Chapter 8: Securitization and the Financial Crisis of 2007-8

Securitization

Securitization is the process of pooling assets (mortgages, credit card receivables, auto loans) and selling claims on the resulting cash flows to investors.

Key structures:

Asset-Backed Securities (ABS)

The underlying assets generate cash flows that are used to pay security holders. The structure can be:

• Pass-through: All principal and interest payments flow directly to investors
• Tranched (waterfall): Cash flows are allocated in a priority order to different tranches

Tranche Structure

Losses are first absorbed by the equity tranche, then mezzanine, then senior. This is called a waterfall structure.

Collateralized Debt Obligations (CDOs)

An ABS backed by a pool of debt instruments. ABS CDOs are particularly relevant to the crisis — they were CDOs backed by tranches of other ABS (mainly those backed by subprime mortgages).

The US Housing Market

Key developments leading up to the crisis:

• Low interest rates in the early 2000s boosted housing demand
• Relaxed lending standards: subprime mortgages (low/no documentation, adjustable rates with teaser periods, high loan-to-value ratios)
• Home prices doubled between 2000 and 2006
• Many borrowers relied on continued price appreciation to refinance

What Went Wrong?

The Chain of Events

1. 2006-2007: US house prices started falling
2. Subprime defaults: Borrowers couldn't refinance or afford reset mortgage payments
3. ABS CDO losses: As mortgage defaults increased, ABS tranches downgraded, ABS CDOs suffered massive losses
4. Bank write-downs: Banks holding CDOs on their balance sheets reported huge losses
5. Loss of confidence: Interbank lending froze because no one knew which banks were exposed

Additional Factors

• Misaligned incentives: Originators sold mortgages to securitizers without retaining risk
• Rating agencies: AAA ratings on complex structured products proved inaccurate
• Model risk: Correlation models underestimated the probability of simultaneous defaults
• Off-balance-sheet vehicles (SIVs): Banks held risky assets in entities that didn't appear on their balance sheets
• Leverage: Investment banks operated with leverage ratios of 30:1 or higher

The Aftermath

• Bank failures and bailouts: Lehman Brothers collapsed (September 15, 2008); Bear Stearns, AIG, Fannie Mae, Freddie Mac were bailed out
• Regulatory response: Dodd-Frank Act (2010) introduced stricter capital requirements, centralized clearing for standardized derivatives, and restrictions on proprietary trading (Volcker Rule)
• Basel III/IV: Higher capital requirements, liquidity coverage ratios, and leverage ratios for banks
• Risk management revolution: Greater emphasis on understanding model limitations, stress testing, and counterparty credit risk