What Role Did Securitisation Play In The 2008 Financial Crisis

ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 1

What role did securitisation play in the 2008 financial crisis?

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ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 2

What role did securitisation play in the 2008 financial crisis?

Introduction

The financial crisis that occurred in 2008 was one of the most significant setbacks ever

experienced in the world since the Great Depression of 1929. The financial crisis occurred amid

attempts of the Federal Reserve and the Treasury Department trying their best to restore the state

of the United States banking system. The financial crisis leads to one of the great recessions in

the history of the world resulting in the fall of housing by about thirty-two percent more than

how it did during the recession. The crisis plunged some of the world’s biggest economies into

problems which lead to the rise of unemployment and a high number of discouraged workers

who gave up looking for jobs. Securitization was one of the main approaches that have been

blamed for the 2008 financial crisis (Kermani, 2012). Securitization, in this case, refers to the

process of creating liquidity in the market by allowing small investors to purchase small financial

assets from a pool of large asset pool (Kermani, 2012). Securitization is essential in promoting

liquidity in a market system and also in helping the companies to get rid of the assets that they do

not require on their balance sheet. Therefore, the paper herein seeks to look at the role played by

securitisation in the 2008 financial crisis. The paper focuses on the role of CDOs, the role of

credit rating agencies, and the reasons why there was a high demand for the CDOs among

investors during the crisis.

Defining Financial Crisis about Securitisation

According to Arnold (2009), a financial crisis can be defined as the sudden and sharp

drop in the value of the financial assets. A financial crisis can also be defined as a massive drop

in the capital of an economy both at macro and micro level which can lead to a failure or a

complete collapse of the entire financial system (Arnold, 2009). Financial crisis can be caused

by internal or external factors which affect the efficiency of the financial institutions such as the

ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 3

banking systems, the asset prices and the exchange rates. An investigation into the 2008 financial

crisis showed that asset securitisation by the banks was one of the main factors that led to the

crisis as banks literary transferred their risks to the third-party individuals (Arnold, 2009). The

United States banks resolved to asset securitisation as the way to caution their risks after the

interest rates had fallen to zero and negative levels as a result of the influx of money into the

United States economy from foreign countries.

Effects of Securitisation on the 2008 Financial Crisis

As already defined in the text above, securitisation involves the packaging of liabilities,

assets or cash flows into tradable securities. The most commonly traded liabilities and assets are

the assets backed securities. The securities are known as the collateralised debt obligations

(CDOs). In a securitization, the banks offer people loans to buy homes and them in return

aggregate the loans into securities (Skreta and Veldkamp, 2009). The securities are then sold out

to the potential investors at good rates and the banks in return get more capital to support their

loans. The eventualities that occurred and led to the financial crisis can be well explained using

the concept of asset securitisation. Most financial institutions based their operations on the

securitisation principles leading to the negative effects experienced during the financial crisis

period (Skreta and Veldkamp, 2009). In most cases, the financial institutions have been able to

control the actions of various players in the industry to prevent the occurrences of the

shortcomings as well as to protect the economy from running into a crisis. However, the rise of

securitisation among the financial institutions in the United States played an important role in

shaping the activities of the 2008 financial crisis (Skreta and Veldkamp, 2009). The negative

effects experienced during the 2008 financial crisis showed that securitisation played a role in

fueling the crisis.

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The main factors that fueled the financial crisis included irresponsible lending, incentives

offered by the banks, lax regulations among other factors. Also, factors such as the push for

home ownership deregulation of banks, and stable collateral financial innovation among other

factors also played a role in escalating the financial crisis (Taureck, 2006). Collateralized debt

obligations played an important role in the financial crisis among other factors which also

contributed greatly to the recession. CDOs are usually risky by design and any decline in the

value of their commodities such as mortgages resulted in significant losses for many

organisations and individuals during the financial crisis (Balzacq, 2010). A CDO is used in this

case to refer to the type of financial instruments that are used to pay investors out of a pool of

capital-generating resources. The years before the 2008 financial crisis, the banking system had

adopted the CDOs approach in conducting their daily businesses. The CDOs proliferated

throughout the shadow banking community as some analysts described it.

The practice of combining assets and splitting risks continued in the banking industry

leading to the CDOs economic becoming more elaborate and a threat to the financial industry.

The CDOs were used in different ways which led to excessive profits for the investors as they

reduced the liquidity of the banks. For example, one of the commonly used forms of a CDO is

the CDO-squared which includes middle tranches of the CDOs aggregated to reduce the risk of

investment for banks. The middle tranches were also grouped into small instruments which they

called a CDO-cubed (Acharya and Richardson, 2009). The CDO-cubed instrument meant that

the return the investors were drawing from the commodity was three times the one removed from

the commodity. Home mortgages were the main commodities used by these banks to lure

investors. Despite the CDOs having the advantage of being able to reduce the risks, they can also

result in serious risks related to debt (Skreta and Veldkamp, 2009). The CDOs helped to

ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 5

encourage the giving of subprime and mortgages to borrowers who were unlikely to use their

payments well. The proliferation of the CDO policies culminated due to the passage of the

Bankruptcy Bill in 2007 which was meant to reform the personal bankruptcy to limit the abuse of

the system (Acharya and Richardson, 2009). The bill also played a role in raising the cost of

personal bankruptcy and left homeowners insolvent without recourse when they were not in a

position to pay their mortgages. As a result, the intricate network of promises that made up the

collateralised debt markets collapsed. Since millions of debtors in the mortgage industry

defaulted their loans, the CDOs failed to reach their targeted tranches which were middle and

upper tranches (Taureck, 2006). Therefore, the investors in the upper tranches of the CDO ended

up losing lots of money on what they had initially seen as a riskless investment.

