Debt Securitization

A lot of the current financial crisis has been attributed to the securitization of debt. This means that debt that is ordinarily illiquid has been converted into a trade-able security and then sold off in the open markets.

In order to sell a security; there should always be an underlying asset that generates income or cash flows. That is the reason why such securities are also known as Asset Backed Securities (ABS). Securitizing debts has several benefits and this concept has been around from the 70’s. It is only recently that things started to go wrong and that was primarily because the underlying risk was not understood properly.

How does it work?

Suppose there is a bank which has given out mortgages worth a $100 million. Ordinarily, the bank can’t resell these mortgages. That is because there is no market for individual mortgages. However, the banks can convert these mortgages into tranches of debt and securitize them.

So that means the banks will create tranches of debt according to the risk that they carry and then sell them off in the markets. These tranches will carry credit ratings to show how risky they are.

It may look something like this:

AAA:Â 20 million dollars
A:Â Â Â Â Â 30 million dollars
BB:Â Â Â Â 40 million dollars
Junk: 10 million dollars

Now, assume that this bank has got a BB rating. So that means that it has got securities worth 50 million dollars which are better than the rating of the bank itself. That means that this bank may be able to raise money on better terms on such securities, than it will be on the strength of its own name. And this was one of the main factors for the popularity of these ABS.

Investment banks were the big buyers of such securitized instruments and that is why investment banks like Lehmann were the first ones to get hit by the current sub prime crisis. They had bought a lot of the sub prime securities and when the bottom fell out, those securities were worth nothing.

Adding Layers of Complexity

During the housing boom, banks never expected the kind of defaults that we are seeing today. That led many to believe that some part of the “A” rated tranche should be worth “AAA”. So then banks took their A tranche and created synthetic tranches out of it and hived some of the A rated tranche as AAA.Â These were then valued at more than they should have.

Then there was the issue of credit default swaps and all these things pretty soon added up to complicated asset structures that became very difficult to value.

Conclusion

The original plan of the US Treasury was to buy the AAA securities (also referred to as Toxic assets) from the banks and transfer the risk of default to the Treasury instead of the bank.

However Paulson and Co later changed this plan to directly infuse capital into the banks. This was most probably due to the realization that valuing the AAA securities was a much more difficult task than originally thought. A lot of these AAA securities went into default and that led to a ‘crisis in confidence’.

There are several asset classes that have been securitized. There is a big fear that mortgages are only the tip of the iceberg. The next wave of defaults may come in credit card debt defaults and the derivative instruments that have credit card debts as their underlying asset.