INDEX

Sr. no
01
02
03
04
05
06
07
08
09

TOPICS
SUMMARY
INTRODUCTION TO SECURITIZATION
INTRODUCTION
MEANING
HISTORY
PARTIES TO SECURITIZATION
BASIC PROCESS
FEATURES
FORMS OF SECURITIZATION

10
11
12
13

STRUCTURES
US SUBPRIME MORTGAGE CRISIS
THE ROLE OF CREDIT DEFAULT SWAPS
FREEZING OF MONEY MARKETS
THE VICIOUS CYCLE OF FINANCIAL

14

CRISIS
ROLE OF SECURITISATION IN US SUB

15
16

PRIME MORTGAGE CRISIS

CONCLUSION
BIBLIOGRAPHY

SUMMARY

The objective of this study is to understand the concept of securitisation, its

history, and its importance in the field of financing in an ever booming global
economy.
Securitisation is the process of conversion of existing assets or future cash flows
into marketable securities. In other words, securitisation deals with the
conversion of assets which are not marketable into marketable ones.
The meaning of "securitisation" is to create a multiple assets generation at a
lower cost of capital while protecting the beneficial interest of the investors. It is
a financial instrument for various investment projects. Securitisation in simple
word scan be defined as "structured project finance. Thus it can be said with
ease that the objective of "true securitisation" is to create a multiple assets
generation at a lower cost of capital while protecting the beneficial interest of
the investors.
The study also gives an overview on the Indian experience of securitisation, its
help in financing infrastructure projects & building credit off stake for banks
and its importance and future in the Indian economy.
Provision of quality infrastructure services at a reasonable cost, is a necessary
condition for achieving sustained economic growth. In fact, one of the major
3

challenges being faced by the Indian economy is to enhance infrastructure

investment and to improve the delivery system and quality of services. There is
a huge critical importance of the infrastructure sector and high priority for
development of various infrastructures is being given these days. Investments in
these sectors involve high risk, low return, lumpiness of huge investment, high
incremental capital/output ratio, long payback periods, and superior technology.
The infrastructure sector, it is the biggest capital deficit sector of Indian
economy; it requires financial engineering and innovations to fund the
infrastructure projects. One of best the solutions to this problem is
"securitisation."
The need of securitisation is not only felt by the infrastructure sector but also
the banking sector. Other than freeing up the blocked assets of banks,
securitisation can transform banking in other ways as well - it helps in the
growth of credit off stake of banks thus funding for release of more loans.
This will benefit investors as they will have a claim over the future cash flows.
The originator will also benefit as loan obligations will be met from cash flows
generated.
The reasons why securitisation gains over other forms is its low capital costs for
high asset generation, an alternative source of fund and minimal risks involved.

Therefore securitisation can be viewed as a major tool for financing the various
projects over different sectors in the present as well as for the years to come.

INTRODUCTION TO SECURITISATION
INTRODUCTION
"Securitisation will be the major financial instrument for the next decade,"
-by ICICI chairman K V Kamat.
Recent years have witnessed the wide spread of western financial innovations
into developing markets. Globalisation and integration of capital markets,
started in the 1990s, have made it possible for such big global players as India
to adopt new financial strategies which allow increasing liquidity and
accelerating development of the capital markets. One of these financial
innovations is securitisation, the process of transformation of illiquid assets into
a security which can be traded in the capital markets.
Securitisation is the buzzword in today's world of finance. It's not a new subject
to the developed economies. It is certainly a new concept for the emerging
markets like India. The technique of securitisation definitely holds great
promise for a developing country like India.
Funds of a firm get blocked in various types of assets such as loans, advances,
receivables etc. To meet its growing funds requirements, a firm has to raise
additional funds from the market while the existing assets continue to remain on
its books. This adversely affects the capital adequacy and debt equity ratio of
the firm and may also raise its cost of capital. An alternative available is to use
6

