Banks, to get rid of illiquid assets they posses and to attain financial freedom in lending, searched for new innovative techniques. This innovative method of converting these illiquid assets in to liquid assets technique is called asset securitization. Banks pool up these illiquid assets like mortgage loans and sell it to agencies called as special purpose vehicle (SPV). These special purpose vehicles convert these loans in to securities and sold to investors. Before agencies sold these securities they got it rated from rating agencies. Asset securitization as a process reduced information asymmetries; increased financial slack; served as a lower cost of financing source; reduced regulatory capital; and reduced bank risk. The process of asset securitization as a whole has many advantages but by the end of year 2007 it started to crack with financial crisis. It is therefore necessary to study what went wrong in the process of asset securitization that lead to financial crisis.
The study analyzes the role of asset securitization in financial crisis by analyzing the economics of asset securitization process as whole. Then in depth analysis of credit rating agencies methodologies and economics of how they rate these securities is studied. As it is difficult to analyze the rating processes and methodologies of all rating companies in this thesis I have decided to analyze Moody’s investor service. Moody’s has been selected because its name is synonym with quality in the market.
The growth and fall of mortgage industry performance of mortgage industry have been analyzed. The factors that led to financial crisis have been analyzed. The study analyze the moody’s rating methodologies and rating models and updates to rating models. The short comes in rating methodologies and rating process has been discussed. The rating models updates effect on default rate of rating has been analyzed. Finally the effect of these default rates on financial crisis has been studied and analysis of role of asset securitization in financial crisis is studied.
The process of asset securitization started in the year 1870 when Government National Mortgage Association (GINNIE MAC) purchased pools of loans and converted in to securities and sold these securities to investors. In the year 1970 special innovative technique called tranching were used to distribute losses involved in these pools of loans backed by mortgages and sold to investors. Kaptan and Telang (2002) Asset securitization is the process of converting illiquid assets in to cash flows. Both financial intermediates such as banks and investors benefited from this process. Banks benefited with extra liquidity to lend more loans to able borrowers where as investors got opportunity to invest in capital market for more returns.
In the process of asset securitization, rating agencies rating securities is crucial because rating influence the marketability of the securities. There are many rating agencies which rate Residential Mortgage Backed Securities, of these three largest credit rating agencies with overseas market that are based in United States are Moody’s, Standard and Poor (“S&P”) and Fitch. These rating agencies use statistical models to analyze risk involved. Rating agencies constantly review performance of these securities and according to performance they upgrade or downgrade rating.
To lessen the effects of a mild recession in 2000, the Federal Reserve cut interest rates. This interest rate cut along with increasing housing price made people to invest in housing this helped to drive growing demand for nontraditional mortgages products. Banks have extra liquidity to lend more loans to borrowers and started to lend more and more loans to non prime borrowers, which led to poor performance of loans and in turn effected whole asset securitization.
This report will explore what is the role of asset securitization in financial crisis. In order to research what is the role of asset securitization in financial crisis the following have done
1. Analysis of asset securitization process
2. Analysis of Evolution of financial crisis
3. Analysis of Rating agencies methodologies and procedures in rating process.
The details of analysis techniques are explained in methodology chapter. And extensive literature review is done to get hold of the subject. Finally in depth analysis has been done to reach the goal of the report.
Professional And Academic Context
2.1 Asset Securitization
Kaptan and Telang (2002) defined Asset securitization as an innovative process which channelizes flow of funds from investors to issuers in efficient manner. In simple words, the process of asset securitization starts with financial institutions like banks which pools up individual loans and create securities against them. These securities are rated and sold to investors. In words of these authors, asset securitization is the process of converting assets in to securities and in turn in to liquid cash.
Origins of securitizations can be traced back to 1870`s where Government National Mortgage Association (GINNIE MAC) started selling securities that are backed by pool of mortgage loans. These securities were named as mortgage pass through securities.
