Question

Explain costs and benefits of securitization, with some emphasis on sub-prime loans. Please provide evidence for your case and site sources.

Answer 1

Securitisation is the incorporation of assets into a form of finance. The securitization of mortgage debt, particularly subprime mortgages, in mortgage-backed securities (MBS) and collateralized debt obligations ( CDOs), was a major cause of both the early and mid-2000s U.S. real estate bubble and the financial chaos that resulted from that bubble bursting out. Down the line, subprime mortgages in MBS and CDOs made them attractive to big investors because they generated higher returns due to the subprime borrowers paying higher interest rates. At the same time, this bundling was assumed to reduce the risk to creditors, and the assets earned consistently stellar ratings from credit rating firms. But the assets were used as leverage to manipulate several trillions of dollars — several times the underlying assets face value.

Advantages of Securitization

Securitization allows investors to have more direct legal claims on credits and receivables portfolios. Also, the costs charged by lenders can be effectively diminished due to disintermediation (lessing the position of intermediaries). Through can the credit origination and fees, banks can increase their profitability.

Investors can easily access securities that suit their needs in terms of risk, return and maturity. For example, long-term real-estate loans can be accessed by a pension fund with a long-term horizon.

Securitization also enables vast quantities of liquidity to be generated for tradable securities and results in more competitive capital markets.

Disadvantages and Risks

Perhaps the greatest downside that securitisation brings is uncertainty, leading to the highest risks. The securitisation process is surprisingly complex. When substantial government involvement is involved, the process can become much more complex, maybe in loans that have social and political consequences. By the end of such a process, all the uncertainties and complexities that have gone into it will have created securities so incredibly complicated that accurate evaluation of their level of risk is all but impossible.

Thus, the tranches of such a securitization could very well end up with risk ratings that do not reflect their true level of risk correctly. Needless to mention, there is a significant danger to investors from inaccurate risk scores. So long as the economy goes well, these securities will produce earnings as expected. However, if an economy fails or crashes, repayments will likely be skipped and if the tranches have been wrongly calculated, not just those investors who placed their money in higher risk tranches will be affected, but also those investors who invested in the lowest risk tranches.

Refernce- Book on The Mechanics of Securitization: A Practical Guide to Structuring and Closing Asset-Backed Security Transactions- Moorad Choudhry