the existing illiquid assets for raising funds by converting them into negotiable
instruments. E.g. a housing loan finance company, which has a portfolio of loan
advances having periodic cash flows, may convert this portfolio to instant cash.
Though the end result of securitisation is financing, it is not financing as such
since the firm securitizing its assets is not borrowing money, but selling a
stream of cash flows that are otherwise to accrue to it.
Securitisation is "Structured Project Finance". The financial instrument is
structured or tailored to the risk-return and maturity needs of the investors,
rather than a simple claim against an entity or asset. The popular use of the term
Structured Finance in today's financial world is to refer to such financing
instruments where the financier does not look at the entity as a risk: but tries to
align the financing to specific cash accruals of the borrower.
The actual and a current meaning of securitisation is a blend of two forces that
are critical in today's world of Finance: Structured Project Finance and Capital
Markets.
The process of Securitisation creates a strata of risk-return and different
maturity securities and is marketable into the capital markets as per the needs of
the investors. The basic idea is to take the outcome of this process into the
market, the capital market. Thus, the result of every securitisation process,
whatever might be the area to which it is applied, is to create certain
instruments, which can be placed in the market.
7

Securitisation is the process of de-construction of an entity:

If one envisages an entitys assets as being composed of claims to various cash
flows, the process of securitisation would split apart these cash flows into
different buckets, classify them, and sell these classified parts to different
investors as per their needs. Thus securitisation breaks the entity into various
sub-sets.
Securitisation is the process of integration and differentiation:
The entity that securitizes its assets first pools them together into a common
hotchpots assuming it is not one asset but several assets. This is the process of
integration. Then, the pool itself is broken into instruments of fixed
denomination. This is the process of differentiation.

MEANING

Securitization is the process of homogenizing and packaging financial

instruments

into

new

fungible

one.

Acquisition,

classification,

collateralization, composition, pooling and distribution are functions within this

process
As defined by The securitisation and reconstruction of financial assets and
enforcement of security interest act, 2002:
securitisation means acquisition of financial assets by any securitisation
company or reconstruction company from any originator, whether by raising of
funds by such securitisation company or reconstruction company from qualified
institutional buyers by issue of security receipts representing undivided interest
in such financial assets or otherwise.
Securitisation is the process by which, financial assets such as household
mortgages, credit card balances, hire-purchase debtors and trade debtors, etc.,
are transformed into securities by the owner (the originator) in return for an
immediate cash payment and/or deferred consideration through a Special
purpose vehicle (SPV) Created for this purpose.
The pooling standard prescribes that the asset portfolio has to be homogeneous
in terms of underlying financial asset, maturity and risk profile. This ensures an
efficient analysis of the credit risk of the asset portfolio and a common payment
pattern. It means only one type of asset (e.g. Car loans) of similar duration (e.g.
9

20 to24 months) having uniform risk (whose repayment is continuous during

the first 10to 12 months of the loan) will be bundled for creating one securitized
instrument.
The special purpose vehicle finances the assets transferred to it by the issue of
debt securities such as loan notes or Pass through certificates, which are
generally monitored by trustees. Pass through certificates are certificates
acknowledging a debt where the payment of interest and/or the repayment of
principal are directly or indirectly linked or related to realisations from
securitised assets.
Let us consider some examples:
1) Suppose Mr X wants to open a multiplex and is in need of funds for the
same. To raise funds, Mr X can sell his future cash flows (cash flows arising
from sale of movie tickets and food items in the future) in the form of securities
to raise money. This will benefit investors as they will have a claim over the
future cash flows generated from the multiplex. Mr X will also benefit as loan
obligations will be met from cash flows generated from the multiplex itself.
2) A finance company with a portfolio of car loans can raise funds by selling
these loans to another entity. But this sale can also be done by securitizing its
car loans portfolio into instruments with a fixed return based on the maturity
profile (the period for which the loans are given). If the company has Rs 100
10

crore worth of car loans and is due to earn 17 per cent income on them, it can
securitize these loans into instruments with 16 % return with safeguards against
defaults. These could be sold by the finance company to another if it needs
funds before these loan repayments are due. The principal and interest
repayment on the securitised instruments are met from the assets which are
securitised, in this case, the car loans.
Selling these securities in the market has a double impact. One, it will provide
the company with cash before the loans mature. Two, the assets (car loans) will
go out of the books of the finance company, a good thing as all risk is removed.

