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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.
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)
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.
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
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.
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
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Report No. 318, Federal Reserve Bank of New York, available at http://www.newyorkfed.org/research/
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