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In 2007 banks in US have been aggressively securitization their home mortgages to

increase their earnings and to avoid credit risk as well as interest rate risk. Explain

securitization in this context.

Securitization is the process of taking an illiquid asset, or group of assets, and through

financial crisis, transforming it into a security. The 2007 financial crisis, describes the process

by which groups of such illiquid assets (debts) are sold to investors. Professor J. Hull (2014)

believes that securitisation of assets opens a new source of funding for the banks and the

credit risk bear to the investors [ CITATION Kos17 \l 1033 ].  A typical example of securitization

is a mortgage-backed security (MBS). Type of asset-backed security that is secured by a

collection of mortgages, it became extremely common by the mid-1990s [CITATION Chr17 \l

1033 ]. Mortgage-backed securities played a central role in the financial crisis that began in

2007 and wiped out trillions of dollars. At the core, an MBS allows a bank to move a

mortgage off its books by turning it into a security and selling it to investors. When a bank is

able to move mortgages off the books, it frees up money for more lending capital. With

investors inspire by the traditional strength of the housing market and the ratings on MBS,

there was steady demand for these repackaged mortgages. So, the MBS market started seeing

more subprime MBS. With Freddie Mac and Fannie Mae also aggressively supporting the

mortgage market, the quality of all mortgage backed securities down fall their increasingly

worthless ratings. When subprime borrowers began to insufficient, the housing market

tightened and then began to collapse, hurting even ordinary mortgage holders. More and more

people walked from their mortgages and the primary assets support the MBS market saw step

over lines. The inundation of non-payments meant that many of the MBSs and collateralized

debt obligations (CDO) based off of the pools of mortgages were extremely overvalued. The

market for MBSs dried up and losses piled up as institutional investors and banks attempted to

unload bad MBS investments. Credit also tightened, causing many banks and financial

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institutions to teeter on the boundary of insolvency. The bank was forced to approach the

Bank of England as lender of last resort [ CITATION Mor \l 1033 ].

. Elaborate the benefits that banks derived from the securitization of home mortgages.

a) Leverage

Leverage is borrowing money to amplify the outcome of the deal bank can make more

money thought that. Bank with the standard capital take a lot of credit to make more profit by

giving loan for example home mortgages loan. This is the benefit that bank can receive from

the loan such as interest from the loan given, collateral as the home owners default to pay the

loan, and margin of profit towards taking credit from the investor and the interest receive

from the loan given.

b) Spreading Risk

From the perspective of bank, one of the chief advantages of mortgage securitization is

that it spreads the risk of a decline in loan value among a far larger number of parties. Instead

of a single lender taking on the risk of its mortgages, the risk is transferred to a wider pool of

investors. Such as from the fixed deposit fund, current account fund, debt, share equity it is

safer securities [ CITATION Wol \l 1033 ].

c) More Market Participation

The securitization of mortgages has turned home loans into an asset with considerable

diversification, attracting a far greater number of investors than would the sale of individual

mortgages. With bank this allows a larger number of participants into the mortgage market,

helping to increase the liquidity of the assets and establish a fairer market price [ CITATION Wol

\l 1033 ].

d) Makes Capital Available

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 Before the advent of mortgage securitization, most lenders who issued loans would have

to keep them on their books and wait for money collected from mortgage payments to trickle

in before they had the capital necessary to make new loans. However, with mortgage

securitization, lenders can package the loans shortly after they are issued and sell them to

investors in exchange for the cash necessary to issue new loans. This allows more loans to be

issued, a benefit for both lenders and borrowers [ CITATION Wol \l 1033 ].

e) Lower Mortgage Rates

One of the advantages of securitization for mortgage holders is that a more liquid

mortgage market and a spreading out of risk eventually lead to lower interest rates on home

loans. While individual rates are still largely tied to a person's credit rating, mortgage rates as

a whole are made lower because securitization allows lenders to reduce costs. A paper

presented to the Federal Reserve Board finds a positive correlation between securitization and

lower rates of interest for home loans, suggesting that the savings enjoyed by lenders are

passed on to borrowers [ CITATION Wol \l 1033 ].