HISTORY

11

Securitization in its present form originated in the mortgage markets in USA. It

was promoted with the active support of the government. The government
wanted to promote secondary markets in mortgages to allow liquidity for
mortgage finance companies. Government National Mortgage Association
(GNMA) was the first one to buy mortgages from mortgage companies and to
convert them into pass through securities - this was 1970. GNMA were passing
through securities backed by mortgage insured by FHA.
These pass through have the full credit and the backing of the US government,
since GNMA has guaranteed both the repayment of the principal and timely
payment of the interest. The 1970 program (GNMA -I) is still in operation. In
1983, GNMA launched another pass through program called GNMA - Ii. These
programs are further classified based on the type of mortgages pooled therein,
such as single family (SF) loans, mobile home (MH) loans, project loans (PL)
etc.
Other us government agencies, FNMA and Freddie Mac jumped in later. The
first FNMA mortgage backed securities (MBS) was issued in 1981. The agency
played a crucial role in promoting securitisation of adjustable-rate mortgages
(ARMs) and variable rate mortgages (VRMS). FHLMC was created in 1970 to
promote an active national secondary market in residential mortgages and has
been issuing mortgage-backed securities since 1971.

12

The first securitisation of receivables outside the mortgage markets happened

in1975 when Sperry Corporation securitised its computer lease receivables.
Another mortgage funding device, slightly different from the US-type pass
through certificates, has existed in Europe for almost two centuries in the past.
In Denmark, for example, mortgage bonds are more than 200 years old.
Germany also has a long history of mortgage bonds and it is stated that there
have been no defaults on these instruments for all these years. Other countries in
Europe have been relatively slow starters, though regulatory and legislative
changes in Germany, France, Belgium and Spain have been fashioned to assist
development of securitisation. In Japan, the securitisation market was not well
developed until recently; the government had restricted securitisation to the
assets of leasing, consumer loans and credit card companies. The government
has, however, amended laws to allow full-scale securitisation in May 1997.

Securitization in India

13

The first widely reported securitisation deal in India occurred in 1990 when auto
loans were secured by CITI bank and sold to the GIC mutual fund. However,
the sound legal framework for securitisation was not drafted until 2002 when
the securitisation and reconstruction of financial assets and enforcement of
security ordinance (ordinance) was promulgated by the president of India.
According to this law, securitisation was defined as acquisition of financial
assets by any securitisation company or reconstruction company from any
originator, whether by raising funds by such securitisation or reconstruction
company from qualified institutional buyers by issue of security receipts
representing undivided interest in such financial assets or otherwise. The
notion of financial assets for the above definition is stated as any debt or
receivables. Non-surprisingly, it follows that the definition of securitisation in
India is very close to that of western countries, especially taking into account
that the experience of the UK is of special relevance to India.

PARTIES TO THE TRANSACTION

14

The securitization process redistributes risk by breaking up the traditional role

of a bank into a number of specialized roles: originator, servicer, credit
enhancer, underwriter, trustee, and investor. Banks may be involved in several
of the roles and often specialize in a particular role or roles to take advantage of
expertise or economies of scale. The types and levels of risk to which a
particular bank is exposed will depend on the organizations role in the
securitization process.
With sufficient controls and the necessary infrastructure in place, securitization
offers several advantages over the traditional bank lending model. These
benefits, which may increase the soundness and efficiency of the credit
extension process, can include a more efficient origination process, better risk
diversification, and improved liquidity. A look at the roles played by the primary
participants in the securitization process will help to illustrate the benefits.

BORROWER

15

ORIGINATOR OR
SERVICER

RATING

SPECIAL PURPOSE

CREDIT

AGENCY

ENTITY / TRUSTEE

ENCHANCER

UNDERWRITER

INVESTOR

Figure 1: Parties Involved in Structuring Asset-Backed Securities

1. Borrower: The borrower is responsible for payment on the underlying

loans and therefore the ultimate performance of the asset-backed security.
Because borrowers often do not realize that their loans have been sold,
the originating bank is often able to maintain the customer relationship.
From a credit risk perspective, securitization has made popular the
16

