Securitization and Subprime Crisis by Falloul Moulay El Mehdi

COMMUNICATION SCIENTIFIQUE
SECURITIZATION AND SUBPRIME CRISIS
Colloque International sur le Management et le Dveloppement

(Ecole Nationale de Commerce et de Gestion de Casablanca)
Ahmed HEFNAOUI
Enseignant chercheur,
Chef de dpartement des sciences conomiques,
Universit Hassan II Mohammedia,
hefnaoui_ahmed@yahoo.com
Moulay El Mehdi FALLOUL
Doctorant en conomie et finance applique,
Laboratoire de performances conomiques et logistique,
Universit Hassan II Mohammedia,
mymehdi.falloul@gmail.com,
Abstract
Securitization had in the beginning a main objective which is facilitating the development of
the credit activity particularly through Credit markets. This innovation has transformed the
nature of the capital and consequently transformed the notion of ownership. Securitization
was created for the purpose of risk management and mitigation, nevertheless it turns out that
this kind of innovation is very dangerous for the entire financial system because it contributes
in the formation of speculative bubbles, the increase of the information asymmetry and the
creation and the spread of highly financial toxic assets. The subprime crisis is clearly the main
illustration of the danger of these practices. Indeed at the heart of the subprime crisis we find
the development of financial engineering and derivative products particularly securitization
which had increased significantly during the last decade, contributing in the development of
the financial disintermediation and the transfer of the credit risk.
Keywords: Securitization, subprime crisis, information asymmetry, leverage effects, financial
engineering.
Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)
INTRODUCTION
Securitization is the financial practice of pooling various types of contractual debt such as
residential mortgages, commercial mortgages, auto loans or credit card debt obligations and
selling
said
debt
as
bonds,
pass-through
securities,
or Collateralized
mortgage
obligation (CMOs), to various investors. The principal and interest on the debt, underlying the
security, is paid back to the various investors regularly. Securities backed by mortgage
receivables are called mortgage-backed securities, while those backed by other types of
receivables are asset-backed securities.
The recent international financial crisis has highlighted excesses in the use of financial
innovations and specifically the securitization of subprime mortgages. Indeed, this financial
innovation was at the heart of the recent financial global financial meltdown.
The crisis has spread by the widespread securitization of subprime mortgages; this type of
loans had been considered as a safe investment before the financial debacle. Securitization has
proved as a vector of complexity and risk propagation in the financial system. It
generates conflicts of interest between stakeholders and creates asymmetric information and
liquidity problems that are very dangerous to the international financial system.
In this article we will first analyze securitization as a sophisticated financial engineering
product by focusing on the different stakeholders, and the benefits that could be generated by
this process, then we will first present a chronology of events of the financial crisis and we
will try to locate the securitization in the context of this crisis while focusing on the
shortcomings that had produced this technique in the global financial system.
1. The mechanism of Securitization