. What seems to be the root cause of the turmoil in the credit markets in 2007?

The main root of the turmoil in the credit markets in 2007 is from the US sub-prime

market. In the year 2007, liquidity has dried up which make the lenders are unwilling or

unable to lend to another in manner to which they had been accustomed. This squeeze in

credit availability is due to the US sub-prime market.

In this market, it is more than half of borrowers have lied about their income or are

encouraged to lie due to the less assiduous in credit appraisal by bank. Sub-prime lending is

lending offered at higher rates of interest to borrowers with poor credit history. Lenders lend

the money to the borrower with less assiduous in credit appraisal to make interest income for

the bank because they felt that the loans granted would very quickly be removed from their

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balance sheets by conversion into debt securities and sold off to eager investors, who were

motivated by the prospect of high returns. The banker has no ethic to lend the money to the

borrowers although they are not the person who are necessarily the people best equipped to

evaluate the risk that was being taken on their books In US sub-prime market, they lend the

money to the people that possibility unwilling to pay back with their poor credit history.

When difficulties in the market gave rise to borrower defaults, the problems were

compounded by a fall in house price and increase in borrowing rates that in turn trapped more

borrowers in debt that they could not afford to repay.

. What is subprime lending?

Subprime lending is a way of giving loans to customers who will be having difficulties or

problems in maintaining the repayment schedule or sometimes having setbacks such as

unemployment, divorce, financial issues, medical emergencies and etc. Subprime lending is

also called as near-prime, subpar, non-prime and second chance lending. The subprime

borrowers were also known to have FICO score below 600 which may change due to time and

certain reasons. These loans given by subprime lending has some specifications such as it has

high interest rate, poor quality collateral and less favourable terms in order to compensate for

higher credit risk. Most of the subprime loans are grouped to be sold to a group of individuals

such as a government agency or an investment bank that securitizes or packages the loans

together into a security that investors can buy and ultimately failing to meet the legal

obligations or condition of a loan which leads to the financial crisis that occurs from 2007-

2008 [ CITATION Sub18 \l 1033 ].

. What was the high-risk profile strategy of Northern Rock that backfired?

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 The high-risk profile strategy of Northern Rock that backfired was their strategy of short

term borrowing and long term lending. Northern Rock had lent long term funds towards

mortgages and had funded these mortgages by cheap short term borrowing from wholesale

money markets. This strategy was highly profitable when the market conditions is under

credit boon which mean that the markets had no liquidity problem and have a lot of money.

When the markets have a lot of money, lenders can easily get cheap funds from short term

borrowing from money markets and gives long term lending to borrowers. Although it is very

profitable, but there is a risk where the bank will face insolvency when the funds ran dry.

Besides that, Northern Rock have to pay back the short term borrowing from money markets

before the borrowers pay back the full amount of the long term lending. To pay back the short

term borrowing from money market, Northern Rock sold the mortgages loan paper to eager

investors thru broker or investment bank and Northern Rock get the money to pay short term

borrowing.

Northern Rock started to give loan mortgages to sub-prime borrowers who does not have

ability to pay and then sold the loan paper to the eager investor. Northern Rock was not

worried whether the borrowers will default the loan or not because they think that it is not

their responsible since they already sold the loan paper to other investors. Northern Rock

thinks that if the borrowers default the loan, the investor will get the house and sell the house

to get back their money. However, when many sub-prime borrowers default the loans, the

investors get the houses and the houses to be sold become more. Therefore, the price of the

houses started to go down. When the price of the houses goes down, the borrowers that have

ability to pay stop paying back because they are paying more than the worth of the house.

When borrowers default the loans, Northern Rock faced insolvency and they try to sell the

loan paper to investors, but nobody want to buy. This makes Northern Rock cannot afford to

pay back the short term borrowing.

