Overview of Securitization and Financial Structure Product Finance Essay

There have a larger number of developed countries faced a banking crisis (124 systemic banking crisis during the period from 1970 to 2007) and the recent global 2007-2008 financial crisis, which is different from many previous financial crisis that affected the global financial system during past several decades. Various studies investigated the role of securitization and structured finance product that causing the global financial crisis and banking crisis.

This paper will base on some theoretical literature and examine current banking and financial crisis in order to provide a better understanding of the role of securitization and structure finance product as the reason of global financial crisis and banking crisis in the developed countries. This paper is organized in the following manner. The first part will briefly define what securitization and structure finance product are. The second part will highlight the role how securitization should play in the economy and why this role is important. It also evaluates the problem in subprime mortgage in the United State. The third part will present the development of financial innovation have effect to create, spread the crisis. Finally, the paper concludes with a brief summary.

2. The overview of securitization and financial structure product

2.1. The overview of securitization

Securitisation is as essential to the financial system as any organised markets are. Securitization has developed and played an important role in the banking. According to Jobst (2008), securitization is ''the process in which certain types of assets are pooled so that they can be repacked into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities''

Furthermore, Mizen (2008) indicates that securitization played a key role in the financial market in the U.S. and strongly supports the financing of the financial system, in two main respects:

First, securitization may contribute to the expansion of the financial support base by transforming illiquid assets into assignable securities for the long-term.

Second, securitization may offer a better match between the borrowers and investors.

Figure 1. The securitization Landscape (International Monetary Fund 2009:80)

Covered bonds

Securitization

Pass-through securities:

U.S government-sponsored enterprises' mortgage-backed securities

Real estate investment trusts

Structure finance:

Asset-backed securities and asset-backed commercial paper

Mortgage-backed securities

Collateral debt obligations

2.2. The overview of structured finance product

According to Evans (2010), when securitization has different and unequal priority, this led to structure finance emerged. Firstly, there are three type of security including Senior, Mezzanine, and Junior. Then the development of structured finance product was more complex with Collateralised Debit Obligations, and CDO squared. This will be illustrated in the graph below

CDO2

Mortgage

MBS

CDO

The structured product has fluctuated dramatically in the last decade. For instance, in the United States and Europe, issuance finance structure product increases from 500 billion dollar to 2.6 trillion dollar, 2000 and 2007 respectively (Kodres 2008). However, in 2008 these quantities had declined sharply.

3. The development in the banking model amongst developed countries and The U.S subprime mortgage crisis

3.1. The development in the banking model amongst developed countries

Looking at first, beginning in 1980s, Kidwell et al. (2007) indicates that there was an increase in the involve of banks and securitization which offers a number of benefit to banks such as banks can reduce the amount of liabilities and assets by selling more than holding loans; moreover, securitization offers a source of funding loan which is less expensive than other fund. In 1988, new kind of securities include commercial paper, securities backed which a process making loans tradable, et; that emerge in commercial bank

Kidwell et al. (2007) offers the explanation of why commercial bank wants to operate as investment banking; the reason is the activity of investment bank was more profitable than commercial banking activity; furthermore, investment bank is more flexibility than commercial bank, in 1999 with the Financial Service Modernization Act. At the same time, in contrary, investment banks were allowed to get into activities, which was traditionally commercial bank activity.

In contrast to investment banks, commercial banks focus on taking deposit and lending. However, the bank 'originating' the loan did not necessarily fund the loan. Supporting this point, UBM TechWeb (2008) argue that the change in the banking models because some reason: firstly, commercial bank has advantages over investment bank: a good illustration of this is while commercial banks have enable to access to the discount window and enable to borrow from the Federal Reserve, the most secure liquidity source, investment bank have not have this condition. As a result, unlevered investment bank would either disappear or be transformed into commercial bank.

On the other hand, Evans (2010) demonstrates that increasing the number of traditional model of banking becomes commercial banking which is more popular, larger, and relevant.

According to Mullineux and Murinde (2003), banks play a vital role in the economy and the bank failure has led to the collapse of the financial system. The major cause of financial crisis is the banking area with the unbalance information, agency trouble and moral hazard. For example, banks in a number of developed countries have experienced severe banking crisis. In the sense, Laeven and Valencia (2008) point out banking crisis which means there are a greater number of non-payment in the financial sector, a country's corporate and bank face huge problems repaying contracts on time which has led to the asset is excess liabilities

The different between current crisis episodes and previous crisis episodes is the expansion of liquidity support not only to commercial bank like previous crisis but also to investment bank (Laeven and Valencia 2008). One of the advantages of commercial bank and investment bank is their off-balance sheet which can make use of assets for purposes of investment without risks of bankrupt to these banks system. For instance, investment bank does not maintain the securities of the company in its balance sheet and they sells them to investor, trading activity, which is more complex, risky, and different functions of classic on balance sheet such as loan expansion, deposit taking.