1.1 Overview of securitization
1.1.1 Securitization process and participants

A securitization operation involves a series of actors, which explains that at first glance, it
appears complicated and that it leads to a relatively high cost. Indeed the increase in the "cost
of entry" is justified by the fact that the operation is complex and requires precision.
1.1.2 The actors in a securitization process
Servicer
A servicer collects payments and monitors the assets that are the crux of the structured
financial deal. The servicer can often be the originator, because the servicer needs very
similar expertise to the originator and would want to ensure that loan repayments are paid to
the Special Purpose Vehicle.
The servicer can significantly affect the cash flows to the investors because it controls the
collection policy, which influences the proceeds collected, the charge-offs and the recoveries
on the loans. Any income remaining after payments and expenses is usually accumulated to
some extent in a reserve or spread account, and any further excess is returned to the seller.
Bond rating agencies publish ratings of asset-backed securities based on the performance of
the collateral pool, the credit enhancements and the probability of default.
When the issuer is structured as a trust, the trustee is a vital part of the deal as the gatekeeper of the assets that are being held in the issuer. Even though the trustee is part of the
SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to
protect the assets and those who own the assets, typically the investors.
Underwriter
Underwriters-usually investment banks- serve as intermediaries between the issuer (the
SPV or the trust) and investors. Typically, the underwriter will consult on how to structure the
ABS and MBS based on the perception of investor demand. The underwriter may, for
example, advise the SPV to issue different tranches each with specific characteristics
attractive to different segments of the market. Underwriters also help determine whether to
use their sales network to offer the securities to the public or to place them privately.
Perhaps most importantly, underwriters assume the risk associated with buying an issue of
bonds in its entirety and reselling it to investors.
Special Purpose Vehicle and the Trust
The SPV can either be a trust, corporation or form of partnership set up specifically to
purchase the originator's assets and act as a conduit for the payment flows. Payments
advanced by the originators are forwarded to investors according to the terms of the specific
securities. In some securitizations, the SPV serves only to collect the assets which are then
transferred to another entityusually a trustand repackaged into securities. Individuals are
appointed to oversee the issuing SPV or trust and protect the investors' interests. The
originator, however, is still considered the sponsor of the pool.
Dealers
Just as in other bond markets, dealers play an important role once an issue is initially
distributed. For most bond investors, liquiditythe ability to easily buy or sell a securityis
an important characteristic. By offering prices at which they will buy or sell bonds to the
investment community, dealers provide this service. Bonds typically trade more actively
closer to their date of issue. Because bond investorsusually institutional investors such as
pension funds and insurance companieshold most bonds to maturity, trading in bonds
declines as they draw nearer to their stated maturity date. The issuance volume of a certain
bond, a bond's credit rating and whether it was issued publicly or privately can also affect
liquidity. All ABS and MBS are traded on the dealer-based, over-the-counter markets so
liquidity depends in part on the ability and willingness of dealers to maintain an inventory, or
make a market, in a certain bond.
Figure 1: Basic Securitization process
Tasca & Zambelli: 2005:1
1.2 Benefits of Securitization

The evolution of securitization is not surprising given the benefits that it offers to each of
the major parties in the transaction.
1.2.1 Benefits for Investors
Securitized assets offer a combination of attractive yields (compared with other instruments
of similar quality), increasing secondary market liquidity, and generally more protection by
way of collateral overages and/or guarantees by entities with high and stable credit ratings.
They also offer a measure of flexibility because their payment streams can be structured to
meet investors particular requirements. Most important, structural credit enhancements and
diversified asset pools free investors of the need to obtain a detailed understanding of the
underlying loans. This has been the single largest factor in the growth of the structured
finance market.
1.2.2 Benefits For Originators
Securitization improves returns on capital by converting an on-balance-sheet lending

business into an off-balance-sheet fee income stream that is less capital intensive. Depending
on the type of structure used, securitization may also lower borrowing costs, release additional
capital for expansion or reinvestment purposes, and improves asset/liability and credit risk
management.
1.2.3 Benefits For Borrowers
Borrowers benefit from the increasing availability of credit on terms that lenders may not
have provided had they kept the loans on their balance sheets. For example, because a market
exists for mortgage-backed securities, lenders can now extend fixed rate debt, which many
consumers prefer over variable rate debt, without overexposing themselves to interest rate
risk. Credit card lenders can originate very large loan pools for a diverse customer base at
lower rates than if they had to fund the loans on their balance sheet. Nationwide competition
among credit originators, coupled with strong investor appetite for the securities, has
significantly expanded both the availability of credit and the pool of cardholders over the past
decade.
1.2.4 Benefits for the transferor

A new source of financing
Securitization enables to change the illiquid portfolio into liquid stocks, which enables to
sell the portfolio, not to an investor anymore, but to many investors, meaning to funds
markets, and a market with an important number of investors, present throughout the world.
Transfer of risks
The risk of loss on the portfolio went on the investors, which means that if the portfolio
appears to be of bad quality and if the flows generated are insufficient, it is the investor that
will undergo, if necessary, a financial loss. However, it is rare for the whole risk to be
transmitted to the investors. In general, some mechanisms are set so that the assignor keeps
what we call the first risk on the portfolio. For banks submitted to a control of risks by their
controller, securitization, used as a risk transfer tool, is therefore particularly important.
Balance-sheet management
Securitization enables to manage the balance-sheet by controlling its inflation if it is

considered as being excessive. Indeed, by refunding the credit portfolio, an assignor liberates
funds and can increase his activity or generate new assets while keeping his balance-sheet at a
controlled level, for the assets went out of his balance-sheet.
Discretion
A bank which gives up a credit portfolio prefers the transaction to stay discrete. What it
wants the most is for its customer (the borrower) not to know anything about it. Securitization
operations made respect the regulation on the protection of private life.
In order to satisfy this need for discretion:
1. In general, customers (borrowers) are not aware of the transfer of their credit.
2. The bank will still be the customers interlocutor, with this distinction that for now on, it
will receive the funds on behalf of the SPC as the manager (no longer as an owner) of assets ;
in securitization language we can say that the bank has become the assets servicer.
1.2.5 Benefits for Investors

