Posted: July 14th, 2022

Risks Associated with the Securitization Mechanism for Originators and Investors

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Choose ONE of the following:
1. To what extent has MiFID legislation (MiFIR and MiFID 2) imposed a new legal paradigm of technological innovations (e.g. algorithmic and high frequency trading activities) on regulated firms within the European Union? Discuss in the context of the UK and Continental financial markets.

2. FinTech aims to support regulation in the financial markets with the use of algorithm and computer systems. It provides innovative solutions to improve the regulatory framework and the compliant behaviour of financial firms. However, the adoption of cloud-based systems and data mining techniques in FinTech raises concerns about the necessary intervention of supervisors to avoid fraudulent activities and ensure data protection and privacy. Critically discuss.

3. Securitisation involves transactions that enable originators to repack a set of risk exposures (market or credit risks), by transforming them into tradable securities. Critically discuss the main risks that may arise from the securitisation mechanism for the originator and investors.

4. The UK financial regulation is characterised by the principles-based regime (PBR) and ‘comply or explain’ approach. Critically discuss the main shortcomings of the PBR in the light of the global financial crisis.
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Securitization Process:
Risks Associated with the Securitization Mechanism for Originators and Investors

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Introduction
Securitization refers to the process of particular assets being pooled for repackaging into interest-bearing securities. The buyers if the securities get to keep the interests and principal payments from the assets. The originating organization will receive payment for having the debts transferred to the master owner and thus becoming out of the transaction. Over time, numerous financial institutions have employed the mechanism to transfer the credit risk of the identified assets from individual balance sheets to other financial institutions. The reasons for employing this mechanism include how cheap it is to raise money through the process. The respective securitized assets are cheaper for banks to hold, considering financial regulators have distinct standards for the assets compared to the other underpinning assets. Principally, the “originate and distribute” mechanism netted widespread economic benefits of spreading out the credit exposures; hence the risk concentrations are diffused and systemic vulnerabilities reduced.
Notably, the securitization mechanism can be a source of risk for the originator, investors and ultimately, the financial system. For instance, securitization amplified the 2008 U.S financial crisis via its contribution to extending the intermediation chain through establishing conditions that led to the misalignment of incentives and interests of the involved parties within the securitization chain. It also increased the dependence on mathematical models and external risk assessments, leading to greater individual and systemic bank risks. To this effect, this report intends to critically discuss the main risks that may arise from the securitization mechanism for the originator and investors.
Risks Affecting the Securitization of Assets
While there are numerous advantages affiliated with securitization, one of its biggest drawbacks is the complexity affiliated with the process. This process becomes even more complex where the governments get involved significantly, especially for loans with social and political implications. At the end of this particular process, the entire complications and complexities encountered lead to enormously complicated securities that it becomes challenging to accurately assess the level of risk. To this effect, the tranches within this securitization could easily lead to risk ratings that are not an accurate reflection of their true level of risk. As long as the economy is progressing accordingly, the process will bring in income as expected. Nonetheless, a contraction or installation of the economy will easily lead to having repayments being inevitably missed. The incorrect assessment of tranches will affect all investors, whether they have high risk or low-risk tranches. This sets forward a string of panic which goes beyond the securities even to affect the whole market.
Apart from the risks that are attached to the complexities of the process, there are other specific risks affiliated with securitization, including:
a) Essential Market Risks
These are the risks extrinsic to the transaction and mainly encompass the market-related factors that could affect that transaction’s performance. In securitization, the risks involved relate to interests rates and exchange rates. The risks may happen in different interest payment arrangements or when the currency to the receivables’ underlying pool is distinct from the issued bonds. A change in interest rates will affect the prepayment rates for assets. In contrast, a change in real estate prices could affect the performance of securitization transactions supported by home loans.
