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Understanding Securitization Role in Subprime Lending: Evidence from

Countrywide Financial (U.S.)


Nikhil Garg

Department of Finance, Asian Business School, Noida, U.P., India


Abstract

This paper provides an insight into the key informational frictions that arise in the process of securitization. Study has
been done to understand the reasons of Liquidity crisis and examining the reasons behind subprime lending. We continue
with a complete picture of the subprime borrower and the subprime loan along with the concept of predatory borrowing
and predatory lending. We have draw the example of a mortgage pool securitized by Countrywide Financial from 2005-
2008 to understand the role of securitization in global financial crisis.

Key words
subprime mortgage credit, securitization, global financial crisis, countrywide financial, debt securitisation
1. Introduction
Why banks go for subprime lending? What is the distinction between selling a bad loan down the chain and issuing
liabilities backed by bad loans? How securitization can lead to increase in liquidity stress? Why banks detoriated loan
origination practices and lending standards? This paper seeks to answer all of these questions. Along the way overview has
been provided on the some of the key players in the process of securitization.
A broad description of the securitization process has been provided and special attention has been given on the key
frictions that need to be resolved. Several of these frictions involve moral hazard, adverse selection and principal-agent
problems. Working of all the frictions has been evidenced by the recent problems in the subprime mortgage market
leading to global financial crisis of 2008. Securitization has always been considered as a tool of dispersing credit risk. But
after the crisis of 2007/8, a less sympathetic view of securitisation has gained support that emphasises the multi-layered
agency problems that took hold at every stage of the securitisation process, starting with the origination of the loan to the
sale, warehousing and securitisation as well as the role of the credit rating agencies in the process.
Indeed, Greenlaw et al. (2008) report around half of the total exposure of potential losses have been borne by US
leveraged financial institutions, such as commercial banks, investment banks and hedge funds. Gorton (2008) also argues
against the hot potato hypothesis by noting that financial intermediaries have borne a large share of the total losses. Hence,
we are faced with the following important question. Why did apparently sophisticated banks act as the ‘greatest fool’?
This paper focuses on the role of subprime mortgage credit in creating liquidity stress further leading to global financial
crisis.
2. Objectives of the study
The present study is undertaken with the following objectives:
1. To understand the reasons for subprime mortgages;
2. To examine key informational frictions that arise in the process of securitization;
3. To provide a few policy recommendations to the preceding analysis.
3. Literature Review
As per the ‘Hot Potato’ Hypothesis, there is always a greater fool in the chain who will buy the bad loan. At the end of
the chain, according to this view, is the hapless final investor who ends up holding the hot potato and suffers the eventual
loss. There have been mounting empirical evidences that proves that lending standards had been lowered progressively in
the run-up to the credit crisis of 2007; Demyanyk and van Hemert (2007), Mian and Sufi (2007) & Keys et al. (2007).
When you sell a bad loan, you get rid of the bad loan from the balance sheet. So, the hot potato is passed down the chain to
the greater fool next in the chain. On the other hand, by issuing liabilities against bad loans, you do not get rid of the bad
loan. The hot potato is sitting in the financial system, on the books of the special purpose vehicles (SPVs). Despite sharing
separate legal entities from the large financial intermediaries that sponsor them, the financial intermediaries have
exposures to them from liquidity enhancements and various forms of retained interest.
A large number of players are involved in complex process of securitization of mortgage loans. An overarching friction
which plagues every step in the process is asymmetric information: usually one party has more information about the asset
than another. Understanding these frictions and evaluating the mechanisms designed to mitigate their importance is
essential to understanding how the securitization of subprime loans could generate bad outcomes; Ashcraft Adam &
Schuermann Til (2008).
4. Research Methodology
Secondary Research has been used in via wide studies done in the field of securitization.
Statistical Analysis of Countrywide Financial has been done using Altman Z Linear discrimination model. Financial
statements of Countrywide have been used to examine the performance of sub-prime mortgages ranging from 2005 to
2008.
5. Liquidity Crisis
Increased use of securitization is associated with a tighter constraint against rapid reductions in balance sheet size. The
consequences of the increased funding of assets by creditors from outside the banking sector are felt most acutely when
the lending boom turns to bust. This happens because the loans to the end-user borrowers are long term, while the debt is
short term. During contraction (crisis or depression) banks attempt to reduce their total balance sheet size by reducing the
size of their notional debt level. However, if the loans to end-users are long term, then banks are not free to reduce the size
of their balance sheets flexibly.
In aggregate, the total long-term lending to end-users is mirrored by the size of the funding obtained from lenders from
outside the banking sector. Thus, at an aggregate level, the increased use of securitization is associated with a tighter
constraint against rapid reductions in balance sheet size. When value at risk increases, banks must cutback the size of their
balance sheets. Some banks will be able to reduce their balance sheets flexibly by not rolling over short-term assets and
short-term liabilities. But not every bank can do this, since the financial system as a whole holds long-term illiquid assets
financed by short-term liquid liabilities. There will be pinch points that are thus exposed when value at risk increases.
These pinch point banks will suffer a liquidity crisis.
Figure 1 and Figure 2 provide long term views of liquidity stress relative to rate and equity volatility. The differences
between the pre-crisis and post-crisis data struck as noteworthy. Before financial crisis, liquidity stress was on a lower
side, while rate volatility, and was generally elevated. After the crisis, liquidity stress was on a higher side, while both rate
and equity volatility has been relatively low.