This process of securitization has changed in 1970 where new innovative concept of tranching was introduced in issuing the securities (tranched securities). These tranched securities are sold to investors. Kaptan and Telang (2002)
(Uzun and Web, 2007) makes understanding of asset securitization more simple through an illustration of the process of asset securitization, banks which are financial intermediaries in capital market has various types of assets such as mortgage loans, car loans, leasing contracts etc on their balance sheets. These assets are not marketable so these are illiquid assets. Banks, to get rid of these illiquid assets and to attain financial freedom in lending search for new techniques. This innovative method of converting these illiquid assets in to liquid assets technique is called asset securitization. So asset securitization plays a major role in converting these illiquid assets in to cash flows (liquid assets).
Uzun and Web, also provide information on what kind of assets the banks securitize. These authors explain this as, the process of asset securitization starts with banks deciding which assets they want to securitize for example mortgage loans. Then bank pools these mortgage loans and sell it to trustee or separate entity which is called special purpose vehicle. (Uzun and Web, 2007)
Role of Special purpose vehicle (SPV) is explained by the Securities and Exchange Staff (2008) as, SPVs either government backed agencies or private agencies such as Fannie Mac, Friede Mac, Ginnie Mac buys these loan pools and are entitled to interest and principal of underlying loans in the pools. Then SPV issues different classes of securities known as tranched securities backed by pool of loans.
The role of SPV is to separate risk of newly created securities from the origin bank loans. If these SPV are not there it is very difficult to assess the risk involved with those securities underlying the loans. It is difficult to access risk because risk involved is closely related to origination bank practices. Information of origination bank practices such as how they lend loans what documentation they check before issuing loans and credit quality of loans. Securities and Exchange Staff (2008) conclude that these securities issued from this SPV isolates the risk involved from origination bank. Investors invest on these securities and investment risk is directly interrelated to credit quality of loan borrowers whose loans are offered as collateral for the securities. To boost the demand for these securities the SPV enhances credit quality by process called over collateralization and subordination.
Over collateralization, is the process in which credit quality is improved by giving payment guarantee by insurer. So if there is any principal or interest default it is insured there by making investors clear in mind that there is no risk involved in investing in these securities. Over collateralization is one way of credit enhancement but the principle way of credit enhancement is done by subordination.
In subordination process SPV issues different layers of tranches (securities) such as junior, mezzanine, senior tranches. If the trust experience any loss in interest or principal payment, lower most tranches, junior tranche absorb all the losses and then mezzanine tranche absorbs any more remaining losses that are left over by junior tranche leaving top most tranches, senior tranche safe from any kind of losses. So senior tranche is safe from all interest and principal default. So by process of tranching top most tranches (securities) get more demand from investors and demand reduces when it goes down the ladder up to junior tranches. Junior tranches are backed by over collateralization for its marketability in capital market. The process of tranching differentiates structured finance from normal securitization process.
In normal securitization process assets are converted into securities and sold. In structured finance these securities are tranched so that at least one class of securities gets better rating when compared to average rating of all securities.
The asset securitization makes calculation of risk more complex using technique called tranching. The calculation of risk is more complex because the risks involved in these pools are distributed.( Securities and Exchange Staff) (2008)
Asset securitization is the process of converting illiquid assets in to cash flows (liquid assets). Both financial intermediates such as banks and investors benefited from this process. Banks benefited with extra liquidity to lend more loans to able borrowers where as investors got opportunity to invest in capital market for more returns. Kaptan and Telang (2002)
In brief benefits of asset securitization are reducing information asymmetries; increasing financial slack; serving as a lower cost of financing source; reducing regulatory capital; and reducing bank risk (Greenbaum and Thakor, 1987)
(Kaptan, Telang (2002), (Uzun and Web, 2007) conclude that asset securitization is the process in which illiquid assets of banks are converted into cash flows or liquid assets. (Greenbaum and Thakor, 1987) conclude these techniques of asset securitization as benefits for banks as well as for investors in capital market. Securities and exchange staff concludes the process of credit enhancement using process called subordination distributed risk of loss in the whole tranche. And the process of over collateralization increased demand for these securities in capital market. Securities and Exchange Staff (2008) concluded that the process of tranching evenly distributed risk and assessing this risk is a complicated process.