practice of grouping borrowers by letter or categories. At the top of the

rating scale, A- quality borrowers have relatively pristine credit
histories. At the bottom, D- quality borrowers usually have severely
blemished credit histories. The categories are by no means rigid; in fact,
credit evaluation problems exist because one originators A borrower
may be anothers A- or B borrower. Nevertheless, the terms A paper
and B/C paper are becoming more and more popular. Borrower will
typically have an extensive credit history with few if any delinquencies,
and a fairly strong capacity to service debt. In contrast, a C quality
borrower has a poor or limited credit history, numerous instances of
delinquency, and may even have had a fairly recent bankruptcy.
Segmenting borrowers by grade allows outside parties such as rating
agencies to compare performance of a specific company or underwriter
more readily with that of its peer group.
2. Originator: Originators create and often service the assets that are sold
or used as collateral for asset-backed securities. Originators include
captive finance companies of the major auto makers, other finance
companies, commercial banks, thrift institutions, computer companies,
airlines, manufacturers, insurance companies, and securities firms. The
auto finance companies dominate the securitization market for
automobile loans. Thrifts securitize primarily residential mortgages
through pass-through, pay through, or mortgage-backed bonds.
17

Commercial banks regularly originate and securitize auto loans, credit

card receivables, trade receivables, mortgage loans, and more recently
small business loans. Computer companies, airlines, and other
commercial companies often use securitization to finance receivables
generated from sales of their primary products in the normal course of
business.
3. Servicer: The originator/lender of a pool of securitized assets usually
continues to service the securitized portfolio. (The only assets with an
active secondary market for servicing contracts are mortgages.) Servicing
includes customer service and payment processing for the borrowers in
the securitized pool and collection actions in accordance with the pooling
and servicing agreement. Servicing can also include default management
and collateral liquidation. The servicer is typically compensated with a
fixed normal servicing fee. Servicing a securitized portfolio also includes
providing administrative support for the benefit of the trustee (who is
duty-bound to protect the interests of the investors). For example, a
servicer prepares monthly informational reports, remits collections of
payments to the trust, and provides the trustee with monthly instructions
for the disposition of the trusts assets. Servicing reports are usually
prepared monthly, with specific format requirements for each
performance and administrative report. Reports are distributed to the
investors, the trustee, the rating agencies, and the credit enhancer.
18

4. Trustee: The trustee is a third party retained for a fee to administer the
trust that holds the underlying assets supporting an asset-backed security.
Acting in a fiduciary capacity, the trustee is primarily concerned with
preserving the rights of the investor. The responsibilities of the trustee
will vary from issue to issue and are delineated in a separate trust
agreement. Generally, the trustee oversees the disbursement of cash flows
as prescribed by the indenture or pooling and servicing agreement, and
monitors compliance with appropriate covenants by other parties to the
agreement. If problems develop in the transaction, the trustee focuses
particular attention on the obligations and performance of all parties
associated with the security, particularly the servicer and the credit
enhancer. Throughout the life of the transaction the trustee receives
periodic financial information from the originator/servicer delineating
amounts collected, amounts charged off, collateral values, etc. The trustee
is responsible for reviewing this information to ensure that the underlying
assets produce adequate cash flow to service the securities. The trustee
also is responsible for declaring an event of default or an amortization
event, as well as replacing the servicer if it fails to perform in accordance
with the required terms.
5. Credit Enhancer: Credit enhancement is a method of protecting
investors in the event that cash flows from the underlying assets are
insufficient to pay the interest and principal due for the security in a
19

timely manner. Credit enhancement is used to improve the credit rating,

and therefore the pricing and marketability of the security. As a general
rule, third-party credit enhancers must have a credit rating at least as high
as the rating sought for the security. Third-party credit support is often
provided through a letter of credit or surety bond from a highly rated
bank or insurance company. Because there are currently few available
highly rated third-party credit enhancers, internal enhancements such as
the senior/subordinated structure have become popular for many assetbacked deals. In this latter structure, the assets themselves and cash
collateral accounts provide the credit support. These cash collateral
accounts and separate, junior classes of securities protect the senior
classes by absorbing defaults before the senior positions cash flows are
interrupted.
6. Rating Agencies: The rating agencies perform a critical role in
structured finance evaluating the credit quality of the transactions.
Such agencies are considered credible because they possess the expertise
to evaluate various underlying asset types, and because they do not have a
financial interest in a securitys cost or yield. Ratings are important
because investors generally accept ratings by the major public rating
agencies in lieu of conducting a due diligence investigation of the
underlying assets and the servicer. Most nonmortgage asset-backed
securities are rated. The large public issues are rated because the
20