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. What can be the impact of poor lending decisions?

Poor lending decisions means is that a bad decision taken by the bank to give loan to the

borrower who are not sure of repaying back the loan or to the borrower who don’t have a

proper collateral. By making such poor decisions it can cause problems and lead to many

unwanted situations. Decision to lend is always the real cause of bank loss when the borrower

do not repay the loan whether is a good or bad decision [ CITATION Toz17 \l 1033 ] . One of the

biggest impacts that can be seen by poor lending decisions is it will cause bank’s loss when

the borrower cannot repay back the loan. This is when banks are no longer able meet up their

obligation. They might lose too much on investment or unable to prepare the cash needed by

the depositors when the want it. When this bank fails the Federal Deposit Insurance

Corporation (FDIC) takes over, where they might sell this bank to any other stronger banks or

they may run the bank for a certain period as a federally owned bank. Although a bank failure

is announced yet there is a little reason to operate the bank if the assets are insured. As a

customer if the FDIC has already taken over the bank then your money is no longer in

available in the weak and failing bank. You can write a check or transfer your money

electronically if you want to take out your money from the bank [ CITATION Pri18 \l 1033 ].

7. What are the lessons learnt here for lenders?

a) Have a plan and stick to it.

There are countless paths to financial success. However, investors that

blindly rush from one strategy to another rarely prosper in the long run.

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Investors who find a plan that they are comfortable with and stick to that

plan across market cycles stand a much better chance of reaching their

financial goals [ CITATION Per \l 1033 ].

b) Remember that fundamental value always matters in the long run.

Investment valuations often do not reflect fundamental value because

the behaviour of market participants is commonly irrational. Nevertheless,

over time, markets always return to long-run equilibrium. This was

demonstrated during the credit crisis by the sharp declines in the value of

many previously inflated asset prices. This will also be demonstrated

when, over time, the prices of quality assets once again increase to their

true values [ CITATION Per \l 1033 ].

c) Always focus on risk management.

Portfolios can carry too much risk, either intentionally or

unintentionally. While risk does not have to be avoided, it does have to be

managed. This principle is important during crises or bear markets, but it

is even more important during bull markets and bubbles [ CITATION Per \l

1033 ].

d) Make a diversification.

Lenders should diversify their asset and not just put all egg in one

basket. This included their cash in hand, bond or stock.

e) Credit Rating.

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 Lenders must have more information about credit rating instead of

information about invest money and to make more money.

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REFERENCES

Gallant, C. (2017, November 1). What is securitization. Retrieved from Investopedia:

https://www.investopedia.com/ask/answers/07/securitization.asp

Kosmidis, T. (2017, January 17). The role of Securitization in the financial crisis of 2008.

Retrieved from https://www.linkedin.com/pulse/role-securitization-financial-crisis-

2008-thomas-kosmidis

Mortgage-Backed Security (MBS). (n.d.). Retrieved from Investopedia:

https://www.investopedia.com/terms/m/mbs.asp

Perry, B. (n.d.). Credit Crisis: Lessons Learned. Retrieved from Investopedia:

https://www.investopedia.com/university/credit-crisis/credit-crisis8.asp

Pritchard, J. (2018, October 24). Bank Failure and What Happens to Your Money. Retrieved

from https://www.thebalance.com/bank-failures-315791

Subprime lending. (2018, October 23). Retrieved from Wikipedia:

https://en.wikipedia.org/wiki/Subprime_lending

Tozer, S. (2017, July). Lending Decisions - Impact on Professional Negligence Claims.

Retrieved from http://www.falcon-chambers.com/images/uploads/articles/ST_-

_Lending_decisions_07.17_.pdf

Wolfe, M. (n.d.). The Advantages of Mortgage Securitization. Retrieved from Home Guides:

https://homeguides.sfgate.com/advantages-mortgage-securitization-8879.html