GLOBAL SECURITIZATION-ARE WE HEADED FOR ANOTHER FINANCIAL CRISIS? BY: MANSI GOEL,

Introduction

The Global Financial Crisis of 2008 was dubbed by many as the Credit Crisis. This financial crisis was the worst economic disaster since the Great Depression of 1929. It occurred despite the efforts of the Federal Reserve and U.S. Department of Treasury. The crisis led to the Great Recession, where housing prices dropped more than the price plunge during the Great Depression. Two years after the recession ended, unemployment was still above 9%. This crisis not only impacted the US economy, but the global economy at large. In retrospect the term was used incorrectly to describe a mortgage mispricing and real estate leverage crisis. But what we face today is rapidly becoming the real credit crisis of our times.

Understanding a Credit Crisis

A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy. A bank shortage of cash available for lending is just one in a series of cascading events that occur in a credit crisis. As the crisis deepens, it begins to interrupt the flow of short-term loans that keeps much of the business community running. Businesses depend on this process to keep operating as usual. When the flow dries up, it can have disastrous effects on the financial system as a whole.

What role did securitization play in the global financial crisis?

The global financial credit crisis of 2007-08 was a result of severe financial distress arising out of high level of sub-prime mortgage lending. Top Credit Rating Agencies downgraded majority securitization transactions, slashing ‘AAA’ ratings to ‘Junk’. Sub-prime borrowers could not repay, lenders were weary of lending further, investor’s investments in Mortgage Backed Securities were stagnant and not reaping any return.

Securitization, specifically the packaging of mortgage debt into bond-like financial instruments, was a key driver of the 2007-08 global financial crisis. Securitization fueled excessive risk-taking that brought many major financial institutions on Wall Street and around the world to their knees when the U.S. real estate bubble burst. Securitization of mortgage debt in bond-like investments such as mortgage-backed securities and collateralized debt obligations was a big cause of the financial crisis. Securitization of home mortgages fueled excessive risk-taking throughout the financial sector, from mortgage originators to Wall Street banks. When U.S. housing prices began to fall, mortgage delinquencies soared, leaving Wall Street banks with enormous losses on their mortgage-backed securities.

Global Securitization impact of COVID-19

The rapid spread and depth of Corona virus (COVID-19) outbreak has had severe impact across the globe in a matter of months. Stock markets are witnessing a global sell off. Countries have imposed complete lockdowns countrywide in order to mitigate the impact of this pandemic. Securitization volumes are likely to witness a drop in light of the pandemic. There is absolutely no doubt that the impact on the financial sector and on economies worldwide is / will be a negative one. Worldwide businesses are affected  due to global travel bans in major economies, affecting airlines, local transport, auto industry, hotels, etc. These industries are highly impacted by the spread of COVID-19. This has impacted cash flows, liquidity, and capacity to repay liabilities in the short term as well as severely impacting profitability.

In the lending space, lenders have put a halt on lending, since collections from borrowers have stopped. Further, borrowers’ capacity to repay has been affected by the outbreak, leading to a halt in repayments as well. Since companies and individual borrowers will have financial difficulties in a slowed down economy, there is an anticipated increase in defaults, delinquencies and NPA recovery rates as a result of the pandemic. What we face today is both more widespread and more worrisome: households and companies of all sizes, already highly indebted, are taking on massive levels of new debt just to survive.

Conclusion

Securitization allows companies to raise funds at a lower cost and without going beyond the permissible level of debts. But when securitization is done internationally, the jurisdiction and law applicable in the particular country should be given special consideration. The socio-economic and political factors of the country should also be kept in mind before securitization. This will help the companies to carry out the process of securitization uniformly. But, the International Monetary Fund (IMF) Managing Director had earlier announced that the global economy has entered a recession as bad as or worse than 2009. This outbreak has certainly caused unprecedented impact on global economies. Given the high level of uncertainty and negative outlook, there is high probability of a credit crisis in the world of structured finance which could replicate or be even worse than the global financial crisis of 2008. In case of securitization structures, the originators or servicers do not have a right to impose a moratorium. There has to be concurrence of investors and the trustee in the matter. Credit enhancements will have to be dipped in most transactions. Ultimately, in the present scenario the impact on securitization will depend upon the duration of the pandemic, which is very uncertain and unpredictable.