2.2 Rating Agencies
The main role of rating agencies in capital market is to rate the bonds and securities in specific scale. Rating agencies use qualitative and quantitative methods to access cash flows of these bonds or tranched securities. These ratings are used by investors in capital market as bench mark in investing. Thus rating agencies helped the investors in making decision to invest in capital markets by reducing information asymmetries between issuers and investors. (Committee on the Global Financial System), (2005).
2.2.1 Evolution And Role Of Rating Process
According to Ruth Rudden, the evolution of rating industry started when there was a big demand for the corporate bonds in USA. The investors interested to invest in these corporate bonds were very skeptical about risk involved as they were not provided with company’s credit information that issued these bonds. So there was a pressing need for an independent and third party institution to analyze credit risk of these bonds which helped the investors in making decision to invest according to their criteria. Thus credit rating agencies came into existence. (Ruth Rudden, 2007),
John moody was the first to introduce credit ratings in 1909. He used rating scale to rate the bonds. These ratings were useful for investors to understand credit risks. Credit rating agencies (CRAs) stressed more on expected cash flow generated by the issuer (special purpose vehicle) ongoing business in determining the rating. In general CRAs revenues were generated from subscribes who subscribed to receive rating on debt securities. Rating agencies from the start has been rating bonds on specific scale. Mason and Rosner, concluded that the rating doesn’t give information on whether particular bonds must be bought or sold. They give their opinion on relative safety of the bonds. (Mason and Rosner, 2007)
The main importance for the credit ratings rose in the capital market because of US treasury department. US treasury department said the quality of the bonds rated by rating agencies is appropriate. Ruth Rudden, concluded that the importance of credit rating agencies in the capital market became prominent and the investors relayed on these ratings to invest on the bonds. (Ruth Rudden, 2007)
Then with the introduction of new structure finance products, rating agencies started to rate these products as well. In one of the reports by the Committee on the Global Financial System, (2005), wrote about the Rating agencies, rated the structured finance products like asset backed securities, CDOs, RMSBs etc, same as the traditional bonds. Rating agencies performed the same function as with traditional bonds that was reducing information asymmetries between issuers and investors. Committee on the Global Financial System, (2005)
Issuers of structured finance products wanted these securities to be rated on the same scale as traditional bonds so that investors think structured finance has same kind of risk that of bonds. (Mason and Rosner, 2007) spoke about the structured finance as, for past few years with the introduction of newly formed structure finance products; these CRAs are chasing the agencies that issue these structured finance products instead of subscribers for revenue.
This lead to three fold increase in the revenues by CRAs and effected the integrity and base source of the aim on which rating industries are build. To meet the demand of these newly introduced structured finance products; CRAs have introduced many new models and approaches to access these products for ratings. (Mason and Rosner, 2007) The three largest credit rating agencies with overseas market that are based in United States are Moody’s, Standard and Poor (“S&P”) and Fitch.
2.2.2 Rating methodologies of RMBS
According to (Rousseau Stephane, 2009), all the rating agencies methodologies are almost same for rating RMBS products.
First issuer of these securities approach rating agencies to rate their securities so that they can sell it in capital market. And issuer provide all the data information of the assets underlying the securities like loan data, proposed capital structure of SPV, proposed credit enhancement for each tranche of the securities.
Rating agency will assign an analyst to analyze the tranches for rating it. First probable looses incurred on all tranches are calculated. Rating agencies used complex statistical models for analyzing loss. The loss analysis gives rough idea of how much credit enhancement is required for each tranche to give particular rating.
Then analyst analyzes proposed capital structure of SPV to check whether it meets particular rating. Then finally analyst analysis the cash flow which gives information of interest and principal paid out of SPV and analyzes whether particular asset which is under tranche meets payment obligation. Analyst then rates each tranche and submits his rating to committee where they vote on the analyst view.
Once rating is confirmed they send the rating to issues rather than publishing it. If the issuer is satisfied with the rating he makes it public. If issuer makes rating public, rating Agencies get paid if not they get breakup fee. (Rousseau Stephane, 2009).
