Securitization, structured finance, and covered bonds.

• Author: Schwarcz, Steven L.

1. INTRODUCTION II. SECURITIZATION'S ROLE IN THE GLOBAL FINANCIAL CRISIS III. ADDRESSING SECURITIZATION'S PROBLEMS A. Problematic Asset Type B. Originate-to-Distribute Moral Hazard C. Servicing Conflicts D. Overreliance on Mathematical Models E. Overreliance on Rating-Agency Ratings 1. Dual Credit Ratings 2. Investor Payment of Rating-Agency Fees IV. THE FUTURE OF SECURITIZATION A. General Observations B. Alternatives to Securitization 1. Covered Bonds 2. Comparing Covered Bonds with Chinese ABN 3. Commercial Trusts Under Chinese Law 4. Trust Indentures 5. Trusts Used as Business Organizations V. CONCLUSIONS I. INTRODUCTION

   The author was hosted by the Shanghai Institute of Foreign Trade to present a series of high-level lectures on financial law at that institution as well as at Shanghai Jiao Tong University, Fudan University, China University of Political Science and Law, Peking University, and Tsinghua University. These lectures, presented in December 2012, focused on securitization, structured finance, and covered bonds, and they included related concepts from commercial trusts and shadow banking. This Article integrates the substance of those lectures.

2. SECURITIZATION'S ROLE IN THE GLOBAL FINANCIAL CRISIS

   The securitization of subprime mortgage loans is widely viewed as a root cause of the global financial crisis. (3) In the United States, there was significant government pressure on banks and other lenders to make home-mortgage loans to expand home ownership, even for risky borrowers. (4) These subprime loans were often made, for example, to borrowers with little de facto income, anticipating that home-value appreciation would enable the borrowers to refinance to lower-rate mortgages. (5) Historically, home prices had generally been increasing in the united States since the Great Depression. (6)

   But this model failed when, in 2007 and 2008, home prices fell significantly. (7) in one sense, the precipitous drop in home prices was unexpected--like Monty Python's skit, "Nobody expects the Spanish Inquisition." (8) In another sense, though, "the fall arguably should have been anticipated based on the [earlier] liquidity glut and artificially low interest rates, driving up housing prices artificially." (9)

   As a result of the fall in home prices, borrowers who were relying on refinancing for loan repayment could not refinance. (10) Furthermore, many subprime mortgage loans had adjustable rates, which increased after an initial "teaser" period. (11) Borrowers, some of whom could not afford the rate increases, had expected to refinance at lower interest rates. (12) Collapsing home prices stymied those expectations. (13) For these reasons, many risky borrowers began defaulting. (14) "These defaults in turn caused substantial amounts of low-investment-grade-rated mortgage-backed securities to default and [the highest] AAA-rated securities to be downgraded." (15) This frightened investors, who believed that "investment grade" meant relative freedom from default, and that "AAA" meant ironclad safety. (16) Investors started losing confidence in rating-agency ratings and started avoiding all types of rated debt securities. (17)

   Fewer investors meant that the price of debt securities began falling. (18) "Falling prices meant that firms using debt securities as collateral had to mark them to market and put up cash--requiring the sale of more securities--which caused market prices to plummet further downward in a death spiral." (19) The U.S. government's refusal in mid-September 2008 to save Lehman Brothers, and its resulting bankruptcy, added to this cascade. (20) Investors lost all confidence in debt markets, and even the short-term commercial paper market virtually shut down. (21) The lack of debt financing meant that companies could no longer grow and, in some cases, even survive. That affected the real economy and led to the global financial crisis. (22)

3. ADDRESSING SECURITIZATION'S PROBLEMS

   Because of its role in initially triggering the global financial crisis, securitization has been villainized. (23) But prior to the crisis, and even now, securitization is one of the primary mechanisms by which companies can obtain financing from the capital markets, bypassing high-cost intermediaries such as banks--an approach known as "disintermediation." (24)

   As a tool for disintermediation, securitization can more precisely allocate risk with capital, avoiding middleman inefficiencies. It also can enable companies to access capital markets directly, in most cases at lower cost than the cost of issuing direct debt (such as bonds or commercial paper). "Moreover, when the securitized assets are loans [such as mortgage loans], securitization can help to transform the loans into cash from which banks and other lenders can make new loans." (25)

   These positives might be outweighed, however, by securitization's flaws, which were revealed by the global financial crisis. Whether securitization, even with the flaws, created net positive value is an unresolved question. My goal in this Article is not to attempt to answer that question. Instead, I examine how to overcome these flaws.

