What role did securitisation play in the 2008 financial crisis?Securitization and Key Players The financial crisis of 2007-2008 also known as the Global Financial Crisis was pondered to be one of the nastiest catastrophes since the Great Depression by many of the renowned economists (Reuters, 2009). Also as quoted by Rogoff, a once in a fifty year event in the same press release, was the cause of the decline in the economy of most of the middle class people of U.S. leading us to the topic of the role of securitization in that crisis. Clearly, the securitization which led to the country?s housing bubble was the lead player in the context of the crisis of which we are going to have a concise discussion. The word securitization started in 70s when the U.S. government supported agencies grouped the home mortgages and later in the 80s other income generating assets were also securitized (Jobst, 2008). The securitization became prominent at the end of the 20th century in the banking world when David Li formulated a method to manage the tranches of the fund (Szulczyk, July 2015). ABSs and CDOs For understanding the role played by the securitization in the financial crisis, first of all we should have a clear understanding of the concept. Securitization is the process in which all the similar mortgages are pooled together to form a fund and issue securities known as mortgage asset-backed security (ABS). TABS is sold to the investors who earn returns on the fund?s assets (Szulczyk, July 2015). When the ABS is devised, the issuer would break it into parts known as tranches whose structure is at the hands of the issuer with an ABS having varying risk tolerances like pension funds with high credit-rated ABS, hedge fund having higher returns and low credit ratings (Gallant, 2015). Also, the bankers convinced the home loan customers to decide on the adjustable-rate mortgages (ARMs) in which the mortgage payment changes with the interest rate change so that initially the home owners who had paid low mortgages had to pay colossal amounts as the interest rates hike. If twas the case in the banks, when we see the investment bank sector they too did not let go of topportunity to go waste. What they did was re-securitization of thbonds. The investment banks combined the mortgage-backed securities into bonds known as Collateralized Debt Obligations (CDOs). They placed thinto funds forming new securities and sold them to the investors in tranches with varying returns and risk levels. The point to be noted here is that the investment bankers did not stop with selling them within the U.S. but around the world which was against the U.S. policies so as to gain more and more by collecting fund setup fees and fund management fees. There is a part played by credit rating agencies also where due to their ineffectual abilities or intentional deceit they gave AAA credits to most of the funds even to those which contained subprime loans. The investors who were often did not have in-depth knowledge of such things started buying thsecurities and the trade of thtypes of funds increased in large numbers. Housing bubble The predicament of the housing bubble started when the banks started relaxing their requirements of the loans. They initialized providing loans to people who did not have creditability of their income and poor history of occupation, known as subprime loans, whereas earlier the banks had stringent rules with respect to thissues and held a tight leash on whom to approve the loans. The banks slackened the loan policies as they did not bear the brunt of the mortgage default and they laid that risk on the investors. They simply liquefied the assets of the mortgages by foreclosing them, which provides the cash for new mortgages and they continued the practice.Thfunds were sold directly to the investors or to the investment banks (Barmat, 1990). The banks received profits of short term from mortgage foreclosing fees and managing the funds. Trepose in the loan requirement made the demand for the mortgage loans to increase, making the banks to create more of ABS. As people got loans easier, more of them were able to buy property and the real estate value increased incredibly which was very convenient for the banks at the time of foreclosure. Tcycle of providing the loans to get property, creating ABS, foreclosing them with good price for the property and again providing the loans continued to be good as far as the real estate values were at the peak. Deflation of housing bubble The trend changed and the downfall occurred when the recession hit the U.S. economy in 2007 where the rate of unemployment increased leading to the defaulting of the housing mortgages with rapid speed. Because of tthe housing development declined and nobody was in a place to get loans anymore. Tsudden flush of the defaults in the market raised doubts in investors and they were not ready to invest in the ABSs or the CDOs. The lending fell in the mid-2007 and kept on increasing with the financial crisis in September 2008 which is reported as lending was 37% lower than the earlier 3 month period and 68% lower than the 3 month period at the peak of the crisis between March-May 2007. By the end of the 2007, the CDOs which were large loan buyers vanished after the decline in the securitized mortgages (Ivashina&Scharfstein, 2008). The investment banks had a plethora of unsold CDOs and the banks faced the foreclosure of homes with far less value. The banks had to face too many foreclosed mortgages which led them to insolvency. Thus the securitization played a major part in the financial crisis of 2008 spreading panic and insecurities throughout the financial sector. It is seen that the main cause for the housing bubble to enlarge is the grave necessity of the larger financial bodies like banks and investment banks to gain their share of money in the market as much as possible by insistently using the securitization tools (Fligstein& Goldstein, 2010). Treason led them to relax their regulations to such an extent that it was made into a joke among the public.Bibliography 1. Barmat, J. (1990). Securitization: An Overview. The Handbook of Asset- Backed Securities, edited by Jess Lederman. New York: New York Institute of Finance. Pp 3-22. 2. Fligstein, N. & Goldstein, A., (2010). The Anatomy of the Mortgage Securitization Crisis, Institute for Research on Labor and Employment UC Berkeley: Institute for Research on Labor and Employment. [Online] Available from: http://escholarship.org/uc/item/9bh786v2. [Accessed: 4th November 2015]. 3. Gallant, C., (2015) what is securitization? Investopedia. [Online] Available from: http://www.investopedia.com/ask/answers/07/securitization.asp. [Accessed: 4th November 2015]. 4. Ivashina, V. & Scharfstein, D. (December, 2008). Bank Lending During the Financial Crisis of 2008, p.1-5.[Online] Available from: aeaweb.org. [Accessed: 4th November 2015]. 5. Jobst, A., (September 2008). What is securitization? Finance and Development, p.48. [Online] Available from: https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf. [Accessed: 4th November 2015]. 6. Three Top Economists Agree 2009 Worst Financial Crisis Since Great Depression; Risks Increase if Right Steps are Not Taken Reuters (February, 2009). Reuters. [Online] Available from: http://www.reuters.com/article/2009/02/27/idUS193520+27-Feb-2009+BW20090227. [Accessed:4thNovember 2015]. 7. Szulczyk, K. (July, 2015). Securitization and the 2008 Financial crisis version 2 Money, Banking, and International Finance.Boundless.[Online] Available from: https://www.boundless.com/users/233416/textbooks/money-banking-and-international-finance/the-banking-business-10/the-banking-business-31/securitization-and-the-2008-financial-crisis-102-15200/. [Accessed: 4thNovember 2015].
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