Figure 1: Liquidity Vs Rate Volatility

Figure 2: Liquidity Vs Equity Volatility

Highly restrictive regulatory regime implemented as a result of financial crisis like increase in capital charges, restrictions
on proprietary trading etc., elevated the liquidity stress. We also believe this elevated liquidity stress, or poor market
liquidity, constrains the ability of central banks to tighten monetary when both liquidity stress and volatility
simultaneously move higher, it lead to crisis.
6. Subprime Lending
At the cost of some additional complexity, it would be possible to incorporate subprime lending into the story. Loans
should be approved only after matching all the terms and conditions of the concerned lending agency like Fannie Mae in
USA. Loans that do not meet all the criteria but are still given shall be classified as follows:
1. Loans that meet the criterion of agency but extensive underwriting is used are called Alt-A loans. For example:
borrowers with less than full documentation.
2. Loans that do not meet the following criteria are known as subprime loans.
a. Poor credit history of borrowers (FICO score of less than 660 in USA)
b. Borrowers with Debt service to income ratio of more than 50%
c. In regard to payment history one of the following:
 60 days delinquency in last 24 months or
 2+ 30 days delinquencies in last 12 months or
 Judgment, foreclosure repossession, or charge-off in prior 24 months and finally
 Bankruptcy in last 5 years
Figure 3: US Commercial Banks (Asset Composition)

Figure 4: US Mortgage Delinquency Rates


90+ days past due or in foreclosure, share of outstanding
Percentage of loans that are ninety days or more past due or are in foreclosure--have moved higher, on balance, from mid
of 2005 leading to serious delinquency issues. This rise is largely accounted for by a sharp increase in the delinquency rate
on subprime residential mortgages.
The deterioration in the subprime sector has been concentrated among borrowers whose mortgages have variable interest
rates. Amid slowing house-price appreciation and rising interest rates, one would expect residential mortgage defaults to
rise because borrowers have slimmer equity cushions with which to buffer increases in their mortgage payments or other
sources of financial stress.
6.1 Why Subprime Lending?
Once all the prime borrowers have been granted a mortgage, the banking system has to find additional means of creating
assets. Once all the prime borrowers in the population have a mortgage, the banks must find new borrowers in order to
expand their balance sheets. The only way they can do this is to lower their lending standards. Subprime borrowers will
then start to receive funding. Subprime lending was the major reason for the crises of 2007/08.
Deterioration in loan origination practices and lending standards
This issue was particularly pronounced in the U.S. (subprime) mortgage market and had many facets like:
1. Unregulated origination of mortgages and other consumer debt.
2. Rise in low- and no-documentation loans
3. As compensation in the loan origination industry (particularly mortgage origination) was tied to origination
volumes and the sale of high fee products—rather than the suitability of products sold to borrowers
(“predatory lending”) and subsequent loan performance—a sharp decline in lending standards unfolded
leading to Predatory lending.
4. When unrealized asset price gains serve as collateral for new borrowing. With additional credit provision
and leverage (as via home-equity lines of credit or cash-out refinancing) based on unrealized capital gains
rather than incomes and cash down payments, borrowers and lenders became highly exposed to a softening
in asset prices.

