Here is the full question: The abuses associated with securitisation have been blamed for the 2008 financial crisis, sparking regulation that has been described by some as overly restrictive and, in some cases, punitive. Critically discuss.
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Securitisation Laws Implemented After The 2008 Financial Crisis
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Introduction
Before the 2008 financial crisis, securitisation was an ordinary means of financing in the United States. Here, a company is allowed to raise finances without borrowing from the bank; hence it eliminates the financial intermediaries, and securities were issued without the prices relying on the company’s creditworthiness. For instance, a company chooses to sell its certain rights to a “bankruptcy remote” Special Purpose Entity (SPE) mainly in financial assets. Then the SPE issues securities to investors paid in the form of cash collections in exchange for the financial assets. Investors will hence wait upon these assets for their repayment and high returns instead of the company. This research paper seeks to critically discuss various commentators’ views on the restrictiveness of the regulations that arose from securitisation abuses during the financial crisis. Some of them have indicated that they are overly restrictive and, at times, punitive.
Undoubtedly, securitisation received a lot of blame for the financial crisis hence sparking the various regulations. These regulations, in turn, garnered different views, especially on how restrictive they are. Notably, the financial crisis, which is generally the sudden and sharp decline in the value of the actual or financial assets or the vast departure of capital from an economy at both the micro and micro levels, was a significant problem that needed to be handled. This is because it led to the failure of the country’s financial system, which could have caused its collapse. Therefore, asset securitisation was one matter that needed to be handled. Asset securitisation is the process of risk transfer against collateral intermediation. A negotiation for future cash proceeds or the receivables of a contractual debt obligation and the supporting collaterals to a third party is done to transfer the credit risk to the party’s debt obligation. Mortgage-backed securities (MBS) occur when mortgages support the negotiated assets that are the securities. The subprime MBS happens when the credit’s base is the value of the underlying properties. Notably, the United States Financial Crisis Inquiry Report Committee indicated that subprime lending or mortgage was the extension of the financial credit to substandard debtors with questionable credit levels. Investors’ motivation to venture into the high-risk investment was generally their objective of achieving higher returns or yields. This situation happens in the United States without adequate supervision, consideration, or an accurate measurement of risk affiliated with the ventures led to the financial crisis. The subprime MBS became the most dominant reason that ignited the United States’ financial crisis that subsequently spilt over to the global financial market.
To this effect, the United States affirmed that it was vital that they implemented prudential regulations and macroeconomic policies that would prevent the crisis from happening again. The financial crisis proved that it was already deep-seated within the unconstrained excess of financial institutions and an extended laxity among the financial regulators. It was painfully clear from the crisis that financial institutions cannot be left alone to regulate themselves. The lack of clear rules, transparency, and accountability caused the financial market to break down, which at times can be very catastrophic. While the United States government incorporated unexpected measures to save the failing financial institutions and stabilise markets so that another Great Depression does not occur, the crisis illustrated a need for thorough regulatory reforms both locally and globally.
An Analysis of the Financial/ Subprime Crisis
The 2008 financial crisis did arise from the challenges underlying the securitisation of subprime mortgages. Generally, the subprime market in the United States has demonstrated that the investors’ demand drives the process of securitisation for increasingly less creditworthy loans. Although the decline in the quality of borrowers had been documented, the risk premiums to the subprime mortgages remained low until the housing market took a downturn. Even without securitisation, the financial market was demonstrating a risk appetite. The securitisation process appeared to be squaring the risk-return cycle.
While principally this was a good idea, housing prices in the country and even globally rarely move together; hence securitisation was a pool of geographically distant mortgaged that have reduced their default risk by diversification. Furthermore, the process created distinct risk classes by allocating the cash flow from the pool by seniority of the distinct security tranches. The validity of the mechanism could easily be questioned in hindsight. The housing prices should move together and tend to, especially during the sustenance of their upward trends via similar systematic factors that make securitisation attractive to boost housing finance and prices subsequently. It would be characterised by lower interest rates and the marketable securities experiencing a steady demand. Failing to account for the correlations explained the losses within the subprime mortgage business but not the financial crisis. Although high, the non-prime mortgage securitisation figures in the country were still too little to cause the crisis. Furthermore, during the crisis’s peak, the approximated write-downs in the asset-backed securities surpassed the most pessimistic depreciation predictions for the underlying assets. Aside from the subprime mortgages, there was no explanation as to why the assets’ price declined. However, there was a time when markets declined to trade and refinance in all types of asset-backed securities, very few of the triple-A bonds had been defaulted.