Securitized assets offer a combination of attractive yields (compared with other instruments
of similar quality), increasing secondary market liquidity, and generally more protection by
way of collateral overages and/or guarantees by entities with high and stable credit ratings.
They also offer a measure of flexibility because their payment streams can be structured to
meet investors particular requirements. Most important, structural credit enhancements and
diversified asset pools free investors of the need to obtain a detailed understanding of the
underlying loans. This has been the single largest factor in the growth of the structured
finance market.
2. Securitization and the financial crisis

The recent international financial crisis has highlighted excesses in the use of financial
innovations and specifically the securitization of subprime mortgages. Indeed, this financial
innovation was at the heart of the recent financial global financial meltdown.
This financial engineering technique had acted as a propagator of the financial crisis by its
uncontrolled use: massive refinancing of the American mortgage by securitization of
subprime mortgage loans (ABS), resecuritization of the ABS in complex products (CDOs),
dissemination of these products throughout the international financial system. As the
downturn in the US housing market began, the credit risk of subprimes unraveled: defaults
accumulated, leading to suspicion on securitized products (ABS, CDOs), these complex
products had begun to collapse with the rise of the Banking panics which had dried up a
source of funding at the heart of the global financial system.
It has also created holes in the balance sheets of financial institutions holding these toxic
products whose market value had sunk dramatically, securitized products had became dirty
financial products and no one wanted to buy them. We devote the next section to discussing
and analyzing the role that had played credit derivatives and securitization in the international
financial crisis. But we should first give a brief chronology of major events in the subprime
crisis, and then we will discuss the crisis transmission channels at the center of the recent
financial crisis, and finally we will analyze three major elements in the originate to distribute
model which, asymmetric information, liquidity problems and leverage effect.
2.1 A brief chronological review of the crisis
The trigger of the global financial crisis is undoubtedly the subprime mortgage market
collapse whose symptoms appeared in the summer of 2006. Before explaining the chaining of
the crisis (see annex II), it is worth mentioning the different types of mortgages In the US
Mortgage market.
Indeed, the U.S. residential real estate market is dominated by two types of credits: the first
type called (conforming loans) granted to less risky borrowers (prime borrowers) this credit
mortgage loan is conform to the standards of warrants issued by governmental agencies
(Government sponsored agencies GSE), and the second type of loans called (non-conforming
loans) which are not consistent with the standards of the GSE's) that include the Jumbo, alt-A
and subprime.
The Jumbos includes loans to prime borrowers with an original principal balance larger than
the conforming limits imposed on the agencies by Congress (this limit is currently USD
417.000);
The alt-A asset class involves loans to borrowers with good credit but include more
aggressive underwriting than the conforming or Jumbo classes (i.e. no documentation of
income, high leverage);
Subprime mortgage asset class involves loans to borrowers with poor credit history.
Subprime mortgage is at the heart of the international financial crisis called Subprime crisis,
specifically the sub-prime are real loans granted by (not subject to bank regulation) brokers
to us household low-income considered insufficient to ensure repayments. These lending
institutions based on anticipation of increase in the value of these properties that could then be
a sufficient guarantee or to get out of debt by reselling the property. In other words, taking
advantage of the rise of the real estate market, these companies have, through techniques of
aggressive selling, encouraged households to engage in real-estate speculation.
These credits were accompanied by a significant margin precisely because borrowers were
below market standards (subprime).
However, the US housing market has been reversed in the third and fourth quarters of 2005.
This downward trend of home prices had accompanied a decline of credits to households as
shown in the following graph.
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Figure 2: The evolution households credits and home prices in the USA in %
The borrowers defaults appeared in the first quarter of 2006 and delays for deadlines
increase in mortgage loans other than sub-prime mortgage credits, home prices had plunged.
Throughout 2007, the defaults had been growing. The increase in number of default of
borrowers had led naturally to an increase in home foreclosures as shown in figure 33.
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Figure 3: Number of home foreclosures in the United States, in thousands
In June 2007 the Investment Bank Bear Stearns announced the collapse of two of its hedge
funds who have invested in subprimes. While the wave home foreclosures of subprime
borrowers (high risk borrowers) kept going, markets discovered that low quality securities
that will now take the nickname of "toxic have been invested in the markets to boost their
performance by forgetting to inform that they are backed by insolvent households.
A few weeks later, we learn that the German bank IKB is in difficulty, indeed it has placed
through the Rhineland investment fund, more than 17 billion in toxic financial products. In
France: Oddo (subsidiary of French bank BNP Paribas) Corporation announces that it freezes
the subscriptions and redemptions on funds exposed to the subprime mortgage.
