Securitisation and Structured Financial Products Flashcards
Week 7
1
Q
What is Securitisation? Why is it used?
A
- Securitisation occurs when a financial institution pools some of its assets and sells them to an intermediary
- The asset disappears from the seller’s balance sheet but still generates a return on the asset side
- The buyer makes a profit by buying below DR
- Customers are unaware if the product is securitised
2
Q
What are the names of the intermediaries in the securitisation process? What do they do?
A
- Special Purpose Vehicles (SPVs) and Structured Investment Vehicle (SIVs)
- SPVs/SIVs are legal entities that are created by FIs
3
Q
Expand on the process of Securitisation
A
- Banks turn assets into marketable security
- This is then removed from the Balance sheet and frees up capital
- When the asset moves to SPVs, they are not affected by seller’s bankruptcy/risk
- Value/cashflow is based on the underlying value of the securitised asset, meaning that it can be risky
4
Q
Name the three main tranche types
A
- Senior (defaults if all default)
- Mezzanine (defaults if at least 2 default)
- Junior (pays out if 0 default)
5
Q
What were the main issues with ABS in the lead up to the GFC?
A
- Easy to obtain a good credit rating (60% were AAA)
- Possible to purchase Credit Default Swaps in the event of a default
6
Q
What are some advantages of securitisation?
A
- Diversification of risk
- Transformation of illiquid assets into more liquid assets
- Allows for greater freeing capital
7
Q
What are some disadvantages of securitisation?
A
- Increased idiosyncratic risk (asset-specific) but increases sensitivity to aggregate risk
- Moral hazard/Adverse Selection of incentive to screen
- Corporate bonds are less favourable
- Can create rating/regulatory arbitrage
8
Q
What is the Shadow Banking system?
A
- Credit intermediation involving entities and activities outside of the banking system
- FIs move activities into SPVs, which reduces the size of the balance sheets and capital requirements as a result of regulatory rules
9
Q
How did regulatory arbitrage occur in SPVs?
A
- Basel 1 (1988) accord required FIs to hold 8% capital of their loans on their BS
- No charge for the credit lines via SPVs
- FIs moved loans into SPVs and guaranteed AAA
- Securitisation allowed for lower capital to conform with regulation
- This steadied bank risk, so there was a mass movement away from loans towards secutities
10
Q
How does rating arbitrage occur in SPVs?
A
- CRAs forecasts for SFPs were optimistic, as models were based on past data and assumed low correlation between house prices
- This boosted AAA valued tranches
- Agencies could collect higher fees for structured products, favourable rating companies to corporate bonds
- ‘Ratings on edge’- tranches slinced in a way so the dividing line was AAA
11
Q
Why wasn’t financial arbitrage stopped?
A
- FIs only faced pipeline risk
- Risk is passed on as the asset leaves the BS
- Low incentive to screen/monitor
- Institutional investord were allowed to hold assets they couldn’t before
- Searching-for-yield: Attractive as SFPs offered high E(R) and low P(loss)
12
Q
What is the correlation between leverage and securities?
A
- 0.62
13
Q
What is the correlation between leverage and liabilities?
A
- 0.74
14
Q
Why is the correlation between liabilities and leverage strong positive?
A
- ST funds are used to leverage and bet on rising prices in Credit Market
- Banks were more exposed to the securities market
- The more exposed, more leveraged & reliant on ST funds
- Large international banks exploited the looser regulations and monetary policy to take greater risk
15
Q
What was the housing bubble? What happened to cause this housing bubble?
A
- Cheap credit and low lending standard so people could buy houses
- Assumption prices could only rise and borrowers could refinance
- No down payment required
- No credit checks and no need to prove income