The securitization transactions are subject to liquidity risk on two fronts. First, the temporal mismatch between an incoming and an outgoing payment flow will need to be managed, which is also the balance sheet liquidity risk. The mismatches commonly arise from the early repayment on the debtors’ part, which is the prepayment risk. Conversely, the market-based liquidity risk can come from the bonds issues within the primary market or traded in the secondary markets, considering the many parties involved in a securitization transaction does cause an agency risk, a particular type of operation risk where the individual parties within the transaction could exploit the discretionary freedom to the detriment of the investors.
The underlying loan agreements’ performance depends on macro-economic factors, including industry downturns or negative price movements of the underlying assets. An example is that a sustained reduction in industrial production may lead to a slowdown within the transport industry. This could lead to a strain on the truck operators’ cash flows, which could affect the repayment of commercial vehicle loans. Also, a drop in the prices on underlying trucks could lead to an increase in default cases. The borrower could choose to default on paying their loans and let the financial institution repossess and sell the trucks instead of retaining the vehicle and work on paying the instalments promptly. It has been necessary to apply proper stress levels to the cash flows coming freeman the underlying assets to consider the risks affiliated with macroeconomic factors.
Another market risk is the prepayment risks which, in conjunction with the volatile interest rates, cause a challenging situation for investors. Normally, retail loans’ prepayments will increase with reduced interest rates, causing a reinvestment risk to the investors. The investors receive their money ahead of the set times and not be able to reinvest the money at the same yields. In particular structures, distinct prepayment procedures could be carved out of the pool cash flows hence exposing them to volatile cash flows due to the prepayments in the pool that is given to the. A prepayment strip ensures that other investors apart from those that have invested in it are protected from the uncertainties within cash flows until the time the cumulative pool prepayments surpass the prepayment strip, the incorporation if relevant prepayment assumptions within the analysis of securitized instruments should be considered is this risk is to be mitigated.
Notably, these market risks have been affiliated to opacity, asymmetries of information and the lack of transparency. Investors are normally efficient in risk pricing, but they cannot price what they do not know. Each investor wants as much information as possible due to their fiduciary responsibilities. Investors have also been concerned with poor underwriting concerns and conflicts of interests among the servicers and affiliates. The originators and issuers are failing to meet their contractual duties via their representations and warranties. Ultimately, investors are working within a market lacking sufficient tools to enforce transparency and enforcement for violations. The investors find themselves incurring losses based on the representations or misrepresentations made in the issues. Complexities and the lack of transparency on the market risks have allowed ignorance among investors. They are manipulated for profit, which is apparent in the broad securities litigation.
b) Credit Risks
These risks are affiliated with the possibility of non-performance or inappropriate performance by the other party on their obligations within the transaction. Credit risks formulate a fundamental element within the analytic process for securitization transactions. The differentiation of credit enhancements could be done using their origins. The internal credit enhancements arise from the pool of received and the external credit enhancement encompass all the other additional enhancements allowed by credit enhancers.
Normally, the transactions involving a pool of loans will have credit enhancements available to deal with the shortfalls within the collections to the investor payouts, primarily arising from the pool borrowers’ defaults. The credit enhancement’s level is adequate to handle the shortfalls within the pool collections equal to the predetermined readings.
The key factors considered in determining the adequacy of the credit enhancements include:
1. The Asset risk as the nature of the underlying assets is a fundamental signal of the pool’s performance. Considering all factors are held constant, the low-risk assets will require lower credit enhancements than high-risk assets. Within the risk continuum of assets, the sufficiency of credit enhancements to various asset classes is determined as they are good indicators of the relative risk levels within the underlying loan assets.
2. The Originator risk associated with the assets’ originator plays an essential role within the transaction. Regardless of the particular asset class, the originators may decide to concentrate on the lower or high-risk sub-segments as an element within their strategy. Therefore, the organization’s quality and the underwriting norms affect the performance of the assets. The strong origination systems and processes will improve the quality of the assets, and any inadequacy and ineffectiveness within the systems and processes cause the origination of poor quality assets. There is a need for a robust control mechanism and management information systems for originators to create a strong portfolio.