2.2.3 Concerns on models used in RMBS
According to (Daníelsson J, 2002), Rating traditional bonds is much easier because of availability of historical data where as rating structural products like RMBS you need much more complex models than that of normal models.
As the financial system become more complex, the need for complicated statistical models becomes greater. More the complexity, lesser the reliability on these models, so does these models tends to be less reliable. It is clear from the credit crisis of 2007 that the rating agencies used over optimistic input data, inappropriate modeling and insufficient checking of data quality and permitting gaming of models. Despite of advanced models, stress tests, and all the numbers, risk models do have important role to play in modeling risk as long as its limitations are known. Risk models are good at managing particularly trading desk but when asked to model whole institution it fails. So relying on such folly statistical models to model risk is foolishness. And the numbers that these models give are inappropriate.
Financial models are not simple and do not have basic or fundamental thermos to build on. These models can easily make you believe the results are accurate, the reason for these are;
1. Endogenous risk: In finance we can only model aggregate behavior. Financial modeling changes the statistical laws governing the financial system in real-time, leaving the modelers to play catch-up. This becomes especially pronounced as the financial system gets into a crisis. This is a phenomenon is called endogenous risk.
2. Quality of assumptions: we can’t take it to consideration all parameters in to model so it is important to take it to consideration the main parameters that affect the outcome of the model. For example if we consider present situation of financial crisis the main parameter is liquidity which has been be ignored by modelers while modeling risk.
3. Data quality: data quality is the most and foremost important thing in statistics because the accuracy of these models depends up on quality of data. (Daníelsson J, 2002)
To prove what Daníelsson J, said Vanessa G. Perry proved, there is always dearth of data on subprime market. The data that is available is proprietary lender data. And this data had drawbacks on analysis of market trends. To analyze data properly we need property records which contain information on mortgagee and mortgager, transaction price, property location, credit score, foreclosure rate of neighborhood state.
This data was necessary for the rating agencies to analyze the market condition properly. Roughly to analyze loan performance, three sets of data was taken into consideration, that is the Borrower data, loan data, property data. Borrower data should contain income, FICO score, and demographics. The loan data should contain loan amount, LTV, loan type, interest rate/fee, terms such as FRM/ARM, payment history. Property data should contain location, prices, sales, foreclosure, and employment rate. One can predict the probability of default if and only if these data of loan is available. (Vanessa G. Perry, 2008).
2.2.4 Concerns on rating in RMBS
According to (Committee on the Global Financial System, 2005), and (Mason and Rosner, 2007) there are many concerns on rating agencies which rated the RMBS, they are;
1. Transparency- Given the role that is played by rating agencies in removing Asymmetries, it is important that they be transparent on what they do. Rating agencies never disclosed completely their methodologies they use to rate RMBS and key assumptions and rating criteria. Credit rating agencies never accepted that the data provided by issuer of securities are not sufficient to rate. And rating agencies never provided historical performance data about their ratings.
2. Quality of rating process- there is a huge growth in RMBS market because of ease in lending loans. And at the same time these RMBS products started to get more complex. The rating agencies did not have enough staff to tackle increasingly complex products and huge volume of these products. Because of shortage of work force these rating agencies were not able to catch up with rating upgrades or downgrades accordingly with change in circumstances like issuers principal or interest short fall.
3. Conflict of interest- the rating agencies main role is to act as an intermediate between investors and issuers. This trust of being intermediate has been broken by rating agencies by charging issuers for rating products instead of getting paid by subscribers who subscribe for these ratings to invest in these products. Because of shift in the axis of being intermediate, these rating agencies got paid from issuer who in turn profited rating agencies by gaining millions of dollars. This process of issuer paying for his rating created conflict of interest. So considering profits they incur from this new role, rating agencies tend to rate products issued by these issuers a higher rating than they actually are. The issuer has ability to adjust deal structure to get desired rating. And issuer has influence on rating process. (Committee on the Global Financial System, 2005), (Mason and Rosner, 2007).