   There are at least five potential flaws: subprime mortgages may be a problematic asset type that should not have been securitized; the originate-to-distribute model of securitization might create moral hazard; securitization can create servicing conflicts; securitization can foster overreliance on mathematical models; and investors in securitization transactions may over-rely on rating-agency ratings. (26)

   This Article uses the following terminology. Subprime mortgage loans (also called subprime mortgages) are loans made to risky borrowers who use the proceeds to purchase homes and then mortgage the homes as collateral; because the borrowers are risky, the collateral is the primary source of repayment. (27) "In the most basic form of mortgage securitization, mortgage-backed securities (MBS) are issued by a special-purpose vehicle (SPV), and payment on the securities is derived directly from collections on mortgage loans owned by the SPV." (28) In addition:

   More complex forms of mortgage-backed securities include collateralized debt obligation ("CDO") securities in which payment derives directly from a mixed pool of mortgage loans and sometimes, also, other financial assets owned by the SPV; and 'ABS CDO' securities in which payment derives from MBS and CDO securities owned by the SPV (and thus indirectly from the mortgage loans and other financial assets underlying those owned securities). (29) Subprime mortgage securitization can reference any of these financial products, so long as all or a material portion of the underlying financial assets consist of subprime mortgages.

   Next, consider these five potential flaws, examining what went wrong and what needs to be fixed.

   1. Problematic Asset Type

      The failure of subprime mortgage securitization was caused by its almost absolute dependence on home appreciation. (30) Some believe this type of particular sensitivity to declines in house prices was unique. (31) "From that perspective, parties structuring securitization transactions can minimize future problems by excluding, or at least limiting and better managing, subprime mortgage loans as an eligible type of underlying financial asset, and also by conservatively assessing the payment prognosis for other types of financial assets underlying securitizations." (32) This is important not only to protect the integrity of securitization transactions but also to avoid the unintended consequence that securitization of a problematic asset type can motivate greater origination of that asset type. However:

      This is not to say these procedures will be failsafe. Parties to and investors in securitization transactions must always be diligent to recognize and try to protect against the possibility that the underlying financial assets might, as in the case of subprime mortgage loans, fail in unexpected ways. What would happen to automobile loan securitizations, for example, if a technological innovation makes cars obsolete, depriving even financially healthy borrowers of the incentive to repay their loans? The invention of a new form of personal transportation is at least as plausible as the idea that home prices--which generally had only risen since the 1930s--would suddenly collapse in value at a rate higher than that seen during the Great Depression as happened in the global financial crisis. (33) The global financial crisis also teaches us the danger of mixing politics and finance. "Before the crisis, there was political pressure to securitize risky subprime mortgage loans to facilitate financing for the poor." (34) We could also see the same type of political pressure, for example, to securitize risky microfinance loans to facilitate financing for the poor and disadvantaged. (35)

      Finally, the impact of the failure of subprime mortgage securitization should be viewed in its larger context. Subprime mortgage loans usually constituted only a small part of the pools of financial assets backing mortgage-backed securities. (36) It was irrational panic that caused the market prices of those securities to collapse, in many cases arguably substantially below the intrinsic value of the mortgage loans underlying those securities. But that collapse became a self-fulfilling prophecy by freezing the debt markets, thereby negatively impacting the real economy and causing even prime mortgage borrowers to lose their jobs and default. (37)

   2. Originate-to-Distribute Moral Hazard

      As I previously indicated:

      Some argue that securitization facilitated an undisciplined mortgage lending industry. By enabling mortgage lenders to sell off loans as they were made (a concept called "originate-to-distribute" or "originate-and-distribute"), securitization is said to have created moral hazard since these lenders did not have to live with the credit consequences of their loans. Mortgage...