Figure 5: Subprime Mortgage Originations


In 2006, $600 billion of subprime loans were originated, most of which were securitized. That year,
subprime lending accounted for 23.5% of all mortgage originations (in billions of dollars)
7. Five frictions that caused the Subprime Crisis
Friction #1: Many products offered to sub-prime borrowers are very complex and subject to mis-understanding and/or
mis-representation.
A borrower might be unaware of all of the financial options available to him. Moreover, even if these options are known,
the borrower might be unable to make a choice between different financial options that is in his own best interest. This can
lead to predatory lending, better known as the welfare-reducing provision of credit Morgan (2005).
Friction #6: The investor provides the funding for the MBS purchase but is typically not financially sophisticated enough
to formulate an investment strategy, conduct due diligence on potential investments, and find the best price for trades.
Asset manager or agent provides this service and he may not invest sufficient time & effort on behalf of the investor
(principal). Friction #3: There is an important information asymmetry between the arranger and third-parties concerning
the quality of mortgage loans. The third parties are as follows:
a. Adverse selection and the warehouse lender: When the arranger is a depository institution, the funding of mortgage
loans can be done easily with internal funds. But mono-line arrangers typically require funding from a third-party lender
for loans kept in the “warehouse” until they can be sold.
Since the lender is less certain about the value of the mortgage loans, it must take steps to protect itself against overvaluing
their worth as collateral. This may lead to haircuts to the value of collateral, and credit spreads by the lender. In such
situations, the bank loan is over-collateralized (o/c) – it might extend a $9 million loan against collateral of $10 million of
underlying mortgages. The arranger is thus forced to assume a funded equity position – in this case $1 million – in the
loans while they remain on its balance sheet.
b. Adverse selection and the asset manager: The mortgage loans are pooled and sold by the arranger to a bankruptcy-
remote trust, which is a special-purpose vehicle that issues debt to investors. This is established as it protects investors
from bankruptcy of the originator or arranger. Thus, loans are now managed by an asset manager on behalf of investors.
Since, arranger has an informational advantage, it creates standard lemon problems.
c. Adverse selection and credit rating agencies: The role of credit rating agencies in crisis.
 Misaligned incentives. CRAs are overwhelmingly paid by issuer. This structure may increase the incentive for
CRAs to upwardly bias their ratings (relative to an unbiased assessment of credit worthiness) in order to win
more business.
 Issuer interaction with CRAs. To ensure demand for their securitized bonds, the arrangers (broker/dealers)
work very closely with rating agencies to develop and effectively game good credit ratings.
 Excessive reliance on CRAs. Most banks had to use CRA ratings for the calculation of capital requirements for
their ABS and RMBS holdings.
Friction #2: Together, frictions 1, 2 and 6 worsened the friction between the originator and arranger, opening the door for
predatory borrowing and lending.
Predatory lending is any lending practice that imposes unfair or abusive loan terms on a borrower. There may be a
situation where borrower can’t afford, doesn’t need, want a loan but is forced to accept using unfair means which may
include deception, coercion, exploitation or unscrupulous action.
Friction #7: Many investors became excessively reliant on external credit ratings (and eschewed their own due diligence
responsibilities) for two principal reasons. First, the mandate of many investors explicitly referenced credit ratings as the
basis for investment eligibility. Second, many investors did not have sufficient internal resources to conduct in-depth
independent credit analysis across the broad spectrum of fixed-income products, particularly with regards to securitization.
As such, some investors relied upon issuer-paid credit ratings as the primary (if not sole) determinant of credit worthiness
Figure 6: Key Players and Frictions in Subprime Mortgage Credit Securitization

Source: Ashcraft, A. and Schuermann, T. (2008)


There are two more frictions in securitization process.
4) Frictions 4: Between the servicer and the mortgagor (Moral hazard). In order to maintain the value of the underlying
asset (the house), the mortgagor (borrower) has little incentive to pay insurance and taxes on and generally maintain the
property.
5) Friction 5: Between the servicer and third-parties (Moral hazard). The income of the servicer is increasing in the
amount of time that the loan is serviced. Thus the servicer would like to delay foreclosure or modify the terms of a
delinquent loan to keep the loan on its books for as long as possible. During delinquency, the servicer shall inflate
expenses for which it is reimbursed by the investors.