Following these accidents, market players are beginning to realize that the phenomenon of
toxic products scattered among investors is not that of saving corporations in The USA, but
no doubt of many others around the world.
These elements have sown a motion of no confidence to market players, as they begin to
realize the extent of the risks associated with these products and the difficulty locate and
evaluate them. This general risk aversion behavior was at the base of first true stock slip of
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the financial values in global financial markets while, throughout the first half of 2007, the
courses of these values remained in line with the General indices.
This movement now does not cease to grow. Indeed, in September 2007 in Britain, queues
of customers formed at the gate of the fifth-largest bank of the country, Northern Rock, to
carry out withdrawals of their deposits. The Bank of England granted Northern Rock an
emergency loan to avoid bankruptcy. At the same time, the European Central Bank (ECB)
and the Federal Reserve System (FED) begin granting cash in exchange for financial toxic
products. Before the end of 2007, large international banks such as Citigroup and UBS and
other US banks or European announce provisions on their sub-prime portfolios.
The year 2008 is as a black year for the financial world, indeed it begins with a big bad
news from the American Bank Meryl Lynch which States have lost on the fourth quarter
nearly 10 billion dollars on derivatives financial products. Another bad news is the
announcement of nationalization of Northern Rock, the virtual bankruptcy of Bear Stearns
bought by JP Morgan with the help of the US Treasury. Meanwhile, the FED lowered interest
rates, to help refinancing investment banks. The IMF evaluates the financial system's losses to
nearly $ 1 trillion (or $ 1 trillion).
End of June a shocking information coming from the United States ;AIG, the largest
insurance company in the world, was also hit by the spectrum of the crisis, mired in the CDS
market and toxic securities and must be rescued and government sponsored enterprises
,Freddie Mac and Fannie Mae, which are in early September, under the authority of the
Treasury.
On Global stock markets, the panic began cracking down. Accelerate the sales of
securities, restructured portfolios and speculative short sells. July 15, 2008, the French indices
and New York indices compared to early January, respectively-28% and -18%. Against its
nature, the price of a barrel of oil turned and began to move down. All cash and derivatives
markets and all financial markets, including financial markets of the emerging countries, are
of extreme volatility.
September 15th, 2008 was the beginning of the banking crisis following the decision by the
US authorities of not to rescue the 4th largest Bank in United States Lehman Brothers. Indeed
this substantial signal has shown to the market that any bank could disappear without the
intervention of the central bank to recue it, an event which gave rise to a movement of general
distrust of banks to all their banking correspondents. The lack of transparency increases the
aversion to risk in times of stress, promoting a complete drying of the liquidity.
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The domino effect could be put in place because no one knew exactly where Lehman
Brothers was counterparty risk and the value of this risk what. Lehman reported having at
least 85 billion of toxic assets, which are on the market of the CDOs and CDS, which makes
their valuation a disastrous situation for all counterparty institutions.
Banks, in front of the opacity of the situation, stopped feeding lines of credit. The money
market is frozen. The first victim is AIG it was about to go bankrupt (its stock price crashed
losing about95% of its value). The only alternative is the nationalization! Lehman Brothers
having sunk, Bear Stearns, having been taken over by JP Morgan for a trivial value, Merrill
Lynch was acquired by Bank of America. A few days later, the last two banks of investment,
Morgan Stanley and JP Morgan, took the status of universal banks. All the giants of the
American Bank are now regulated.
Now, the financial world plunged into a crisis without precedent. On the stock market,
financial values show historical decreases, followed by the rest of the values. The major
indices lose between 2 September and late October, 31% for the Standard and Poors 500, 25%
for the CAC 40. Now, the world of finance immersed in a severe crisis of confidence, this
catastrophic situation, States took urgent measures to save their banking system. Indeed,
central banks granted banks daily liquidity, moreover these institutions coordinate a historical
global cut in interest rates. The States have developed rescue plans of bankrupt institutions. In
this context, stimulus plans have been proposed, these roadmaps objectives guarantee the
banks on their loans and deposits and recapitalize those who are most in difficulty. First the
Paulson plan with a $ 700 billion to the United States, and the European plan of 1 700 billion
Euros (which is an attempt to develop a general plan that aggregates the European national
plans under the impetus of the French Presidency of the European Union). In each of the
countries, States bring cash or equity or quasi permanent financing specific to institutions in
difficulty. According to the IMF the loss of banks, was amounted at end January 2009 to 2
200 billion, a figure which maybe 16 times undervalued in the eyes of some other
stakeholders. It is in this context and at the request of Europe that brings to Washington a G20
(see annex III) which had set a number of recommendations that have never seen the day.
The question that arises here is;
How a crisis on a segment of the real estate market in the States is transformed into a global
economic crisis?
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2.2 Channels of crisis transmission

