Further Reading: Securitization and the Global Financial Crisis

Question 1

What is Securitization?

Answer 1

“A method of asset-backed financing whereby debt finance… is raised… against a specific portfolio of assets, in a manner which seeks to insulate the investor in the debt securities from risks,” aside from asset underperformance

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (3)

Question 2

In a short sentence, what is Securitization?

Answer 2

The process of transforming assets, e.g. loans, into marketable debt securities.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (3)

Question 3

What is Arbitrage?

Answer 3

A style of trading that, “exploits the tiny differences in price between identical assets in two or more markets.”

Investopedia

Question 4

When does Securitization become Problematic?

Answer 4

When the underlying assets used as collateral are themselves complex or dubious.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (4)

Question 5

What mainly Drove the development of the European Securitization Market?

Answer 5

The introduction of Basel I in 1988, i.e. minimum capital adequacy requirements, and the increasing need for banks to transfer assets off of their regulatory balance sheets.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (5)

Question 6

How did Securitization help Alleviate the newfound capital constraints from Basel I?

Answer 6

By allowing banks to transform current assets, i.e. loans, into debt securities and to store them in OBSVs.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (5)

Question 7

What is a Collateralized Debt Obligation (CDO)?

Answer 7

A derivative which describes any debt securtiy that derives its value from the cashflow of a specific portfolio of underlying assets.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 8

What is an Arbitrage CDO?

Answer 8

A arbitrage-style derivative designed to capture, “the spread between the yields paid to securitisation investors and the yield realised on the assets used as collateral for CDO issuance.”

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 9

What is a Structured Finance-Backed CDO?

Answer 9

A derivative product which describes any debt securtiy that derives its value from the cashflow of a portfolio of ABSs.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 10

What is a Synthetic CDO?

Answer 10

A derivative product which describes any debt securtiy that derives its value from the cashflow of a portfolio of other derivates.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 11

What Caused the Perversion of Securitization?

Answer 11

A bullish attitude towards securitization and the use of progressively poorer underlying assets to fuel it.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 12

What Resulted from the Perversion of Securitization?

Answer 12

The creation of an increasingly economically-detached asset bubble which was predicated upon unsuitably weak credit foundations.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (6)

Question 13

What made the Perversion of Securitization so Dangerous?

Answer 13

Its convoluted and synthetic variants were very opaque, a trait which concealed their underlying liquidity, solvency, and systemic risks and facilitated their transmission.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (10)

Question 14

In the immediate aftermath of the GFC, what were the main Regulatory Concerns regarding Securitization?

Answer 14

1. Securitization inspired perverse incentives.
2. Securitization’s complexiy and opaqueness obscures risk.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (10)

Question 15

Explain the Regulator’s perception regarding Securitization’s Inspiration of Perverse Incentives. (De Larosière)

Answer 15

Securitization was, “tainted by adverse selection,” and had, “created a moral hazard problem,” by allowing banks to, “transfer their risk to an unknown base of investors.”

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (11-12)

Question 16

What is Adverse Selection?

Answer 16

The pre-contractual form of information asymmetry, where one party, “has ex ante superior material information about the value of the asset it intends to sell and is able to conceal it,” to the detriment of the other.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (11)

Question 17

What is Moral Hazard?

Answer 17

The post-contractual form of information asymmetry, where one party acquires undue benefits by acting riskily post-transaction due to the other’s inability to effectively monitor them and to the latter’s detriment.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (11)

Question 18

With hindsight, was the Regulator’s Perception regarding Securitization’s Inspiration of Perversion accurate?

Answer 18

No. The market was in a state of ‘mutual misinformation’, i.e. banks were not leveraging their superior informational position for gain because they enjoyed no such position.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (12)

Question 19

It is a fact that banks regularly maintained a large stock of securitized products on and off their balance sheets. What does this imply?

Answer 19

That they were either unable or unwilling to transfer the associated risk onto investors, that these products served some alternative use, or both.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (12)

Question 20

What use did Securitized Products serve Banks as Balance Sheet assets? (C-CE-PR)

Answer 20

1. Collateral in short-term borrowing arrangements.
2. Credit Enhancement in securitization deals.
3. Profit generation, i.e. as investments.
4. Regulatory Relief.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (12-13)

Question 21

Regarding the Perversion of Incentives, what does Penn’s and Papadogiannis’ analysis ultiamtely demonstrate?

Answer 21

“[T]hat the incentives between the originators… and investors engaging in securitisation transactions were, in reality, very much aligned.”

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (13)

Question 22

According to Penn and Papadogiannis, in lieu of securitization, what was it that perverted banks?

Answer 22

Greed. The gains made from arbitrage waned incentives to perform due diligence, effectively rendering, “the provision of loans and the generation of assets,” a means rather than an end.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (12, 14)

Question 23

What further Evidences Penn’s and Papadogiannis’ ‘End-to-Means’ proposition?

Answer 23

The fact that once real assets became insufficient, investment banks instead sought out synthetic substitutes.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (14)

Question 24

With hindsight, was the Regulator’s Perception regarding the Opacity and Complexity of Securitized Produces accurate?

Answer 24

Not entirely. Simply because securitization has the ability to create opaque and complex financial products does not necessarily mean that all securitized prodcuts are inherently opaque or complex.

In other words: Securitization ≠ Specific Securitized Products

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (14)

Question 25

What was the Regulatory Response to Securitization following the Crisis?

Answer 25

Stringent clampdowns on the perceivedly problematic elements of securitization, i.e. inspiration of perverse incentives and complexity.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (19)

Question 26

With respect to Perversion of Incentives and Complexity, what Specfic Actions were taken in Europe?

Answer 26

1. Amendment of CRD I (Capital Requirements Directive).
2. Introduction of CRD II & III.
3. Introduction of CRR (Capital Requirements Regulation).
4. Introduction of Basel III.
5. Introduction of Solvency II Directive.
6. Introduction of AIFMD (Alternative Investment Fund Managers Directive).

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (19-21)

Question 27

According to Penn and Papadogiannis, due to the Regulatory Mischaracterization of Securitization, what resulted?

Answer 27

Miscalibration. To the detriment of the European economy, the beneficial and harmful variants of securitization transactions were conlfated.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (22-23).

Question 28

Most recently, how has the European Regulator treated Securitization?

Answer 28

Improvedly. Through the introduction of Regulations 2017/2042 & 2017/2041, many of the restrictions imposed during the Crisis’ aftermath have begun to be relaxed. Still though, many punitive elements remain.

G. Penn & T. Papadogiannis – Regulating Securitisation in the Aftermath of the Global Financial Crisis Lessons from Europe (24-28).