The Role of Credit Rating Agencies in the Financial Crisis

Apart from the poor financial practices by the financial institutions such as the banks and

the investment companies, the credit rating agencies have also been blamed for the 2008

financial crisis. Credit rating agencies are large companies that evaluate the large debtors and the

financial instruments used by the debtors (Frost, 2007). There are several credit rating firms in

the United States with Standard and Poor’s and Moody’s Corp being the most prominent

institutions that evaluate the debtors in the United States and advise the investors on the best

approach to take while investing. The other prominent firm is the Fitch Ratings which is a British

credit rating company. The three firms dominate almost ninety-five percent of the credit rating

market (Frost, 2007). Apart from the three big firms, there are other hundreds of firms that help

in regulating various financial instruments, industries and national markets. The CRA firms are

charged with the responsibility of rating the creditworthiness, which refers to the ability and

willingness of debtors to pay. Credit ratings are highly important in the finance industry as they

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act as the accepted standards across countries, financial institutions and other institutions

(Levich, Majnoni and Reinhart, 2012). The CRAs should provide information about the debtors

and inform the lending institutions about the creditworthiness of the debtors. The information

about the creditworthiness of a company or an individual shows whether it is worth lending at

what cost.

Many scholars and financial experts have blamed the credit rating agencies for the 2008

financial crisis citing their failure to regulate the credit industry effectively. However, the

argument has raised mixed feelings with the opposition to maintain that the credit rating agencies

played their role well but the investors and the financial institutions failed to hid by the advice

(Levich, Majnoni and Reinhart, 2012). For instance, the credit rating agencies have been blamed

for failing to regulate the CDOs and other financial instruments such as securitisation to prevent

the crisis. However, the investors relied too much on the ratings and failed to perform due

diligence. The ratings should not be treated as the absolute truth but as data that is subject to

other considerations before an investor decides to commit his or her resources to an investment

project. The investors also failed when they relied solely on the published ratings and the

ongoing market excitement on the CDOs as well as the MBSs (Levich, Majnoni and Reinhart,

2012). The credit rating companies, however, failed to advise the investors on the

creditworthiness of the lenders which later resulted in most of them defaulting. Another issue

surrounding the role of CRAs in the financial crisis is the conflict of interest due to the close

relationships that exist between them and the banks that they regulate. The CRAs depend on the

institutions they rate, and most of their revenues are generated through these institutions, and this

is said to have plaid a role in creating a conflict of interest between the institutions and the rating

agencies (Partnoy, 2006). At some point, the credit rating companies started offering their

ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 7

services at a fee which further complicated the issue of conflict of interest hence affecting the

accuracy of their data.

The 2008 financial crisis was a costly affair that affected the entire global economy

leading to one the longest recessions ever experienced. Many reports have been published about

the cause of the crisis, but securitisation is one the main factors that led to the failure or collapse

of the finance industry. Securitization financial instruments such as the CDOs played a crucial

role in initiating the crisis. The use of CDOs instruments increased in the finance industry in the

early 2000s making it difficult for the banks, investors and financial institutions to control the

situation. The credit rating agencies are also blamed for the crisis for failing to advise both the

investors and the financial institutions. The credit rating agencies have the responsibility to rate

companies and individuals based on their creditworthiness and whether they can be lent or not.

However, other experts have maintained that the credit rating agencies cannot be blamed entirely

for the crisis and all players should take responsibility for their contributions including the

investors and the banks. The crisis resulted from a mixture of factors that increased the rate of

securitisation.

ROLE OF SECURITISATION IN THE 2008 FINANCIAL CRISIS 8

References

Acharya, V.V. and Richardson, M., 2009. Causes of the financial crisis. Critical Review, 21(2-3),

pp.195-210.

Arnold, P.J., 2009. Global financial crisis: The challenge to accounting research. Accounting,

organizations and society, 34(6), pp.803-809.

Balzacq, T. ed., 2010. Securitization theory: how security problems emerge and dissolve.

Routledge.

Becker, B. and Milbourn, T., 2011. How did increased competition affect credit ratings? Journal

of Financial Economics, 101(3), pp.493-514.

Frost, C.A., 2007. Credit rating agencies in capital markets: A review of research evidence on

selected criticisms of the agencies. Journal of Accounting, Auditing & Finance, 22(3),

pp.469-492.

Kermani, A., 2012. Cheap credit, collateral and the boom-bust cycle. University of California-

Berkeley, Working Paper.

Levich, R.M., Majnoni, G. and Reinhart, C., 2012. Ratings, rating agencies and the global

financial system (Vol. 9). Springer Science & Business Media.

Partnoy, F., 2006. How and why credit rating agencies are not like other gatekeepers.

Skreta, V. and Veldkamp, L., 2009. Ratings shopping and asset complexity: A theory of ratings

inflation. Journal of Monetary Economics, 56(5), pp.678-695.

Taureck, R., 2006. Securitization theory and securitization studies. Journal of International

Relations and Development, 9(1), pp.53-61.

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