The following figure shows the transition from a markets crisis to a global economic crisis,
and the channels of the crisis transmission.
Figure 4: a crisis in three time: markets, banks, real economy
The sub-prime crisis has spread to a certain structured products because these sub-prime
credits entered in the composition of these complex financial products, and then to all
structured products because there was doubt the composition of this securitized products. At
the same time, these products have experienced a wide dispersion in the whole financial
system throughout securitization.
Structured products are difficult to understand because of the complexity of this kind of
products. So to facilitate the sale, these products were rated by rating agencies. The sub-prime
crisis has naturally resulted in a degradation of the rating of structured products and therefore
a distrust of investors.
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This element explains well the transition from a phenomenon of market to the banking
crisis. Indeed the degradation the rating of structured products has generated difficulties for
vehicles "SIV" because they hold them in their assets, and because these vehicles couldnt
anymore fund them by issuing commercial paper "ABCP" (see annex IV). To ease this
situation, the vehicles used liquidity lines which had been granted by the banks.
Two specific propagation channels explain the transition from a market crisis (sub-prime) to
a financial crisis (commercial paper ABCP market) and then to a banking crisis, liquidity and
valuation.
2.2.1 The liquidity

The drawing of the lines of bank liquidity granted by banks to their vehicles is
accompanied in many cases with a phenomenon of re-intermediation by the banks. This
phenomenon has had an impact on the balance sheet channel. Indeed many financial
institutions have reinstated operations, either because of financial ties (liquidity lines), and
either for reasons of notoriety (avoiding the materialization of a risk of reputation). This
channel of balance occurs in two ways:
-The reintegration of the stock of liquidity of "SIV" vehicles.
-The inability to securitize new assets.
2.2.2 Valuation
The fact that these financial products have been registered in accounting at their market
value caused a problem in their funding. Indeed the degradation of the rating of these
financial products led to a reduction of their value. In fact; investors removed from the market
and have no more wanted to buy this type of product, this had of course led to a draining of
liquidity which has in turn maintained a reduction in their value and the engagement of a
vicious circle. This phenomenon has had a significant impact on financial institutions through
the profit and loss account, which generated a crisis of the real economy via the restriction of
credit.
Next, we will analyze the role that had the securitization in global financial crisis.
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2.3 Securitization, transfer of risk and information asymmetry