Figure 7: Top Subprime Mortgage Originators


$80.00
$70.00
$60.00
$50.00
$40.00
$30.00
$20.00
2006
$10.00
$0.00 2005

Data Source: Inside Mortgage Finance (2007)


Figure 8: Top Subprime MBS Issuers
$60.00
$50.00
$40.00
$30.00
$20.00
2005
$10.00
$0.00 2006

Source: Inside Mortgage Finance (2007)


8. Countrywide Financial: Case of Subprime Mortgage
In particular, we focus on a securitization of subprime loans by Countrywide Financial. Countrywide was a conglomerate
holding company with four main activities conducted in largely separate subsidiaries – mortgage banking, general
banking, institutional broker-dealer activities that specialized primarily in trading and underwriting mortgage-backed
securities, and mortgage servicing. Until 2005, Countrywide was a designated “financial services holding company” and
its bank was a chartered national bank. The bank was also a primary dealer with the Federal Reserve Open Market Desk.
However, in December 2006 it converted the commercial bank to a federal savings bank and it became a savings and loan
holding company. The change switched the primary regulator from the Comptroller of the Currency for the bank and the
Federal Reserve for the holding company to the Office of Thrift Supervision (OTS) for both. This move is a clear example
of regulatory arbitrage since the OTS was widely perceived to be a less stringent supervisor.
Countrywide was the largest home mortgage originator in the U.S. and had originated about 17% of all the mortgage loans
in the country in 2007. The freezing up of the short-term asset-backed commercial paper market in August of 2007 made it
extremely difficult for Countrywide to finance its mortgage warehousing business. This, combined with growing
delinquency and default problems in its non-prime mortgages, resulted in a downgrade in its credit ratings and increased
its costs of funds sharply. Its stock price took a substantial hit, falling more than 50% during the first three quarters of
2007 to $ 21 per share as investors began to price in a significant probability of default. The firm’s funding problems
intensified and in mid-August it began drawing on its outstanding bank credit lines to replace its lost funding in the
commercial paper market.
The Federal Reserve, responding to the broader disruption in the commercial paper market and in capital markets more
generally, lowered the discount rate 50 basis points in August 2007 to a spread of 50 basis above the target Fed funds rate
and lengthened the term of discount loans from primarily overnight to up to 30 days.9 But more importantly from
Countrywide’s perspective, the Federal Reserve began accepting mortgage backed securities as collateral for repurchase
agreements from primary dealers one of which was Countrywide. At the same time, Countrywide also increased its
collateralized advances from the Federal Home Loan Bank of Atlanta from approximately $ 30 billion to over $ 50 billion
at the end of September 2007. These advances accounted for nearly a quarter of its total liabilities and were over
collateralized. The Home Loan Bank claims stood ahead of the claims of both the uninsured depositors and the FDIC.10
When it finally became apparent to the federal regulators that the institution might not be viable, a sale was encouraged by
the Federal Reserve to Bank of America, which assumed all the assets and liabilities of the holding company without
government assistance at a price of approximately $ 4 billion in January 2008.
8.1 Statistical Evidence: Altman Linear Discriminant Model
The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company's
likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can be calculated from data found on a
company's annual report. It uses profitability, leverage, liquidity, solvency and activity to predict whether a company has a
high degree of probability of being insolvent.
Interpretation of Z score
A score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3 are not
likely to go bankrupt. Investors can use Altman Z-scores to determine whether they should buy or sell a particular stock if
they're concerned about the underlying company's financial strength. Investors may consider purchasing a stock if its
Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8.
Analysis of Countrywide using Altman Z Model from 2005 to June 2008
S. December December June 2008
No. Financial Ratios 2005 December 2006 2007
1 1.2*(Working Capital/Total Assets) 0.08783733 0.08593018 0.08440427 0.07266583
2 1.4*(Retained Earnings/Total Assets) 0.07812764 0.08508471 0.07151958 0.05864836
3 3.3*(EBIT/Total Assets) 0.19185246 0.07153246 0.10703241 -
4 0.6*(Equity/Total Liabilities) 0.04738731 0.04627906 0.04538989 0.03867487
5 1*(Revenue/Total Assets) 0.05721042 0.05710099 0.0237762 -
Z Score (1+2+3+4+5) 0.46241516 0.3459274 0.3312265 0.16998906

