax controls and willingness
to rely on shortcuts led them to approve borrowers that under a less-automated
system would never have made the cut are at fault for the subprime meltdown.
Role of government and regulators
Some economists claim that government policy actually encouraged the
development of the subprime debacle through legislation like the Community
Reinvestment Act, which they say forces banks to lend to otherwise
uncreditworthy consumers. Economist Robert Kuttner has criticized the repeal
of the Glass-Steagall Act as contributing to the subprime meltdown. A
taxpayer-funded government bailout related to mortgages during the Savings
and Loan crisis may have created a moral hazard and acted as encouragement
to lenders to make similar higher risk loans.
Some have argued that, despite attempts by various U.S. states to prevent the
growth of a secondary market in repackaged predatory loans, the Treasury
Department's Office of the Comptroller of the Currency, at the insistence of
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SECURITIZATION AND
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national banks, struck down such attempts as violations of Federal banking

laws.
In response to a concern that lending was not properly regulated, the House
and Senate are both considering bills to regulate lending practices.
Role of credit rating agencies
Credit rating agencies are now under scrutiny for giving investment-grade
ratings to securitization transactions holding subprime mortgages. Higher
ratings are theoreticall y due to the multiple, independent mortgages held in
the MBS per the agencies, but critics claim that conflicts of interest were in
play.
Role of central banks
Central banks are primarily concerned with managing the rate of inflation and
avoiding recessions. They are also the lenders of last resort to ensure
liquidity. They are less concerned with avoiding asset bubbles, such as the
housing bubble and dotcom bubble. Central banks have generally chosen to
react after such bubbles burst to minimize collateral impact on the economy,
rather than trying to avoid the bubble itself. This is because identifying an asset
bubble and determining the proper monetary policy to properly deflate it are
not proven concepts. There is significant debate among economists regarding
whether this is the optimal strategy.
Federal Reserve actions raised concerns among some market observers that it
could create a moral hazard. Some industry officials said that Federal Reserve
Bank of New York involvement in the rescue of Long-Term Capital
Management in 1998 would encourage large financial institutions to assume
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SECURITIZATION AND
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more risk, in the belief that the Federal Reserve would intervene on their
behalf.
A potential contributing factor to the rise in home prices was the lowering of
interest rates earlier in the decade by the Federal Reserve, to diminish the blow
of the collapse of the dot-com bubble and combat the risk of deflation.

CONCLUSION
Originating in the mortgage markets of the US in the 1970s
securitization has developed and come a long way from there to spread throughout
the globe to benefit organizations Securitisation is the buzzword in today's World of
Finance. It's not a new subject to the developed economies. It is certainly a new
concept for the emerging markets like India. The Technique of
Securitisation definitely holds great promise for a Developing Country like
India. Securitisation has worked well over the other tools of financing
as it does not increase the liability of the Originator but at the same time provides him
financing .It in fact converts the NPA of the company into cash flows. The above
features help infrastructure companies to get finance easily and also helps the
banks by reducing the burden on them and helping them to concentrate on their core
business activities. But the tool has not been utilized to its fullest in our country
as cuase of the legal complications. However a welcome step was seen in the form
that securitized paper scan now be traded as assets in the market and also the reduction in
the stamp duty of the securitisation transaction. The development till off late was slow
but the future for securitisation is said to be very bright in Asias 2nd largest economy
where financing is of prime importance and the growth potential are very hi
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BIBLIOGRAPHY
BOOKS
WEB SITES
WWW.BSEINDIA.COM
WWW.FITCHINDIA.COM
WWW.NHB.ORG.IN
WWW.REDIFF.COM
WWW.ECONOMICTIMES.COM
WWW.WICKIPEDIA.COM
WWW.SOOPLE.COM
WWW.FEDERALRESERVE.GOV

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