In the United States of America, the existence of banks was based on a model in which they
granted credits and keep their value on their balance sheet until the maturity date. This model
called originate-to-hold has clearly been exceeded with the development of securitization: the
activity of the banks has indeed changed over the past decades, with the gradual development
of an originate-to-distribute model. They were able to free themselves from certain
constraints related to the production, distribution and marketing of credits. Thus securitization
allowed banks to clean up their balance sheets of risky credits that they were obliged to keep
in their balance sheets till the maturity date. Moreover, banks can even redeem credits granted
by other financial intermediaries, to unite them and then transfer them to off-balance sheet
vehicles to securitize them, securities so issued was then purchased by other banks, insurance
companies and other investment corporations.
In theory, securitization is intended to improve the efficiency of the financial system as a
whole allowing a better spread of risk. In practice this technique could lead to substantial
increase of risks and complexities in the financial system. Indeed, risk transfers generated by
securitization has developed among the originator a lax attitude vis--vis the risk analysis
(screening) and tracking (monitoring). Therefore, the amount of the credits in the system
rises, their quality deteriorates, funds that guarantee them are more and more low, and the risk
taken by the purchaser of the securitized products increase.
The securitization process games many players, and operations in this process are complex
and costly. Securitization generates conflicts of interest between: the originator (the
transferor), arranger, Management Company, the paying agent (servicer), credit Enhancement
Companies, credit rating agencies, the guardianship authorities, and investors.
In their article, "understanding the securitization of sub-prime Mortgage Credit the" (2008),
Aschcraft and Schuerman compile a list of sources of conflicts or frictions generated by
securitization which are represented in the following figure.
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Figure 5: Key players and Frictions in Subprime Mortgage credit securitization
Adam B. Aschcraft and Til Schuerman, March 2008,
1. Conflicts of interest between the mortgagor (the mortgage holder) and the originator:
abusive loan;
2 Conflict of interest between the originator and arranger: mortgage fraud;
3. Conflicts of interest between the arranger and third parties: adverse selection;
4 Conflicts of interest between the claimant and the mortgagor: moral hazard
5. Conflicts of interest between the claimant and third parties: moral hazard
6. Conflicts of interest between asset manager and investor: Agent-principal
7. Conflicts of interest the investor and the rating agencies: the model error
In the United States sub-prime crisis showed clearly the problems of information
asymmetry that can cause the securitization, thus causing a lack of general transparency
which can be very dangerous for the financial system as a whole. Traditionally, these
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problems of information asymmetry were limited since securitization transactions were