Figure 9: Z score of Countrywide Financial

Z Score
0.6

0.4

0.2 Z Score

0
2005 2006 2007 2008
The fall in Z score from 2005 to 2008 clearly indicates the detoriating financial strength of Countrywide. The sharp fall
from mid of 2007 shows a likelihood that company is on the verge of bankruptcy by the end of June 2008.
8.2 How have subprime loans performed in Countrywide Financial?
The Delinquent mortgage loans columns report mortgage loans still in the pool that are 30-days, 60-days, and 90-days past
due. Fourth column represents Nonprime Delinquent Mortgage while last column shows Nonprime Mortgage Pending
Foreclosure.

Table 1: Mortgage details of Countrywide Financial


Year Delinquent mortgage loans (1) Total Nonprime Nonprime Mortgage
30 Days 60 days 90 days Delinquent Delinquent Pending Foreclosure
mortgage Mortgage (1) (1)
loans
2005 2.59% 0.87% 1.15% 4.61% 15.20% 2.03%
2006 2.95% 0.98% 1.09% 5.02% 19.03% 3.53%
2007 2.73% 1.01% 1.24% 4.98% 20.15% 3.96%
2008 3.23% 1.39% 2.92% 7.54% 28.92% 8.55%
(1) Expressed as a percentage of the total number of loans serviced Source: SEC
Figure 10: Total Delinquent Mortgage Loans

8.00%
6.00%
4.00%
2.00%
0.00%
Mar-06
Dec-05

Dec-06

Dec-07
Mar-07

Mar-08
Jun-06
Sep-06

Jun-07
Sep-07

Jun-08

Figure 11: Non Prime Delinquent Mortgage


35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%

Apr-06

Apr-07
Dec-05

Oct-06
Dec-06

Oct-07

Apr-08
Dec-07
Aug-06

Aug-07
Jun-06

Jun-07

Jun-08
Feb-06

Feb-07

Feb-08
Figure 12: Nonprime Mortgage Pending Foreclosure
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Apr-06

