Is securitization a hero or villain? The practice of packaging mortages and other collateral into bonds has been blamed by some as a cause of the credit crunch, even while others hail it as the engine of the global financial system. Perhaps too many people have ventured opinions with little more than a superficial understanding of what securitization really means.
Securitization in essence involves converting a long series of little cash flows into one giant up front cash flow through the issuance of bonds based on the secured collateral. The motivation – viewed by some as ironic in the credit crunch era – was to spread and diversify risk, so that instead of the risk of a debt going bad being borne by the lending bank it was instead split among thousands of different investors in the public marketplace.
Even better, investors could specifically choose the level of risk they were prepared to take. The most risk-averse could invest in so-called “AAA” securities which were viewed, rightly or wrongly, as gold-plated. Other investors, perhaps chasing a higher yield, could invest in the so-called “subordinated tranches”, or more junior notes. These notes would be the first to take the impact of any loss in the event that credit losses and delinquencies on the portfolio exceeded expectation. The junior notes were termed part of the “credit enhancement” in the deal since they supported the senior notes by being first in the firing line. Of course the investors’ unwritten expectation was that reserve accounts or the seller loan (in a master trust) would probably make good all losses in normal economic times
However, when the Case-Shiller index of US house prices declined year on year for the first time in its history, and the global macro-economy entered its most devastating recession since the Great Depression of the 1930s, things did not turn out to be quite so simple…
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