generated by good quality loans. But in recent years these financial operations were generated
by subprime mortgage loans. The following two graphs illustrate this trend.
Figure 6: Portion of securitized prime credit mortgage and subprime credit mortgage
Patrick Arhtus et al, La crise des subprimes, conseil danalyse conomique, Paris(2008)
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The figure above illustrates not only the increase in subprime mortgage loans, but
particularly in the share of subprime mortgage loans securitized. We note that in 2001, the
securitization of premium products (approximately three-quarters of the originated products)
were more important than the subprime (about half of the originated products). Due to
competition and declining interest rates, the share of securitized loans increased for both
categories, but not at the same rate, since the emission/origination of premium products ratio
known variation about 15 percent (from 76% in 2001 to 87% in 2006) against a change in
spectacular sub-prime by 63% (46% in 2001 to 75% in 2006).
The massive sub-prime securitization combined with the complexity of some products
amplified the problems of information asymmetry that locate mainly in the ring that binds the
originator and the investor in the chain of securitization.
Another problem related to the securitization is caused by the relationship between the
assignor and the specialized vehicle (located in a tax haven), in fact it is the grantor that
creates the vehicle for the occasion, which means that securitization does not allow an
important risk transfer as mentioned in theory.
Securitization allows Banks to transfer part of risk, nevertheless it incentive to take
advantage (Franke and Krahnen 2006). Accordingly, it seems that securitization, contrary to
the idea that it would foster the stability of the system by allowing a better spread of risks,
lead in fact to an amplification of these risks.
2.4 Securitization and the liquidity problems
To be readily negotiable assets, it must become a common transaction product that is
standardized to some extent. More an asset has a transparent economic value, whose
characteristics can be easily understood by a broad base of investors, more its potential
liquidity is important. Indeed, the standardization of financial products reduced the need for
recourse to costly investments to obtain detailed information and reinforces the certainty of
the nominal value attached to any assets.
In this perspective, the creation and development of an organized market for derivatives
have simplified the process of negotiation of many products by defining a common investors
informational framework. When the base of the securitization process relies on homogeneous
claims. He can then generate information about the pool of underlying assets and reduces
informational costs to investors. The pooling of homogeneous assets is a way to reduce the
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problem of adverse selection because the performance of a group of pooled assets is more
predictable than those of individual assets. Indeed, investors can more easily distinguish
between the sellers of good and bad products. In addition, the slicing through revenues from
the pool of assets according to their risk of failure reduced moral hazard problems, when the
seller agrees to bear the first losses.
However, for a large part, the creation of asset-backed securities (are OTC) not
accompanied by information necessary to market participants to control fully the risk of their
investments. Indeed structured products faced this cognitive problem which is increasing the
costs of information relating to those products which limits significantly the investor base. As
the centralization of information institutions, rating agencies can in principle alleviate this
cognitive problem without solving it. This observation is especially true for market liquidity
risk which can be apprehended by a simple rating.
It is remembered that the accumulation of several strata of securitization, which largely
characterizes complex products markets, tends to hide the amount of commitments and
leverage in the market. This situation causes significant valuation difficulties, especially for
products which are very rarely negotiated and which cannot be compared with similar assets.
Normally, or if these products are part of a strategy of detention to maturity (buy and hold),
this feature is not prejudicial to market liquidity. But it can become a serious threat in the case
urgent requests for liquidity.
The difficulty of assessing certain assets composed of structured products is in itself an
essential cause of the spread of liquidity crises. In General, the emergence of an important
flow of orders for sale on an asset is likely to give rise to the suspicion of privileged
information of donors of order on this asset quality, and bring potential buyers requiring a
significant haircut on the price in return. This fall in prices may even lead to the complete
disappearance of transactions, as demonstrated, particularly, in the compartment of
commercial paper (ABCP) asset to the United States when the subprime crisis-backed,
economic agents were being suddenly become reluctant to buy this type of securities.
More products are adapted to the needs of a specific client; they are more subject to such
access of mistrust on the part of investors. It is precisely for this reason that a liquidity crisis
which originated in complex structured products markets is manifested in a "flight to
simplicity" to benefit, including US Treasury bills. This rush to the simplest to understand
assets can have negative effects even for the markets it is likely that from now on, investors
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needs permanent liquidity (asset managers and funds related to the banks) will decide to turn
to forms simple or extremely standardized securitized instruments (securities-backed pools of
homogeneous assets). To other investors that may keep the assets maturity (life insurance
companies, pension funds) are in principle in a more favorable situation to invest in illiquid
structured products such as CDOs, because they are more interested in the flow of revenues
generated by these assets by their market value at a given time. Total securitized financial
system is particularly exposed in some standardized and opaque compartments, upgrading and
confidence crises. Where the risk of a sudden loss of confidence and an interruption the
activity of market (market-making) with disruptions affecting the liquidity of the assets
underlying markets.
2.5 Securitization and leverage effect
The lever effect that generate credit products and particularly structured credit CDOs or
ABS type, products had a major role in this crisis. Indeed, the creation and the multiplication
of these products is one of the most significant factors in the outbreak of this crisis.
Take it for instance the following example to explain this problem of leverage effect:
First suppose the existence of a hedge fund that has leverage of 2. At this point there is
nothing to worry about. Suppose now that a part of the equity capital of this Fund is provided
by a Fund of funds which has a leverage of 3. Finally, suppose that the hedge fund investing
in subordinate tranche CDO debt which got a leverage of 9. If we calculate the total of this
operation, we realize that each million of obligations of CDO is supported by less than
20000 capital (or more specifically 1000000/54 = 18518.5). In this situation, if the price of
final investment, here the obligation falls more than 2%, all the capital that supports this
investment is completely lost.
Figure No. 9 shows the disastrous situation in which structured products were able to be
transformed into toxic and extremely dangerous products because of the unbridled use of the
mechanism of the leverage effect.
22
Figure 7: Securitization and leverage effects in the United States
Federal Reserve Bank of St. Louis.
23
American sub-prime mortgages have mixed with other categories of residential mortgages
(Alta A, premium, and the FHA / VA) forming products called RMBS (Residential Mortgage
Backed securities), RMBS were mixed too with other claims such auto loans, student loans,
etc. to form ABS (Asset Backed Securities) allowing the loan originators to avoid regulatory
constraints, but especially an optimization of their performance and risk transfer.
By analogy to the example of the hedge fund cited above, bonds backed with subprime
mortgage loans have in turn been resecuritized in new vehicles, forming a CDO of ABS, these
products have been resecuritized a second time forming CDO2, which are extremely complex
financial products securitized in its turn to form CDO3 purchased by American investors.
This situation of extreme complexity can be described as a glass of water completely filled
and who could not tolerate no bucket.
This situation had spread around the world through securitization causing catastrophic
losses in large financial institutions (too big to fail institutions) considered to be institutions as
being symbols of financial capitalism such as AIG, Meryl Lynch, UBS, BNP Paribas.
24
CONCLUSION
In theory, securitization is intended to improve the entire financial system as, allowing a
better spread of risk. In practice the misuse of this technique leads to an increase of financial
risks and complexity in the financial system.
Securitization generates conflicts of interest between: the originator (the transferor), the
arranger, the management Corporation, the paying agent, credit agencies, the monetary and
financial authorities and investors.
The mass Securitization of sub-primes combined with the complexity of certain financial
products amplifies the problems of information asymmetry which is located primarily in the
ring that binds the originator and the investor in the securitization chain.
In other hand, securitization generates problems of draining of liquidity that may be
harmful to the entire financial system.
The leverage effect that generate credit products and particularly structured credit CDOs
and ABSs, had a major role in this crisis. Indeed, the creation and the multiplication of these
products is one of the most significant factors in the recent crisis outbreak and development.
25
REFERENCES
[1] Adam B. Aschcraft and Til Schuerman. (2008) understanding the securitization of the
Subprime Mortgage Credit, Staff report no. 318, Federal Reserve Bank of New York.
[2] Demyanyk, Yuliya S. and Van Hemert, Otto. (2008) Understanding the subprime
crisi Available at SSRN: http://ssrn.com/abstract=1020396.