Therefore, another reason led to the financial crisis. Securitisation typically completes the financial markets by permitting the funding of assets that would not be proper for the conventional intermediation except with high rates. At the time, plenty of investors wanted the asset-backed securities regardless of an alleged incentive challenge arising from the ‘originate to distribute’ model. The high demand rose from a moral hazard where investors held minimal incentives to be careful with how risky the securitisation was. They had access to a safety net or depended on the implicit government guarantee. Also, the professional investors were irrational by failing to disregard the pieces of available knowledge systematically. Investors believed that the asset-backed securities had similar portfolio restrictions for the institutional investors and similar capital charges as the corporate and government bonds with similar ratings. Their benefit from the available knowledge was that rear Rey could get higher returns. Furthermore, these securities had attracted wide acceptance as collateral for short-term funding, with the high-grade financial institutions regularly providing the funds quickly and with very minimal interest rates. It would be irrational; for the investors to forego the profit opportunities.
Investors did not neglect the things they knew but overlooked the things they did not know. They failed to consider all the downturn situations that could arise while deciding whether to buy or finance the asset-backed securities. The decisions made followed the Keynesian conventions so that any uncertainties present were dealt with. However, while the credit ratings are fundamental in the conventions, they have not considered the credit default swaps reassuring. It is on this basis that shadow banking flourished. Since the asset-backed securities were traded with almost no volatility, they were now considered better collateral in line with treasury bonds and attractive earning spreads.
Therefore, the United States financial market with extensive securitisation was running with minimal monitoring intensity, and any informational asymmetries in the secondary loan market were being exploited. Generally, the mortgaged that are to be securitised have a higher default rate of 25% than those that are not securitised. The existing securitisation practices negatively affected the screening incentives of subprime lenders. Lax regulations and abuse of the securitisation processes led to the creation of poorly underwritten mortgages, and credit was made overly available to unqualified homeowners. All these circumstances led to the financial crisis.
Regulatory Reforms After the Financial Crisis
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was imposed in the United States in 2010. It would increase the securitisation markets’ regulations in numerous respects, such as implementing the new credit risk retention rules in Regulation RR. 17 CFR Part 246. The regulations proposed to print an alignment of the sponsors and investors by needing the former to retain the economic interests within the credit risk of the securitised assets for a particular period. The Securities and Exchange Commission (SEC), among other federal agencies, jointly adopted the final rules that require the sponsors of asset-backed securities to maintain more than 5% of the aggregated credit risk of the securitised risks in 2014. The United States Risk Retention Rules became effective in considering the residential MBS in 2015 and for the other asset classes in 2016. The rules were considered the most fundamental part of the bill as they were tailored to handle the particular perceived flaws within MBSs that were ever-present before the financial crisis. In 2018, the United States Court of Appeal ruled that an open market CLO manager was not a securitiser, the Dodd-frank Act needs them to comply with the Risk retention Rules.
Despite being very extensive and comprehensive, these regulations had a fundamental role in making the securitisation process better. Generally, the regulations focused on four functions, specifically increasing disclosure, requiring risk retention, reforming the rate agencies, imposing the capital requirements, and requiring particular due diligence. These objectives or responses were similar to the European regulatory responses implemented. The Dodd-Frank Act required the companies selling products such as the MBS to disclose more information on the underlying assets so that their quality can be assessed. This is in conjunction with retraining at least 5% of the credit risk except when the underlying loans have met the standards that demonstrate reduced risk levels. The losses would hence be suffered along with those that buy the securities. The capital regulations are expected to account for the actual risk, while any parallel changes within the accounting rules bring the most standard forms of securitisation on the balance sheet. The credit rating agencies whose ratings for securitisation made significant contributions to the market distortions were also subject to extensive oversight by the SEC, including policing the rating shopping and the conflicts of interest. Ratings were expected to be more transparent due to the mandatory information disclosure on the rating methodologies, the basal data and the outcomes from due diligence done on third parties.
