Securitisation and the global financial crisis: can risk retention prevent another crisis?

Abstract

Prima facie securitization played a prominent role in the recent global financial crisis. Moral hazard associated with securitization is the key element behind the failure of securitization. Risk retention is the U.S legislator's response to address the moral hazard issue associated with the originate-to-distribute model. This paper adopts a lexieconomic framework to analyse the risk retention provisions of the Dodd-Frank Act and proves that said provisions are not capable of eliminating moral hazard associated with securitization. This paper argues that in order to ensure proper screening of the borrower, the cost for the lender for not engaging in proper screening and monitoring should be higher than the benefits she gains by not screening. Inter alia this paper further argues that the inclusion of non-recourse mortgages would make securitization schemes susceptible to changes in home prices.

Political and Institutional Dynamics of the Global Financial Crisis

“…Leading borrowers to default. Douglas et al (2012) identifies the 2007-8 Global financial crisis had resulted in significant negative impact all over the world, while making policy makes re-consider the fact that they can or should manage such asset bubbles [5][6][7].…”

“…Financial innovation, in the form of asset-backed securities issued under securitization schemes, largely facilitated much of the indirect investment by domestic and overseas institutions in U.S. housing assets [27]. As had conventionally been the case, the purpose of much of this financial innovation was to minimise risk and enhance expected returns by 6 For example, credit default swaps were outside the ambit of the Commodity reducing bank funding costs, differentiating fundamentally similar products, 7 and for balance sheet management purposes. In addition however, much of this innovation-in particular, securitization contacts themselves and credit default swaps, which were designed to compensate investors when security issuers defaulted-was designed to transfer credit risk and liquidity risk [4,5].…”

“…As with all products, innovation implies risk. 7 In terms of market structure, banking and investment is characterised by an oligopoly of large firms (eg. market-makers) with a competitive fringe of small firms.…”

“…In the securitization context, for example, where the quality of the underlying investment may be difficult to ascertain because it is packaged jointly with other investments, it could be optimal for a securitizer, who knows the quality of the underlying investments in the asset pool, to seek to guarantee performance to institutional investors by contracting with a mortgage insurer. 22 Once mortgage insurance is in place, however, the insurance creates a moral hazard problem for the securitizer (or its fund manager), who may no longer manage its asset portfolio with sufficient care and diligence [6,7].…”

“…Abstracting somewhat from this background, the GFC's chief characteristics as identified in the literature can be clustered around excessive system liquidity; high levels of executive compensation by community standards; high levels of financial innovation; banks and other financial intermediaries undertaking activities beyond their traditional roles; speculative asset bubbles; and the U.S. sub-prime crisis and the fallout resulting from it [6,7].…”