investment policies of many corporate investors require ratings. Private

placements are typically rated because insurance companies are a
significant investor group, and they use ratings to assess capital reserves
against their investments. Many regulated investors, such as life
insurance companies, pension funds, and to some extent commercial
banks can purchase only limited amounts of securities rated below
investment grade.
The rating agencies review four major areas:
Quality of the assets being sold,
Abilities and strength of the originator/servicer of the assets,
Soundness of the transactions overall structure, and
Quality of the credit support.
From this review, the agencies assess the likelihood that the security will pay
interest and principal according to the terms of the trust agreement. The rating
agencies focus solely on the credit risk of an asset-backed security.
They do not express an opinion on market value risks arising from interest rate
fluctuations or pre-payments or on the suitability of an investment for a
particular investor.

21

7. Underwriter: The asset-backed securities underwriter is responsible

for advising the seller on how to structure the security, and for pricing and
marketing it to investors. Underwriters are often selected because of their
relationships with institutional investors and for their advice on the terms
and pricing required by the market. They are also generally familiar with
the legal and structural requirements of regulated institutional investors.
8. Investors: The largest purchasers of securitized assets are typically
pension funds, insurance companies, fund managers, and, to a lesser
degree, commercial banks. The most compelling reason for investing in
asset-backed securities has been their high rate of return relative to other
assets of comparable credit risk. The OCCs investment securities
regulations at 12 CFR 1 allow national banks to invest up to 25 percent of
their capital in Type V securities. By definition, a Type V security:
C Is marketable,
C Is rated investment grade,
C Is fully secured by interests in a pool of loans to numerous obligors and
In which a national bank could invest directly, and
C Is not rated as a mortgage-related or Type IV security.

22

BASIC PROCESS

23

Fig. 2 Process of securitization

The basic process of securitization is explained in following steps:

1) Selection and Pooling of homogeneous assets& estimation of

the Cash Flows:
Securitization in its basic form consists of the pooling of a group of
homogeneous assets. Homogeneity is necessary to enable a cost efficient
analysis of the credit risk of the pooled asset and to achieve a common payment
pattern. The originator estimates the cash flows from the underlying assets. The
payment of interest and principal on the securities is directly dependent on the
cash flows arising from the underlying pooled assets. For this purpose, the
originator uses his historical data. Appropriate and accurate calculations are
done keeping in view of the pre payment rates, amortization, etc for estimation
of the cash flows.

2) Creation of SPV:
The next step is to create an SPV. The basis logic behind the creation of an SPV
is
a) To isolate the underlying assets from the originator. This is an important
stepin the whole process as the ultimate result of this is "BankruptcyRemoteness
" from the Originator.
24

b) Aggregation of the underlying assets into a Pool. Thus the assignment of the
cash flow to the SPV is done in this manner.

3) SPV issues securities/notes to the Investors:

The SPV formed (Trust / MF / Corporate Form) now issues securities/notes to
the investors to invest in the securitised exercise done by the originator.

4) Investors - Proceeds of the issue of securities to SPV

The collection from the investors for their investment in the securitised
instrument

is

forwarded to the SPV. The SPV, in turn, channelises these proceeds to theOrigin
ator.

5) Collections and Servicing from the Obligors:

The Originator generally performs this function. In some cases, specializedservi
cing agents are appointed to collect and service from the loan obligors.

6) Pass Over to the SPV:

In this step the Servicing agent passes the collected payments from the obligors
to the SPV less his fees.

7) Reinvestment of Cash Flows:

25

The SPV if permitted reinvests the proceeds from the Servicing agent
(Generally in the Pay through Structures) and in turn receives the reinvestment
proceeds also. If the structure of the instrument is the Pass Through Structure
then Step no. 8 is followed directly after Step no. 6.

8) Payment to the Investors:

The Investor earns on his investments by receiving the proceeds from the SPV.
Depending upon the structure of the Instrument the payment of the investment
is made to the Investors.

9) Originators Residuary Profit:

After the payments are made to the Investors if any residue is left, it is passed
on the Originator as his residuary profit, which is generally maintained, by the
originator for the over-collaterisation and guarantee purpose.

