Securitization

According to Hu (2001) Securitization is the process through which companies use liquid assets and transform them into security using some financial ways. It involves an issuer creating a financial instrument through a combination of financial assets and after wards marketing varied tiers of the instruments that have been repackaged to potential investors. Through the process, liquidity is created by allowing smaller investors to buy shares in bigger pool of assets. A good example of securitization is a mortgage-backed security (MBS).

There are some distinctions between agency (Fannie, Freddie, Ginnie) securities and from private label securities. An agency security is a debt obligation bearing a low risk which is normally issued by U.S Government sponsored enterprises (GSEs).   In addition to bonds issued by GSEs, the term agencies is also used to refer to bonds that are guaranteed or issued by united states federal government agencies.  Those guaranteed or issued by federal agencies like Ginnie Mae are fully backed by the U.S. government.  It comes as an unconditional dedication to pay interest costs. However the bonds that are normally issued by GSEs like Fannie Mae and Freddie Mac do not have similar guarantee backing as federal government agencies and they also bear credit risk.

In contrast, Private Label Securities are described as the mortgage backed securities (MBS) that are not conventional to the loan limits that are established by the GSEs. Normally, they are jumbo loans or pools. These kinds of securities are offered by private institutions like commercial banks, home builders, thrifts, investment banks and other financial institutions. The mortgage securities may be issued as either non-agency mortgage passthrough or agency securities but their essential collateral in most cases is made up of varied or specialized forms of mortgage loans/pools which are not eligible for agency securities. This transaction involving private label securities may use of alternative credit improvements like letters of credit (Fagan & Frankel, 2008).

As opposed to agency securities, these securities are the lone obligation of whoever their issuer is and are not subject to guarantee by the U.S. government or the any of the GSEs. Additionally, private label securities are allotted credit ratings in relation to their issuer, structure, collateral and any other relevant factors by credit agencies that are independent. For extra investor protection, the private-label mortgage security issuer in general separates the collateral or deposits it under the care of a selected trustee, who keeps and manages it for restricted benefit of the beholders of the mortgage security (Roger, 2010).

Fagan & Frankel (2008) assert that there are two opposing schools of thought that are linked to the role of securitization in the financial crisis. One of the arguments is in support of securitization as having played a positive role in ensuring that credit risk is dispersed hence improving the financial systems’ resilience to defaulting by borrowers. The proponents of the process go ahead to it ensured that many families became responsible homeowners and helped them get finances from corporations at a lower cost. They insist that a wider collection of risk-return products created new capital in to the asset and housing markets.

However on other side of the coin are those who present cases against securitization that led to economic crisis. They claim that the process led to creation of many moral hazards like appraisers/raters, investors and originators/lenders. It also enhanced the distance between lenders and borrowers leading to many defaulters hence negatively impacting on financial institutions to a point of making many of them, banks mostly, bankrupt. Some of the complex products that were introduced by the process were abused and misused.  They also argue that it promoted predatory lending and sometimes it called for off-balance transactions. All this were key to aggravating global financial crisis as suggested by those against securitization (Fagan & Frankel, 2008).

Roger (2010) observes that to aid in bringing back private-label securities, the bonds in operation have to be backed by jumbo mortgages which is not accepted by Freddie and Fannie. This means that the loans will have to be in many occasions larger than $ 730,000 depending on the locality. There must be assurance for prospective buyers that the documentation of the loans are proper and also that they obtain income. In addition, all deals must be over-collateralized to make them resistant to losses on the mortgages that are underlying.