3. Portfolio risk: The portfolio comprising a group of outstanding loans handed out by the originator will determine the pool to securitized. Traits such as the originator’s track record within the asset class and previous delinquency sequences on the portfolio may predict the securitized pool’s performance. For instance, an originator with a car loan portfolio that has been making losses could be utilized to indicate the potential future losses of the car loan pool. Furthermore, the levels of delinquency of the originator’s portfolio are contrasted to others in similar asset classes for other originators during benchmarking. The securitization process acknowledges the analysis of portfolios as part of the overall risk assessment framework.
Apart from understanding the factors in determining the credit enhancements’ adequacy, it is prudent to understand the origins of credit risks. The individual debtors will create these risks within the receivables pool and other parties in the transactions. For the individual debtors within the pool of receivables. They could choose not to uphold their contractual payment obligations entirely or partially due to numerous reasons such as bankruptcy. A securitization transaction’s main objectives are to structure and transfer the risks to a pool of receivables. To this effect, credit risks within the pool are normally the aims of risk management activities in securitization transactions,
Nonetheless, the securitization transactions will encompass numerous additional payment flows that are also subjected to credit risks. The payments include those sent to investors by paying agencies, fees from the special purpose vehicle to the service, those from the servicer tithe paying agency, and throes from credit enhancers related to credit enhancement obligations. Each of the payments faces the risk of default by any of the parties; the additional credit risk should be handled by risk management within the securitization transactions despite it being less significant than the sum of individual credit risks arising from the pool of receivables.
c) Counterparty Risk
Several counterparties ate part of the securitization transaction, and their performance is fundamental for a streamlined operation of the transaction. The transaction that involves a pool of loans will have the credit risks simulated to make out the adequacy of the credit enhancements. Nonetheless, the counterparty risks are normally digital and very extensive to be simulated to establish the adequacy of the credit enhancements. It has strict measures to select and replace the counterparties if these risks are equivalent to the assigned rating. The fundamental risks to be considered within the securitization transactions include:
1. Servicer risk where the investors are exposed to a bankruptcy and a non-performance risk from the servicer. Subsequently, the maintained performance of the servicer during the pool’s tenure becomes fundamental in the process. The quality of a servicer’s team, collection strategies, follow-up mechanism, and other servicer systems need to be evaluated as their credit rating becomes a proxy of their expected performance.
2. Commingling risk: For many securitization transactions, a time lag exists between the pool collections and investor payouts. Normally, the servicer will collect the payment from the borrowers in the pool for a particular month and deposit it into the Trust and Retention Account in the following month. During this interim, the servicer held the collected money and could easily co-mingle with the individual cash flows. The collected amounts are held by the servicer due to the trust, according to the servicer. However, if this party becomes bankrupt, a total or partial loss or delayed recovery of the commingled amounts is possible to affect the originator and the investors. Such situations could lead to legal proceedings. The servicer’s short-term credit quality determines the commingling risk as the pool collections are commingled for a short duration. The short term credit rating of service should be evaluated if this risk is to be greatly mitigated.
3. Swap Counterparty risk: Within the securitization transactions, Interest Rate Swaps (IRS) may be utilized in mitigating interest rate risks identified under market risers. Transactions that incorporate IRS payouts to investors rely on the received payments from the IRS counterparty. Therefore, the IRS’s credit risk is also critical to these transactions.
4. Counterparty risk is also linked to credit enhancement; the latter could be availed in two ways: the cash collateral or a guarantee; the cash collateral involves the maintenance of the credit enhancement in either cash or cash equivalents forms. The guarantee involves the originator arranging for a bank or a corporate guarantee with an equivalent amount. If the cash collateral is in a fixed deposit form, investors are exposed to the credit risk affiliated with the bank holding the fixed deposit. Similarly, if a guarantee is availed, there is exposure on the bank’s credit quality or the corporate guarantee providing the guarantee to the investors. Therefore these risks need to be factored in these transactions.
d) Legal Risks
Particular legislation and a long track record of decisions surrounding securitization cause a great degree of predictability to the legal position in respective transactions and facilitate the development of transparent and properly founded legal criteria for respective transactions. Nonetheless. The lack of judicial precedents or clear statutory provisions on these transactions means that they get to be structured by their counterparties in the present framework of transfer of property, trust and contract laws.
