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Asset Securitization Capabilities

Securities firms also play a crucial role in asset securitization, one of the most important results of financial innovation. Although the collapse of Bear Stearns and Lehman Brothers is inseparable from those structured financial products that once brought huge profits and benefits to the companies, asset securitization does have a profound impact on modern financial markets.

According to the SEC Rules for Asset-Backed Securities (2005), asset securitization is a financing technique in which financial assets (in many cases less liquid themselves) are pooled and converted into instruments that may be offered and sold more freely in the capital markets. Professor Frank J. Fabozzi from Yale University (see, for example, Fabozzi & Kothari, 2008) believes that asset securitization is a process whereby mortgage loans, installment contracts, and other less liquid assets of common characteristics are packaged into market-oriented, interest-bearing securities of investment value. Generally, securitized products can be divided into mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs), among others. Figure 2.4 shows the rationale for asset securitization (MBS).

Usually, when granting loans to borrowers, commercial banks are faced with certain risks over a long period. They are also required by regulatory authorities to set aside risk provisions in proportion to the loan size. Before the advent of asset securitization, loaning banks had to count on loan repayment and interest and could not do anything about default and payment difficulties. However, by means of asset securitization, a bank may redivide and regroup its loans by bundling loans of the same or similar type, period, and default risk. The underlying assets are then repackaged into an asset pool and cause a special purpose vehicle (SPV) to be formed to fund the bank-held loans and buy the underlying assets by issuing securities. In this way, securitized assets are separated from the bankruptcy risk that may exist in asset owners. Certainly, this process also needs credit enhancement and rating. Investors invest in SPV-issued securities and receive repayment and interest that flows in on a stable basis.

To cater to investors of different risk preferences, such securities may be split into tranches. For example, mortgage-backed securities (MBS) are usually split into six tranches. Figure 2.4 showed three tranches—senior, mezzanine, and junk tranches. The senior tranche has the least risk exposure and the lowest returns, whereas the junk tranche has the maximum risk exposure but the highest returns. The mezzanine tranche falls somewhere between the two as to risk exposure and returns. Cash flows usually cascade from senior to junk tranches, while loss is absorbed from junk to senior tranches.

Commercial banks are very keen on securitization of mortgage assets. Because asset securitization is an off-balance-sheet business activity (meaning it is not reflected in the balance sheet), commercial banks can circumvent mandatory regulatory capital requirements, reinvest the money gained from the transfer of loans in new activities, and also collect certain fees and charges in the process. As this business evolves, the subject of securitization is supplemented with car loans, credit card receivables, student loans, intellectual property, carbon emission infrastructure, and many others. In other words, securitized products have been or are being developed for any asset that can generate cash flows in the foreseeable future. Encouraged by strong market demand, Wall Street "rocket scientists" and quantitative analysts push securitization even further. Figure 2.5 shows the notional amount of global over-the-counter (OTC) derivatives as of July 2011.

From Figure 2.5, we can see that there is an enormous amount of outstanding OTC derivatives, totaling up to USD 707 trillion in notional value.

Rationale for Asset Securitization

FIGURE 2.4 Rationale for Asset Securitization

Notional Amount of Global OTC Derivatives (USD in billions)

FIGURE 2.5 Notional Amount of Global OTC Derivatives (USD in billions)

Source: BIS Quarterly Review, December 2011.

(In contrast, the gross value for such derivatives is USD 19.52 trillion as of July 2011, according to the estimates of the Bank for International Settlements.) Interest rate derivatives occupy the largest portion, and interest rate swaps take the lion's share thereof. Credit default swaps (CDS) is a product once developed to further circumvent and hedge credit risk, which has now gone astray from its original purpose due to speculation. During the 2008 financial crisis, which was triggered by a subprime mortgage crisis, the American International Group (AIG) suffered a huge loss in CDS insurance policies.

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