2.2.5 The role of rating agencies in the crisis
According Tom Bulford (2008), (Ruth Rudden, 2007) “The credit rating agencies like Moody’s, Standard and Poor’s and Fitch played a central role in growing the residential mortgage-backed securities, these credit rating agencies were titled to rate these securities on behalf of the huge investment banks to sell to the investors.
The ratings of these securities were to identify the risk involved in the securities, they followed a particular three main flow in calculating the risk rating for the investors, the first as to interest the investors on the securities, they provided portfolios of RMBS which highlighted a certain level of risk involved in it, this was done through tranches which means, the different level of risks involved securities were put into different groups called tranches. This helped the investors in deciding whether to stay first in line during the event of default or down the queue. This was one point where the investors relayed on the ratings to invest on the securities.
The other two things which they followed to rate the securities, one was data which was used in the financial models of the rating agencies to rate these securities, the data contained here are the information about the mortgage loans that are parceled by the investment banks. These mortgages came from the originators who provided all the information about the mortgagees like their credit history, income, etc. hence these originators provided information was historical.
The information given source was not sure about as they stood by the words of the originators. Using this information on the models they used in the rating would off course end up being inaccurate. This made the investors relaying on the high rating given by these rating agencies and hence invested confidently.
The rating agencies assured that the portfolios of mortgage backed securities were “stress tested” by ‘Monte Carlo simulation of macroeconomics variables to create a loss distribution’. The assumptions were not wide enough because the rating agencies relied upon historical data, and till now MBS were concerned ‘the performance history that did exist occurred under very benign economic conditions’. The reasons just don’t stand on rating agencies following the historical data for the calculations but also the workload and the conflicts when the interest rates rose which laid the investment bank concentrate on getting the best ratings on the securities that is laid for sale.
This increased the competition between the agencies; they did not want to lose deals and hence gave ratings as necessary with one initiative that was not to lose deals. One of the illustration proves the above comment, one of the member in an rating agency who did not want to lose a deal wrote a mail which said “I had a discussion with the team leaders here and we think that the only way to compete is to have a paradigm shift in thinking, especially with the interest rate risk”. Another said “We are meeting this week to discuss adjusting criteria for rating CDOs of real estate assets because of the ongoing threat of losing deals”. Tom Bulford (2008),
Tom Bulford (2008) concluded that the roles of these rating agencies in financial crisis are to be studied thoroughly. Rating agencies main duty is reducing information asymmetries between issuers and investors but with the introduction of structured finance products rating agencies deviated from their main role of reducing information asymmetries. In fact they started to favour security issuer as they are paid for rating.
Committee on the Global Financial System, (2005) concluded that role of rating agencies in capital market is to rate bonds or securities on specific scale. (Ruth Rudden, 2007), (Mason and Rosner, 2007) concluded that the importance of credit rating agencies in the capital market became prominent and the investors relayed on these ratings to invest on the bonds and the rating doesn’t give information on whether particular bonds must be bought or sold. They give their opinion on relative safety of the bonds. The rating agencies got paid by issuer of securities for rating structured finance products on same scale as normal bonds.
Tom Bulford (2008) concluded that change of role by rating agencies as information intermediation between issuer and investor got strained with the introduction of structured finance products. (Daníelsson J, 2002) concluded that to rate structured finance products rating agencies need more complex models. (Vanessa G. Perry, 2008) concluded that there is no enough historical data on subprime market and in turn this dearth of data affects accuracy of the rating process. Committee on the Global Financial System, (2005) concluded that there are some concerns relating rating process of RMBS. Tom Bulford (2008) concluded rating agencies had played their role in financial crisis and need to be blamed for their irresponsible behavior.