Apr-07

Apr-08
Dec-05

Dec-06

Dec-07
Aug-06
Jun-06

Oct-06

Aug-07
Jun-07

Oct-07

Jun-08
Feb-06

Feb-07

Feb-08

Overall increase in delinquencies in the servicing portfolio of Countrywide from June 30, 2007 to June 30, 2008 is due to
increased production of loans in recent years with higher loan-to-value ratios and reduced documentation requirements,
combined with a weakening housing market and significant tightening of available credit and to portfolio seasoning.
All Prime Mortgage Loans were securitized on a non-recourse basis, while Prime Home Equity and Subprime Mortgage
Loans generally were securitized with limited recourse for credit losses. During the six months ended June 30, 2008,
Countrywide didn’t securitize any Subprime Mortgage or Prime Home Equity Loans.
Countrywide made advances to borrowers when they make a subsequent draw on their line of credit. Reimbursements to
Countrywide were received from the cash flows in the securitization. This reimbursement normally occurs within a short
period after the advance. However, in the event that loan losses requiring draws on monoline insurer's policies (which
protect the bondholders in the securitization) exceed a specified threshold or duration, reimbursement of advances for
subsequent draws occurs only after other parties in the securitization (including the senior bondholders and the monoline
insurer) have received all of the cash flows to which they are entitled. This status, known as a rapid amortization event, has
the effect of extending the time period for which advances are outstanding, and may result in Countrywide not receiving
reimbursement for all of the funds advanced.
During the fourth quarter of 2007, off-balance sheet obligations of Countrywide, relating to rapid amortization events
contained in their home equity line-of-credit securitizations were triggered as a result of actual and probable future losses
relating to loans underlying these securitizations exceeding specified thresholds or durations. Normally, Countrywide
didn’t expect rapid amortization events to occur. However, sudden deterioration in the housing market experienced in late
2007 resulted in it becoming probable that a rapid amortization event would occur. Because of these events, Countrywide
recorded impairment losses of $704.1 million in 2007 related to estimated future draw obligations on the home equity
securitizations that have entered rapid amortization status. During the six months ended June 30, 2008, Countrywide
recorded impairment losses of $56.0 million.
As of June 30, 2008, 62.2% of the total unpaid principal balances of total securitizations were subject to rapid amortization
events.
Countrywide experienced the following challenges by end of June 2008:
 Lower loan production volumes
 Higher credit losses, impairment of subordinated interests and higher claims under representations and
warranties
 Reduced access to secondary mortgage and debt capital markets
 Increased cost of debt
 Reduction of availability of credit enhancements for the loans
The major reasons were as follows:
 Continued declines in housing values. Declines in housing values affect us by negatively impacting the demand
for mortgage financing, increasing risk of default by mortgagors and increasing risk of loss on defaulted loans.
 Increasing delinquencies and foreclosures
 Continued disruptions in the secondary mortgage and debt capital markets and
 More restrictive legislative and regulatory environments.
In December of 2007, The American Securitization Forum ("ASF") as developed to address large numbers of subprime
loans that are at risk of default when the loans reset from their initial fixed interest rates to variable rates. The ASF
Framework requires the loan servicer to categorize the targeted loans into one of three segments and address the borrowers
according to the assigned segment:
 Segment 1 loans: the borrower is likely to be able to refinance into any available mortgage product—
the borrowers should refinance their loans into the available products if they are unwilling or unable to
meet the reset payment
 Segment 2 loans: the loan is current but the borrower is unlikely to be able to refinance into any readily
available mortgage industry product—these borrowers should be evaluated for streamlined (or "fast
track") evaluation and modification
 Segment 3 loans: the loan is not current—the servicer should determine the appropriate loss mitigation
strategy—other than a streamlined modification—that maximizes the recoveries to the securitization
trust that holds the loan. Loss mitigation strategies may include loan modification, forbearance, short
sale or foreclosure.
Specifically, the ASF Framework targets loans:
 originated between January 1, 2005 and July 31, 2007
 with initial fixed interest rate periods of 36 months or less and
 that are scheduled for their first interest rate reset between January 1, 2008 and July 31, 2010.
Following is a summary of loans in SPVs that hold subprime ARM loans as of June 30, 2008.