The Federal Reserve and other two federal agencies also adopted the final rule that combined the Basel III capital requirements and the Dodd-Frank Act Framework to incorporate the liquidity Coverage ratio (LCR) of Basel III in the United States. The LCR obligates the banks to maintain a minimum amount of high-quality liquid assets, quickly convertible into cash without losing value. In withstanding the stress scenario of 30days, the bank’s stock of high-quality liquid assets will need to 100% of the total net cash outflows during the entire duration, in providing definitions of what comprises the high-quality liquid assets and those that need to be discounted in computing the 100% requirement, Basel III has disfavored the investments on asset-backed securities. This does not allow some of them to be part of the high-quality liquid assets and discounting some to even 50% for computing the 100% requirements. The implementation of the LCR in the United States is considered to be of even higher stricter levels.
An analysis of the current regulatory approaches represents good faith and, in many scenarios, demonstrates careful thoughts focused on reducing the systemic risk. For instance, the liquidity requirements would help protect against the risk of maturity transformation that could lead to Systemically Important Financial Institutions (SIFIs) defaults that subsequently cause systemic shocks. Also, stress testing has been determined as the most effective mechanism to safeguard the financial system’s resilience. However, despite the evident efforts, these regulations do have their vulnerabilities, which pose a risk of making minimum progress in preventing another financial crisis. The United States Secretary of the Treasury, Timothy Geithner, indicated that while the specific regulatory requirements have been imposed, they could not go very far in governing the risk taking behaviour and subsequently preventing another crisis. Officials from the Bank of Spain believed that macroprudential mechanisms that are well-calibrated still cannot perfectly achieve the goals for which they are desired for. The United States Federal research has also indicated that the financial regulatory reforms are still working in progress, affirmed by the European Central Bank.
Criticism of the Regulation Responses for Securitisation
The vulnerabilities of the various regulatory reforms make up the criticisms that have been made against them. Securitisation’s regulatory reforms focus on protecting against or reducing the impact of the harmful risks, including preventing another financial crisis from happening.
The need for increased disclosure in securitisation transactions is unlikely to produce meaningful results. Before the financial crisis, the risks associated with the complicated securitisation transactions and the underlying financial assets such as the subprime mortgage loans were already disclosed. Still, they did not prevent the collapse of the securitisation markets. The challenge is that disclosure is solely not adequate for highly complex securitisation products. For instance, decrypting a prospectus will entail analysing numerous extensively detailed pages with technical and legal phrases. This burdensome analysis becomes complicated even for the most high ranking institutional managers. This leads them to rely on the credit ratings, mainly when other financial institutions ate making investments into similar securities. Also, a comparison of the E.U. and the U.S. disclosure approach demonstrated that the former’s approach tied to simple, transparent, and standardised (STS) securitisation is more likely to be effective than the latter’s transactions having a relatively standardised simplicity. The standardised simplicity in the U.S. puts restrictions on the economic utility of securitisation, including financial innovation. The E.U.’s STS approach will not need standardisation but merely reward its respective simplicity and seem to be contemplating a considerable degree of market flexibility to achieve the simplicity.
The risk retention implemented within the regulatory reforms was intended to mitigate the moral hazard originated from the originating model of loan origination. Therefore, this would have improved the quality of the financial assets that underlie the securitisation transaction. However, there are still uncertainties on how the legal risk-retention requirement would have improved the financial asset quality. Generally, a market will individually mandate its risk-retention. Before the financial crisis, originators and sponsors in securitisations typically retained risk affiliated to respective financial assets such as the mortgage loans that are part of the transactions. Nonetheless, the challenge was that these two parties and investors overvalued the assets. The overvaluation was partly due to the irrational trait of the asset-price bubbles; the baseless belief that the downside risk of home prices declining would have never happened.
It is also prudent to consider that the originators were targeted via the Mortgage Reform and Anti-Predatory Lending Act to ensure that loans are not more than the property value. The lawmakers appropriately identified the mortgage originators as fundamental players in the transparency challenge. However, they failed to handle investors’ needs and then provide the tools required to make better-informed decisions. The SEC also targeting creditors ignored essential financial tools already existing that could increase transparency levels for investors. Therefore, while Congress of working on protecting the defaulted homeowners, it fails to consider the systemic risks and macroprudential policies.
Additionally, it was uncertain whether the ‘originate-to-distribute model was the primary reason for the morally hazardous behaviour hence reducing the mortgage-loan underwriting standards. Theoretically, separating origination and ownership should not be considered since the final owners will need to assess and value the risk before purchasing their ownership positions. If the model did not lead to lower underwriting standards, then risk retention requirements would have a limited impact. Risk-retention may also be dangerous apart from being inadequate as it causes a “mutual misinformation” challenge. By retaining the residual risk portions of particular sophisticated securitisation products being sold before the financial crisis, the underwriters to the securities could have advanced false investor confidence that contributed to the crisis.