1.3 Subprime Crisis
The roots of financial crisis are complex and obscure. The main culprits are mortgage banks brokers, rating agencies, to some extent federal reserve and government. Financial crisis started with Federal Reserve slashing interest rates to encourage spending and reduced 30-year bond issues to increase the prices. This along with American dream of home ownership triggered housing boom. This housing boom has been used by many mortgage lending banks. The introduction of FICO scores instead of traditional point based system and the off-balance sheet vehicle made lending loans easy. Loans were given to people with low credit history (sub-prime loans) Souphala, C and Anthony, P.C, (2006)
1.3.1 Evolution of the crisis
According to Souphala, C and Anthony, P.C , (2006), the introduction of FICO scores instead of more traditional “point based system” credit scoring. And the off balance sheet vehicle (OBSV) made banks to lend loans to people with low credit score. This type of lending is called subprime where these borrowers are who fail credit history requirements in the standard (prime) mortgage market. The subprime lending is known as high cost lending and primarily driven by credit history and down payment where as prime lending is driven by down payment only. People thought prime lending is complicated but have great promise and great peril.
The subprime lending provided opportunity for homeownership to those who haven’t passed credit history in the past. Lower credit history of subprime lending which could have resulted in more delinquent payments and defaulted loans.
US mortgage market, which for decades was dominated by fixed rate mortgages, included nontraditional mortgages, simultaneous second-lien mortgage, and no documentation or low documentation loans. Nontraditional mortgages allow borrowers to defer payment of principal and sometimes interest and include interest only mortgages (IOs) and adjustable rate mortgages (ARMs) with flexibility payment options. Interest rates are much higher than that of prime loans, is the main reason of risk for borrowers.
Strong home price appreciation and declining affordability have helped drive growing demand for nontraditional mortgage products that can be used to stretch home buying power. Souphala, C and Anthony, P.C , (2006).
1.3.2 Role of US federal government
National partners in home ownership in the largest private public partnership program whose solo aim is increasing home ownership rate to all time high by the end of decade by increasing creative financing methods for mortgage loans. In this program, retailer, home builders, Fannie Mac, Freddie Mac, mortgage bankers are the partners who came up with innovative ideas such as using FICO score instead of point based system is introduced to ease the requirements to lend loans to people whose credit history is not good to get mortgage loan. Another innovation is off balance sheet vehicle which made lending loans easy. (Mason and Rosner, 2007)
According to Souphala, C and Anthony, P.C , (2006),The government and the quasi-government agencies were main reason who influenced the US mortgage credit cycle by their legislative reforms and the mandates, the alternative mortgage transaction parity act in 1982 eliminated regulatory disparities between state and federal chartered mortgage by granting state chartered institutions the authority to issue alternative mortgage(sub-prime), including the use of variable interest rates and balloon payments, regardless of state mortgage lending law. The tax reform act 1986. Then stimulated demand for mortgage debt by retaining the deduction for home mortgage interest.
To lessen the effects of a mild recession in 2000, the Federal Reserve cut interest rates. Although the Fed has raised interest rates past year, mortgage rates have largely been unaffected. This interest rate cut along with increasing housing price made people to invest in housing. Home ownership is best way of making wealth in fact most households find it difficult to invest in anything but their homes. These factors helped to drive growing demand for nontraditional mortgages products that can be used to stretch buying power. Souphala, C and Anthony, P.C , (2006).
1.3.3 Financial Market Turmoil
Due to poor standard of lending there has been raise in subprime loans, the delinquency rate increased in the year 2006-2007 because of subprime loans issued in previous years. The overall rise in delinquency rate is sudden and overwhelming. The market started to response to these high delinquency rates in the second half of 2006 and first half of 2007. In spite of high delinquency rate, market had confidence on highly rated tranches of subprime RMBS (senior tranches). In the second half of 2007 this confidence came to its low when credit rating agencies lowered their rating on highly rated tranches. These downgrades created uncertainty and doubt on quality of rating these rating agencies assigned. With more exposure to risk related to subprime debts, restricted liquidity of banks, the inter market for term loans was effected so there was a sharp increase in risk premium. These authors concluded that banks lost confidence and have less liquidity. This resulted in present financial crisis.
The result of this is freezing all structured finance products and cut down in non confirming mortgages. This is because of those agencies giving non confirming mortgages had lots of loans and RMBS which were