Table 2: Subprime ARM Loans


Subprime ARM Balance at June 30, Pay Offs Fast Track Other Workout Foreclosure
Loans 2008 Activities
Segment 1 $ 5865.1 $ 940.2 - $ 219.4 $ 0.6
Segment 2 6450.4 304.5 411.5 750.5 -
Segment 3 10054.7 59.4 - 3056.4 1358.3
Total 22370.2 1304.1 411.5 4026.3 1358.9
Other Loans 32039.2
Foreclosure 3343.7
$ 57,753.1
In June 2007, a "Statement on Subprime Mortgage Lending" was issued by the federal financial regulatory agencies to
address issues relating to certain ARM (adjustable rate mortgages) products that can cause payment shock. Adjustable-rate
subprime loans have been plagued by so-called "early payment defaults," in which the borrower defaults well before their
mortgage payment resets.
In the wake of the housing bust, Countrywide was toppled by bad subprime loans, and Bank of America bought the
troubled subprime lender in a shotgun wedding in July 2008 for $4.5 billion. Since 2009, Bank of America has paid $55
billion in fines and charges, mostly attributed to shoddy Countrywide loans.
9. Conclusion
After financial crisis, securitization has been blamed for allowing the hot potato of bad loans to sit in the financial system
on the balance sheets of large banks rather than being sold on to final investors, since the aim of financial intermediaries is
to expand lending in order to utilise slack in balance sheet capacity.
For effective securitization, it is important to ensure by the servicer that that all payments due on the securitized assets
have been received timely and all the receivables that have been defaulted are liquidated.
Typically, the originator continues to provide servicing for the pool of assets that it securitizes 1 . If servicing
responsibilities are transferred to some other servicer 2 , adequate back-up arrangements as well as sufficient liquidity
should be assured to ensure minimal negative impact on asset performance.
The combination of two factors, elevated liquidity stress and high volatility has led to a somewhat vicious cycle and
feedback loop, where poor liquidity is spreading, and liquidity problems appear to be turning into fundamental problems.
Moreover, tightening of monetary policy by the Fed in U.S., through tapering before crisis and through tightening after
crisis, may have been necessary from an economic perspective, but the tightening of credit has worsen the liquidity
deterioration.
The harder question, which the analysts attempt to answer, is how these current market dynamics can be fixed or
improved.
10. Recommendations
The market of securitization is attractive but needs some rectification steps, some of which have been highlighted below.
1. The task of re-regulating securitization markets is a complex one—new measures must strike a fine balance
between preventing the accumulation of excesses on the one hand and unduly constraining securitization activity
from supporting credit and economic growth on the other.
2. Sufficient resources for servicer, the responsibility of collecting payments from borrowers, transferring them to
the trustees of the SPV, and taking remedial action in the event a payment is late.
3. Credit enhancement through guarantees is one of the main tools used by the official sector.
4. Establishing and ensuring solvency of monoline bond insurers.
5. Credit risk of the collateral asset pool is delinked from credit risk of the originator, thus increasing the
attractiveness of the instrument to investors.
6. Intense scrutiny of credit rating agencies from policymakers, regulators, analysts, and investors.
7. Need for Uniform net capital rule and stronger quality of capital.
8. The need for addressing the systemic risk in the context of banks outsourcing the development of internal control
systems and the technical models.
9. The need for strengthening disclosure requirements and monitoring compliance with standards
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Palgrave Macmillan UK.
13. Adrian, T., & Shin, H. S. (2010). Liquidity and leverage. Journal of financial intermediation, 19(3), 418-
437.

1
Except for mortgage securitizations, servicing is typically performed on a “blind” basis. That is, the servicer does
not know whether any particular asset has or has not been securitized, thus preventing the servicer from favouring
an owned asset over a securitized asset or vice versa.
2
For example, servicing may be transferred if the servicer files for bankruptcy protection and is unable to carry out
its responsibilities as servicer
14. Ashcraft, A. and Schuermann, T. (2008) Understanding the securitization of subprime mortgage credit, Staff
Report No. 318, Federal Reserve Bank of New York, available at http://www.newyorkfed.org/research/
staff_reports/sr318.pdf
15. International Monetary Fund (2008). Global Financial Stability Report, April, Washington DC: IMF.
16. Confidence, R. (2012). Global Financial Stability Report.
17. Demyanyk, Y., & Van Hemert, O. (2007). Understanding the Subprime Mortgage Crisis working
paper. New York University, Stern School of Business.
18. Kashyap, A. K., Rajan, R., & Stein, J. C. (2008). Rethinking capital regulation. publisher not identified.
19. Giddy, I. H. (2000). Asset Securitization in Asia. New York University accessed from http://www. stern. nyu.
edu/~ igiddy/ABS/absasia. pdf.
20. Bothra, N. (2016). State of Indian Securitisation Market, 2016.
21. Fons, J., Cantor, R., & Mahoney, C. (2002). Understanding Moody’s corporate bond ratings and rating
process. Special Comment. Moody’s Investors Services.
22. Mohanty, D. (2012). RBI Working Paper Series No. 06 Evidence of Interest Rate Channel of Monetary
Policy Transmission in India.
23. Carlson, M., & Weinbach, G. C. (2007). Profits and balance sheet developments at US commercial banks in
2006. Fed. Res. Bull. A37, 93.
24. Annual Report (2007, 2008) available at www.sec.gov.

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