26

FEATURES OF SECURITISATION
A securitised instrument, as compared to a direct claim on the issuer, will
generally have the following features.

1) Marketability:
The very purpose of securitisation is to ensure marketability to financial claims.
Hence, the instrument is structured to be marketable. This is one of the most
important features of a securitised instrument, and the others that follow are
mostly imported only to ensure this one. The concept of marketability involves
two postulates: (a) The legal and systemic possibility of marketing the
instrument (b) The existence of a market for the instrument. Legal aspect with
27

respect to marketing instrument is concerned; traditional law relating to

business practices has not evolved much. Negotiable instruments were mostly
limited in application to what were then in circulation as such. Besides, the
corporate laws mostly defined and sought to regulate issuance of usual
corporate financial claims, such as shares, bonds and debentures. This gives
raise to the need for a codified system of law for security and credibility of
operations. We need to note that when law is not inexistence, we should not
conclude that it is not permitted. The second issue is marketability of the
instrument. . The purpose of securitisation is to broaden the investor base and
bring the average investor into the capital markets. Either liquidity to a
securitised instrument is obtained by introducing it into an organized market
(such as securities exchanges) or by one or more agencies acting as market
makers. That is, agreeing to buy and sell the instrument at either pre-determined
or market-determined prices.

2) Quality of security:
To be accepted in the market, a securitised product has to have a merchantable
quality. The concept of quality in case of physical goods is something, which is
acceptable in normal trade. When applied to financial products, it would mean
the financial commitments embodied in the instruments are secured to the
investors' satisfaction. "To the investors' satisfaction" is a relative term, and
therefore, the originator of the securitised instrument secures the instrument
28

based on the needs of the investors. The rule of thumb is the more broad the
base of the investors, the less is the investors' ability to absorb the risk, and
hence, the more the need to securitize.
For widely distributed securitised instruments, evaluation of the quality, and its
certification by an independent expert, for example, rating is common. The
rating serves for the benefit of the lay investor, who is not expected to appraise
the risk involved.
In case of securitisation of receivables, the concept of quality undergoes drastic
change; making rating is a universal requirement for securitisations.
Securitisation is a case where a claim on the debtors of the originator is being
bought by the investors. Hence, the quality of the claim of the debtors assumes
significance. This at times enables investors to rely on the credit rating of
debtors (or a portfolio of debtors) in the process make the instrument
independent of the originators own rating.

3) Dispersion of Product:
The basic purpose of securitisation is to disperse the product as much as
possible. The extent of distribution, which the originator would like to achieve,
is based on a comparative analysis of the costs and the benefits achieved. Wider
dispersion or distribution leads to a cost-benefit in the sense that the issuer is
able to market the product with lower return, and hence, lower financial cost to
29

him. However, wide investor base involves costs of distribution and servicing.
In practice, securitisation issues are still difficult for retail investors to
understand. Hence, most securitisations have been privately placed with
professional investors.

4) Homogeneity:
The instrument should be packaged as into homogenous lots for market ability
of the product. Homogeneity, like the above features, is a function of retail
marketing. Most securitised instruments are broken into lots affordable to
the small marginal investor, and hence, the minimum denomination becomes
relative to the needs of the smallest investor. Shares in companies may be
broken into slices as small as Rs. 10 each, but debentures and bonds are
sliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors,
commercial paper may be in denominations as high as Rs. 5 Lac. Other
securitisation applications may also follow the same type of methodology.

5) Special purpose vehicle:

In case the securitisation involves any asset or claim that needs to be integrated
and differentiated, that is, unless it is a direct and unsecured claim on the issuer,
the issuer will need an intermediary agency. It acts as a repository of the asset or
claim, which is being securitised. In the case of a secured debenture, it is a
secured loan from several investors. Here, security charge over the issuer's
30

several assets needs to be integrated and thereafter broken into marketable lots.
For this purpose, the issuer will bring in an intermediary agency whose function
is to hold the security charge on behalf of the investors. In turn, it issues
certificates to the investors of beneficial interest in the charge held by
the intermediary.

Thus,

the charge

continues

to

be held

the intermediary, beneficial interest therein becomes a marketable security.

