Securitisation and the sub prime crisis

Securitisation as a concept was introduced by Lewis S Ranieri in 1977, but has gained currency only in recent years. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Of the $10.7 trillion worth of residential mortgage debt, $6.3 trillion had been securitised by mid-2007. A brief account of how securitisation works, follows.

Securitisation as the name suggests converts loans into tradable securities. Illiquid loans are packaged into a special purpose vehicle and sold in parcels to investors who are happy to receive payments from the underlying mortgages over time. Effectively, securitisation aims at generating cash out of relatively illiquid instruments. Lenders can free up capital for more lending. On the other hand, investors receive returns higher than they would have got in case of equivalent traditional investments. In the early 2000s, as the housing market boomed, securitisation seemed to create a win-win situation for lenders and investors.
As the market boomed, financial engineering and increased trading went hand in hand. Many investment banks bought the mortgages from lenders and securitized these mortgages into bonds, which were sold to investors in various forms. This “plain vanilla” securitisation soon gave way to more sophisticated structured products. Assets of different risk characteristics were combined. The cash flows expected from these assets were tranched and traded in the extremely large and very liquid secondary mortgage market. This is how Collaterised Debt Obligations (CDOs) were born.
The originate-to-distribute model of securitisation ensured that the identity of the original instruments was completely lost. Indeed, the instruments were transformed beyond recognition. Simple instruments became “exotic” ones.
In hte process, a huge shadow banking system was created. Banks did not want to keep mortgages and loans on their balance sheet as they needed more capital backing. Instead, they held mortgage backed securities with low risk weights as per the Basle framework. The funding for the loans increasingly came from non banking institutions. These included investment banks, hedge funds, money market funds, finance companies, asset backed conduits and SIVs.

According to Mark Zandy of Economy.com, the shadow banking system provided credit to the tune of $6 trillion by the second quarter of 2007. The shadow banking system was subject to minimal regulatory oversight and did not have to make significant public disclosures. The use of leverage amplified the problem. At the peak of the frenzy in 2005-06, hedge funds were leveraging their investments as many as 50 times.