Concerning the rating agency reforms, the Act has authorised the SEC to propagate the regulations in rating agencies’ conduct and business. Nonetheless, the SEC has achieved very minimally in this aspect. The steps that have been taken have not yet handled the conflicts of interests within the issuer-pays model, which has been considered to play a fundamental role in the overestimated ratings if the investments given to the complex securitisations before the financial crisis. Conversely, the proposed regulations to the E.U. need the fees to be disclosed. While those will not eliminate the conflict of interest within the issuer-pays model, it does play a role in mitigating the conflict or reducing any impropriety appearance. Additionally, the Dodd-Frank Act also considerably mitigates a dependence on rating agencies by the banks and federal agencies. While this reduced dependence on the ratings does have its benefits, there is a need to seek highly reliable credit ratings.
More criticism has been directed to the capital requirements that apply to securitisation transactions by needing investors in asset backed securities to maintain more capital than for the investments related to other securities’ types. Some have considered rhythm too restrictive against securitisation, while others consider them illogical. This is because they are seen to be representative of conservative tightening of capital standards which investors in asset-backed securities will need to hold further regulatory capital compared to when they make direct investments to the financial assets that back those securities, the industry representative have been supporting “capital-neutrality” which entails needing the investors in asset-backed securities being backed by the initial priority claims against the financial assets for holding capital based on underlying assets. Regardless of whether merit to require investors to hold more capital is existent or not, t6he European framework has allowed the investors in the securities that also comprise of the STS securities to obtain a 25% decrease in the capital fees, the purpose of this is to reflect the reduced affiliated with simple, transparent and standardised securitisations.
Finally, in the due diligence requirements, the E.U. proposed regulations need the institutional investors in securitisation transactions to conduct particular due diligence before and after closure. This requirement in due diligence is similar to what parties such as investors typically conduct during securitisation transactions. To this degree, the due diligence requirements could be considered redundant and unnecessary. However, the requirements are valuable in ensuring enough due diligence when another investor is seeking securitisation products.
Apart from the criticisms on the specific regulatory reforms, the commentator Professor Turk indicated that the Regulation of securitisation imposed after the crisis has made minimal progress. The administrative enforcement actions against the sponsors to securitisation that led to multibillion settlements was the only strategy that has achieved fundamental reforms. The settlements that are considered in entirety have created a de facto legal prohibition against gross conduct in the securitisation markets, which are equal to negligence standards. While other commentators consider the settlements simply the costs of doing business, they undoubtedly have affected the respective sponsors more carefully. These enforcement actions, especially in the settlements, raise two-fold concerns. The first one is the extent to which the securitisation sponsors acted illegally, considering the organisations are individually the second-best deterrence targets. Hence, the target on managers in their capacity is broadly perceived as a greater deterrent than putting liability on firm levels. The second one is that many of the settlements had been compelled by the reputational and politically induced duress of the securitisation sponsors who had acted legally. Therefore, it created strict liability instead of negligence standards. However, the imposition of strict liability for legal actions is not in line with the “American legal system”, which has constantly stated to be committed to the “rule of law” values.
Conclusion
The abuse of securitisation led to the United States housing bubble and, subsequently, the severe financial crisis. The misconduct and fraudulent actions of the stakeholders created harm that would be felt across the entire financial industry, economy and international investors. The financial crisis did expose the need for better regulations and oversight of securitisation, which received considerable blame for the crisis. The regulations would have been essential to protect investors from possible abuse and ensure that the global economy remains stabilised.
Although the regulatory responses implemented have, however, achieved minimal progress. The regulations that are considered to be highly stringent and transparent are still devoid of the realities of the financial industry and when it comes to securities regulation. The general goals of regulating securities are creating market efficiency, protecting investors, enforcing regulations and ensuring the entire financial market is stable. However, the present regulatory reforms have their vulnerabilities which means that the investment industry is still running under an appropriately regulated climate. The minimal progress of these regulations is that they are too restrictive on particular elements without providing a meaningful direction on handling the debt market. Securitisation has proven to be an effective method of generating wealth globally hence cannot remain unregulated. The existing systemic risks require a unity of effort from all stakeholders who will identify opportunities and be responsible for implementing better regulations that would achieve securitisation objectives while preventing another financial crisis.
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