Money, Banking, and International FinanceSecuritization and the 2008 Financial Crisis
Securitization is similar to a mutual fund. We define securitization as the process of
transforming illiquid financial assets into marketable securities. Banks and financial institutions
package similar loans together, such as mortgages, place them into a fund, and issue securities
that are tied to the fund’s assets. Then investors buy the securities to earn the return on the
fund’s assets. On average, the pool of funds has a predictable cash flow as people pay their
loans. Then investors receive these payments as investment. Banks used securitization because
they use computers to simplify the record keeping process.
Securitization is more complex because a fund could issue different bonds called tranches.
A tranche is a French term meaning a portion or slice. Each tranche has a bond associated with
a risk level and a different credit rating. Credit-rating agencies could rate some bonds as AAA
that pays the lowest return to investors, but investors are first in line if the fund goes bust.
Furthermore, the fund issues risky bonds, called speculative grade that pay a higher return, but
investors would lose their investments if the fund bankrupts.
Banks did not use securitization on a large scale before the 1990s because the banks could
not price the different tranches in the fund until a statistician, David Li, devised a method in
- Li’s method allows easy and quick pricing of these tranches. Consequently, the bankers
and financiers applied securitization to a variety of assets. They securitized mortgages, car
loans, third world debt, credit cards, and student loans. Securitization of mortgages has its own
named, mortgage asset-back securities (ABS). Unfortunately, the securitization of mortgages
led to the U.S. housing bubble between 2000 and 2007. Even in 2013, banks held $1.3 trillion in
asset-back securities.
A problem of the U.S. housing bubble was the banks relaxed their loan requirements.
Before 2000, banks would grant home loans only to borrowers with a stable work history and
good credit history. Furthermore, the borrowers documented their incomes completely. During
the housing bubble, several large U.S. banks relaxed their lending standards. Homebuyers could
state their incomes without verifying them. Furthermore, banks granted mortgages to people
with poor credit or poor work history, called subprime loans. After the U.S. economy had
entered the 2007 Great Recession, the subprime loans turned into toxic loans as the subprime
borrowers began defaulting on their loans in record numbers.
Banks relaxed their loan standards because they would not suffer from a mortgage default.
Banks used securitization to “cash” out the mortgages and “pushed” the default risk onto the
investors. Cashing out of the mortgages gave banks funds to grant new mortgages and continue
the process. Consequently, the banks relaxed their loan standards maintaining a strong demand
for mortgage loans. This credit flow rapidly appreciated housing prices in the United States
between 2000 and 2007. If a borrower had defaulted on the mortgage, homes kept appreciating
over time, so foreclosures did not harm banks and investors. Banks and investors foreclosed on
homes that soared in value.
Banks earn short-term profits from the mortgage closing cost fees and managing the fund.
In addition, attorneys earn legal fees from the fund’s setup. Of course, the banks do not earn the
cash flow from a mortgage because the fund investors do. For example, if a family bought a