The Art of Credit Derivatives: Demystifying the Black Swan

22

Securitization and the Credit Crunch

There are 10¹¹ stars in the galaxy. That used to be a huge number. But it’s only a hundred billion. It’s less than the national deficit! We used to call them astronomical numbers. Now we should call them economical numbers.

Richard Feynman

22.1 INTRODUCTION

As we have seen in this book, securitization refers to the pooling and packaging of financial assets in the form of new securities that are sold to investors. Via securitization, financial institutions create instruments that can be sold into the market instead of being kept on the balance sheets. That is, it brings liquidity to a potentially illiquid instrument that would otherwise remain in hold to maturity on the balance sheet of an institution. On the issuer side it improves leverage ratios, the efficient use of capital, and lowers the cost of funding. Additionally, it permits the institutions to focus on the business side instead of managing the assets on the balance sheet. From an investor point of view, the investment on a pool of assets inherently implies diversification. An insurance company can get exposure to an emerging market asset class by investing on a senior portion of the capital structure of a portfolio of securities. Via the same mechanism a pension fund can get access to a pool of credit card receivables or auto loans.

This was the securitization business model until June 2007 when the credit crunch brought up additional awareness for the consequences underlying ...