31

by

The US Subprime Mortgage Crisis

The Dot com bubble burst in 2001. Shares in internet companies collapsed and
with events of 9/11, the US faced recession. The Federal Reserve responded by
cutting interest rates to 1% - there lowest level for a long time.
Low Interest rates encouraged people to buy a house. As house prices began to
rise, mortgage companies relaxed their lending criteria and tried to capitalize on
the booming property market.
Mortgage companies actively sold mortgages to people with bad credit, low
incomes - often first generation immigrants. This 'subprime market' expanded
very quickly.
Mortgage salesmen were paid on commission. Therefore, they often hid the true
cost of adjustable rate mortgages and did little to check whether the
homeowners could actually afford repayments in the long term. Even the feeble
lending checks were ignored
Many took out adjustable rate mortgages which were affordable for the first two
years, but, then the interest rate increased making mortgage payments much
more expensive.
In 2006, inflationary pressures in the US caused interest rates to rise to 4%.
Normally 4% interest rates are not particularly high. But, because many had
32

taken out large mortgage payments, this increase made the mortgage payments
unaffordable.
Also many homeowners were not coming to the end of their 'introductory offers'
and faced much higher interest rates. This led to an increase in mortgage
defaults and companies lost money.
As mortgage defaults increased the boom in house prices came to an end and
house prices started falling.
The falls in house prices were exacerbated by the boom in building of new
homes which occurred right up until 2007. It meant that demand fell as supply
was increasing causing prices to collapse, especially in suburban areas.
The Fall in house prices made the mortgage defaults more costly. If house prices
are rising and someone defaults, the mortgage company can get most of the loan
back by selling the house. But, now with falling house prices, they may end up
with only a fraction of the house value.

33

The Role of Credit Default Swaps

You might imagine that this irresponsible lending by US mortgage companies
would mean they would go out of business - end of story. However, the problem
of the US mortgage defaults was spread across the financial system.
Mortgage companies in the US borrowed from other financial institutions to
lend mortgages. They sold collateralized mortgage debt in the form of CDOs to
other banks and financial institutions. This was a kind of insurance for the
mortgage companies. It means that other banks shared the risk of these
subprime mortgages.
Because these subprime mortgage debts were bought by 'responsible' banks like
Morgan Stanley, Lehman Brothers etc. risk agencies gave these highly dubious
and risky debt bundles triple A safety ratings. Thus banks either ignored or were
unaware of how risky their financial position was.
Therefore, when mortgage defaults in the US occurred, many banks and
financial institutions around the world had to write off bad assets. E.g. AIG had
been insuring many of these mortgage debts so was faced with huge losses
The extent of this bad debt is estimated by the IMF to be close to 1.3trillion.

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Freezing of Money Markets.

In addition to bad debts, the other problem was one of confidence. Because
many banks had lost money and had a deterioration in their balance sheets.
They couldn't afford to lend to other banks. This caused a shortage of liquidity
in money markets.
Banks usually rely on lending to each other to conduct every day business. But,
after the first wave of credit losses, banks could no longer raise sufficient
finance.
For example, in the UK, the Northern Rock was particularly exposed to money
markets. It had relied on borrowing money on the money markets to fund its
daily business. In 2007, it simply couldn't raise enough money on the financial
markets and eventually had to be nationalized by the UK government.
Because banks were short of liquidity, they have been selling assets such as
their mortgage bundles. This caused further falls in asset prices, further liquidity
shortages and further deterioration in bank balance sheets. (The Paulson plan is
to try to reverse this cycle by the government buying these financial assets no
one else wants to buy.)

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The Vicious Cycle of the Financial Crisis

1.Share Prices
Because banks have lost money, people have been selling shares in banks. This
fall in their share prices was speeded up by aggressive 'shorting' of banking
stocks. The fall in share prices have compounded the problem of banks because
investors / consumers lose confidence
More difficult to raise finance on the stock market.
Part of the UK plan is to buy bank share capital to give greater confidence to the
banks and enable them to raise sufficient finance.

2. Housing Markets

The shortage of finance means that banks have had to reduce lending, especially
mortgages. The shortage of mortgages has caused further falls in house prices,
especially in the UK. Falling house prices are magnifying the loss of banks as
more default on their mortgage and loan payments.