[3] Lamya Obay. (2000), Financial innovation in the banking industry, Garland Publiching
Inc. New York.

[4] Michel Aglietta et Antoine Rebrioux. (2004), Drives du capitalisme financier,
Bibliothque Albin Michel Economie.

[5] M. Aglietta. (2008), 10 cls pour comprendre la crise, le nouvel observateur, n 2290.
[6] M. Aglietta. (2008), Comprendre la crise du crdit structur, la lettre du Centre dtudes
prospectives et dinformation internationales, N 275.

[7] M. Aglietta, L. Moreau, M. Roche. (2008)), De la crise financire lenjeu dune
meilleur valuation des crdits structurs Universit Paris X Nanterre.

[8] Michel Dietsch et Joel Petey. (2003), Mesure et gestion du risque de crdit dans les
institutions financire, Revue Banque dition.

[9] Monique Bourven et M. Yves Zehr. (2009), La crise bancaire et la rgulation
financire, Avis et rapports du conseil conomique, social et environnemental.

[10] Olivier Mellennec. (1999), Asset backed Securities, guide pratique pour investisseurs,
Groupe, SG Paris.
[11] P. Arthus, J P Betbeze, C. De Boissieu, G. C .Blancard. (2008), La crise des
subprimes, rapport rlais au conseil danalyse conomique par Christine Carl, la

documentation franaise paris 2.
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COMMUNICATION SCIENTIFIQUE

SECURITIZATION AND SUBPRIME CRISIS

Colloque International sur le Management et le Dveloppement

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Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)

SECURITIZATION AND SUBPRIME CRISIS

Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)

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1. The mechanism of Securitization

1.1.1 Securitization process and participants

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Figure 1: Basic Securitization process

Tasca & Zambelli: 2005:1

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1.2 Benefits of Securitization

1.2.1 Benefits for Investors

1.2.2 Benefits For Originators

Securitization improves returns on capital by converting an on-balance-sheet lending

1.2.3 Benefits For Borrowers

SECURITIZATION AND SUBPRIME CRISIS

1.2.4 Benefits for the transferor

Securitization enables to manage the balance-sheet by controlling its inflation if it is

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In order to satisfy this need for discretion:

1.2.5 Benefits for Investors

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SECURITIZATION AND SUBPRIME CRISIS

2. Securitization and the financial crisis

2.1 A brief chronological review of the crisis

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Figure 3: Number of home foreclosures in the United States, in thousands

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Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)

SECURITIZATION AND SUBPRIME CRISIS

2.2 Channels of crisis transmission

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2.2.1 The liquidity

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2.3 Securitization, transfer of risk and information asymmetry

Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)

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Figure 5: Key players and Frictions in Subprime Mortgage credit securitization

Adam B. Aschcraft and Til Schuerman, March 2008,

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problems of information asymmetry were limited since securitization transactions were

Laboratoire de Management, d'Innovation et d'Economie (LAMIE - ENCG Casablanca)

SECURITIZATION AND SUBPRIME CRISIS

SECURITIZATION AND SUBPRIME CRISIS

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