The fundamental legal matter arising in securitization transactions us affirming whether the transfer of receivables is a “true sale”. This would ensure that the originator does not hold onto any control over the receivables nor make any claim in them that could override any investors’ claims. A true sale would male the assets securitized, and the originator’s bankruptcy cannot affect an investor’s claim on the securitized pool’s cash flows. A dispute concerning the assets’ legal ownership could easily lead to uncertainties on the investor payouts from the pool cash flows. Additionally, the favourable ruling from a judicial proceeding could lead to an apparent loss for forge investors together with increased concerns in the basic concept of securitization.
A detailed study of the relevant legal documents related to the transaction is fundamental during the rating process. Furthermore, the progenitor is required to provide an external legal opinion on the individual transaction to affirm the high-level third=party due diligence on legal matters by the legal fraternity’s professions. Normally, the legal opinion is expected to handle the assets’ transfer not contravening any underlying loan documents assets transfer to the SPV being a true sale and the credit enhancement that is in cash form being bankruptcy remote from the originator or if in guarantee form, it is enforceable by the trustees and irrevocable and unconditional. Also, the legal opinion could speak in the transaction documents being valid and enforceable without contravening any applicable laws and the documents being duly executed as per the current stamp duty and registration regulations.
e) Misalignment of incentives and conflicts of interest.
The securitization markets were previously affected by the misaligned incentives or conflicts of interests, which are circumstances where particular participants have the incentives to conduct themselves to further the interstate and not that of others. Their actions could also be detrimental to the interstate of others within the securitization chain or the wider market. For instance, when the participants get incentivized to transact quickly and in high capacities without conducting any assessments or taking the time to understand the risks affecting them and others within the chains, generally, the misalignments and conflicts are considered to have led to investors losing confidence in the market ad also acted as a barrier to market recovery. Evidently, the originator will be affected by lacking a place to transfer their own risks…
Extensive research pointed out significant developments that led to the conditions for incentives and interests to be misaligned or conflict. They include the evolution of the origin to a distribution model, having a relatively large number of parties involved in the transactions and an increase in the distance between the loan’s originator and the final bearer of the loan’s default risk.
The primary effect of the misalignments and conflicts is that due diligence along the securitization chain is weakened. This causes poorly-underwritten assets being securitized by the originators and the investors end up purchasing securities without a full understanding of the extent of risks they were taking on. Particularly, the originators weaken asset screening and monitoring practices. This was particularly apparent during the US private-label MBS market, where there were minimal quality control incentives, and many of the quality control reviews were not asked for by the arrangers. Even the results obtained from the reviews were ignored. Similarly, the great investor demand for products with high yield encourages issuers to move further down the credit spectrum. Furthermore, many originators already had a considerable operational capacity that they wanted to continue to use.
f) Operational Risks
Generally, these are not quantified in cash flow models. Issues such as the availability of a few cases and the instrument’s newness make it challenging to derive statistically important observations on the identified operational risks from previous respective transactions. Similarly, tracing the operational risks to the underlying risk factors will only bring forth risk statements that have minimal value; for the reasons of indirect risk quantification, the statements on the credit standing if involved parties are the most suitable available data. Nonetheless, the statements will handle credit risk and not operational risks. Therefore, the qualitative method should be utilized in the securitization risk management as it will aid in identifying the operational risks.
Dangers of Securitization
While securitization does have carefully analyzed benefits, its corresponding risks would require the same attention. There is still limited research on the impacts on transferring credit risk will have in regional and global financial stability. There is still little global development in the standardization of the securitization regulations. The gap has allowed the investment industry to run in an unregulated climate posing extensive risks to the originators and investors.
Conclusion
In the blame game that came after the U.S financial crisis, securitization was considered one of the main reasons. The reputation, among other issues, led to a significant decline in issuance since the crisis in the U.S and Europe. Nonetheless, the accurate picture is more nuanced even when securitization does present actual risks; it brings in benefits to those involved, including the originators, investors and the economy generally. There is still a need to have better risk management measures that will evaluate the environment’s actual circumstances to develop a simpler and more transparent mechanism involving the different stakeholders.

Bibliography
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