3. Economy

Falling house prices, shortage of finance and collapsing confidence have caused
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the 'real economy' to decline. Investment and consumer spending has fallen
therefore major economies face recession and rising unemployment. The rising
unemployment increases the chance of more mortgage defaults and further bank
losses.

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ROLE OF SECURITISATION IN US SUBPRIME

MORTGAGE CRISIS
The securitization of subprime mortgages into mortgage-backed securities
(MBS) and collateralized debt obligations (CDOs) was a major contributing
factor in the subprime mortgage crisis. Subprime MBS and CDOs were
attractive to investors due to the higher interest rates they offered versus assets
backed by prime mortgages. Subprime borrowers with less than perfect credit
had higher interest rates on their mortgages due to the increased risk of default.
Further, many loans with adjustable-rate mortgages were made that later added
a great deal of fuel to the mortgage crisis.
During this time, lenders pooled the subprime mortgages into MBS and CDOs.
These financial products often received high ratings from credit agencies.
Tranches of these securities were then sold to unsuspecting investors, who were
not aware of the risk associated with them. The lower-quality tranches offered
higher interest rates but absorbed the first losses associated with defaulting
mortgages before the senior tranches.
Subprime lending caused a dramatic increase in available mortgage credit.
Many loans were made to borrowers who would have previously had difficulty
obtaining mortgages due to below-average credit scores. Private lenders made a
lot of money by pooling and selling the subprime mortgages. However, the risk
of foreclosure increased with the relaxing of credit standards. Lenders and
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buyers incorrectly assumed that real estate values were impervious to a

downturn. Private-label MBS provided a lot of the necessary capital for the
subprime mortgages. Around 80% of subprime loans were made with privatelabel MBS in 2006. In March 2007, the value of subprime mortgages was
valued at around $1.3 trillion. The mortgages issued by private lenders had
greater risk since they were not backed by the government, like those
from Freddie Mac and Fannie Mae. The real estate market boomed, with more
buyers bidding up the prices of available houses. The real estate markets in
Florida, Arizona and the Las Vegas area were very hot during this time. At first,
subprime borrowers who fell behind could refinance their mortgages based on
higher property values or could sell homes at a profit. The amount of risk for
subprime mortgages was not an issue at this time.
Only when property values began to decline did issues begin to appear.
Adjustable-rate mortgages began to reset at higher rates, and mortgage
delinquencies grew substantially. The default on subprime mortgages led to
more problems. By August 2008, around 9% of all mortgages in the U.S. were
in default. MBS and CDOs began to lose value with the higher default rates.
Freddie Mac and Fannie Mae were seized by the government in 2008 as they
began to realize large losses. Foreclosures and repossessions increased, with
more properties being placed on the market as banks attempted to liquidate their
inventories. This depressed property values even more, leading to a downward
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spiral for the real estate market. Some borrowers attempted short sales for their
underwater mortgages, but they often found lenders difficult to work with or
unwilling to negotiate.

CONCLUSION
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Originating in the mortgage markets of the US in the 1970s securitisation has

developed and come a long way from there to spread throughout the globe to
benefit organisations
Securitisation is the buzzword in today's World of Finance. It's not a new
subject to the developed economies. It is certainly a new concept for the
emerging markets like India. The Technique of Securitisation definitely holds
great promise for a Developing Country like India.
Securitisation has worked well over the other tools of financing as it does not
increase the liability of the Originator but at the same time provides him
financing. It in fact converts the NPA of the company into cash flows.
The above feature help infrastructure companies to get finance easily and also
helps the banks by reducing the burden on them and helping them to
concentrate on their core business activities.
But the tool has not been utilised to its fullest in our country as cause of the
legal complications. However a welcome step was seen in the form
that securitised paper scan now is traded as assets in the market and also the
reduction in the stamp duty of the securitisation transaction.
The development till off late was slow but the future for securitisation is said
to be very bright in Asias 2nd largest economy where financing is of prime
importance and the growth potential are very high.
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BIBLIOGRAPHY
BOOKS:
SECUTIRIZATION VINOD KOTHARI
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WEB SITES:
www.vinodkothari.com
www.fitchindia.com
www.bseindia.com
www.nhb.org.in
www.economictimes.com
www.wikipedia.com

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