For example: Traditional banks originated illiquid loans and funded them with liquid deposits. Consequence, decrease in deposit supply which leading to falls loan supply and reduce in the securities value

Balance sheet

Asset

Liabilities

Loan -securities 100 -> 95

Deposit 90

securities falling value 40

Equity 10 ->5

withdraw deposit 40

3.2. The U.S subprime mortgage crisis

Jobst (2008) indicates that securitization started in 1970s. Park (2009) point out that during the period from 2004-2007, US subprime mortgage markets exploded and melted down, as an example, the housing bubble explode in early 2007 that led to quick decrease in the market value of many securities such as Mortgage Backed Securities, CMOs and CDOs. There are two types of mortgage in the U.S such as prime and subprime. Subprime mortgage means lenders used to offer mortgage, lower quality and nonstandard mortgages to borrowers with nonstandard income or credit profiles and one of these borrowers is Ninja loans borrowers have no income, little or no assets, and no job; After that these subprime mortgage loans were sold rapidly to Wall Street Company as collaterals for securitization. These loan were ensured high ratings, however, their value depend on the movements in the price of house. Therefore, when decreasing the price of house led to failure to pay the loan increased in the subprime mortgage sector, as a result the crisis occurrence.

3.3. The role of securitization and structure finance product in the banking crisis and global financial crisis.

Mizen (2008) point out commercial bank and investment bank undertake securitization through special purpose vehicles which create new asset-backed securities and enable sell the product with different risk ratings for each level. International Monetary Fund (2009) provides securitization play an important role in banks due to they allowed banks more actions in lending, liquidity risk and less cost for the bank to hold.

Laeven and Valencia (2008) demonstrates that "almost crisis have used generous liquidity support to deal with illiquidity banks"; which means banks use Asset-backed securitization that is the process transformation of illiquid assets into liquid assets ( Mullineux and Murinde 2003).

For instance, previous to the fail of the securitization, in the United States, Japan, and Western, asset-backed securities and covered bond offered the new residential mortgage loan approximately 20 to 60 percent. In addition, Park (2009) argue that ''A larger commercial banks acting as credit enhancers for the securitized instrument in order to satisfy the growing demand for new mortgage loans, that become most crucial materials for the securitization process''

Financial crisis: how it happened

4. The role of financial innovation in creation, spread of the crisis

The current financial crisis is different and much more complex than earlier financial crisis because the development of financial innovation such as new ways of packaging, reselling assets in MBS and more complex, subprime mortgage which weaker fundamental assets (Mizen 2008).

Park (2009) demonstrates that the primary cause of the current global financial crisis is the misuse of financial innovation such as new financial products, structure finance product, and risk management. Another reasons is balance sheet mismatches, on or off balance sheet

To begin with, the question arises as to the traditional model of banking would find and make the loans and hold the loans to maturity and fund it themselves which bearing the credit risk. Many economists argued without securitization and structure finance the banking would be less bad loan made due to securitization and structure finance lend so many bad loan.

Secondly, the securitization and structure finance play a vital role in banking crisis because of creating and spreading in many countries financial system, and deepening the crisis (Evans 2010)

According to Evans (2010), there are a rose rapidly of securitization and structure finance in Europe and The United State due to they seem to be benefit for everybody. For borrowers they can access to international capital market and securities market that was unavailable to them previously and probably cheaper. In addition, for originators of loan could back the loan together without having to fund them. This led to emerge of subprime mortgage in securitization.

On the other hand, Laeven and Valencia (2008) argue that in 1980, bank building society made many bad loans which not spread to another country; nevertheless, when U.S faced with problem in the housing market which spread to many countries. The reasons for this problem are when the dollar did depreciate against the Euro in the previous 2007; however there was not a decline sharply in the demand of US assets due to the use of dollar as a reserve currency. Moreover, the US mortgage market has spread with the speediness to many countries

Evans (2010) highlight the reason of this is ''the securitization and structure finance product creates marketable securities out of the underlying non-marketable loans and complicated financial assets with relatively high-yielding assets and good credit ratings''. In addition, King (2007) indicates that there was a strong demand for high yields assets such as MBSs and CDOs. Supporting to this point, Mizen (2008) argue that these securities, which were sold in the worldwide financial markets due to the high yields that attractive to investor. As a result, the subprime mortgage in the U.S spread internationally. Therefore, this clear that risk about uncertain of unfolding of the subprime crisis in the U.S was misprice and opaque in exposures and the complexity of structure finance product

Evans (2010) highlight that the process of securitization and structure finance created very complex from the underlying loans, which led to the quality of these securities were opaque In addition, according to International Monetary Fund (2009), the securitization and structure finance have to become simpler, transparent in order to improve liquidity in the future

5. Conclusion

As we know, the development of securitization and structure finance is vital for the financial market growth. It is undeniable that the role of securitization and structured finance products on financial market has caused the recent banking and financial crisis in the worldwide, particularly in developed countries. The recent crisis has been far more complex than earlier crisis because financial innovation has allowed new ways of packaging and reselling assets.

From several decades, the securitization always changes their rules in order to achieve efficient and fair in their operation. Although there are some signs of improvement, in this sense, securitisation is still certainly unable to fulfil the objectives. However, if securitization works properly securitisation should be a welfare-improving tool which makes financial market more efficient and reduce transaction costs. Nowadays, there was an increase in securitisation which use by bank as a resort, beside with other innovations such as credit derivatives, which is the next step in the growth of securitization, and help to reduce barrier for investor.

Given the rapid expansion of loan securitization (as well as the growth of loan sales and syndication), the results suggest that access to capital is less subject to variations in the supply of local deposits to banks than in the past.

https://www.americansecuritization.com the importance of securitization

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