Real Estate Securitization Structure

Simplified structure

Basic Securitization Structure

Securitization is the process that links the economic performance of any asset with the financial and capital markets.

It is a technique for re-structuring the cash flow of assets for which there is limited liquidity or cash flows
generated by combinations of assets that, after the restructuring, creates investment products worthy of
investment in accordance with the demand of investors and participants in the capital markets.

Generally, there are 4 basic elements to securitization (debt side):

1) Assets generating the cash flow that are to be securitized (underlying asset mortgage)
2) Investors that invest in the cash flows generated by the underlying asset
3) An SPE that functions as the conduit linking the underlying asset and investors (often referred to as a special
purpose vehicle (SPV))
4) The securitization product which represents the rights the investor will purchase (mortgage of the underlying real
estate RMBS, CMBS)

In other words, a securitization is a structured finance with 3 ingredients:

a) Pooling credit sensitive assets
- Combined risk will be revalued and weighted differently
- Bringing together different risky assets
b) Transferring (de-linking) credit risk
 - Transfer the risk off your balance sheet to investors to take on your risk for a return through a SPV
- As SPV sells the bonds/tranches, these SPVs have a value (right to claim) to the tranches. Investors
are buying a claim to these tranches through the SPV.
c) Tranching liabilities (CMOs)
- Liabilities are stacked and there is a pecking order in terms of claims, losses, etc.

Securitization Process in Singapore

1. The originator transfers the ownership right of the securitised property off-the-balance-sheet to an SPV in return
for sale proceeds. (a way to raise capital for the company)

2. The SPV will then finance the purchase of the securitised property by issuing secondary market instruments in
the form of bonds and redeemable preference shares to investors.

3. 2 tranches of bonds (senior and junior) are issued by the SPV with different priority of claims on the securitised
real estate in the case of distress.
o The senior and junior bond investors will receive, through the SPV, a periodic fixed coupon payment
generated from the rental and other revenues from the property.
o In addition, the investors (bond holders) will also be entitled to a percentage share of any capital
appreciation of the property when the originator exercises the options to buy-back the property.

Benefits of Securitization (overall)

Securitization, or ABS in specific, creates a new way for property owners/developers/companies to directly access to
the source of funds from the investors/borrowers via a secondary market for real estate. RE securitization is where a
financial institution or other business that owns assets places those assets in a structure so that the risk and rewards of
owning the asset are transferred to a third party.

More specifically, this is done by placing cash generating assets in a bankruptcy remote vehicle (SPV) and implementing
control functions on the asset to maintain its creditworthiness. Investment products that possess greater liquidity
characteristics than the underlying assets, such as negotiable securities, are then issued backed by the securitized
assets and cash flows those assets generate.

It also bridges the gap between users of funds and suppliers of funds. By creating a secondary market product that
match investors risk preference, funding costs can be reduced for buyers and investors in real estate markets.

Securitization model helps to balance flow of funds between capital-deficient and capital-excess regions.
Deleveraging and liquidity are the dominant issues of risk in a volatile market.

In the ABS arrangement, the SPV takes over the roles of the traditional deposit-oriented financial intermediary,
like banks and finance companies, to facilitate the matching and the exchange of cash flows between investors and
property owners/developers/companies

From the investors perspective

ABS opens up an array of opportunity for them to directly own securitized interests on prime commercial
properties.
Securitisation being a structured finance instrument can be more closely aligned to investor needs. Investors
can invest in exactly what suits their investment policy the best.
Linking debt market to the national capital markets, it eliminates the regional pockets of monopoly power
that marked bank and thrift markets for decades.
o Today, home loan interest rates and terms are essentially national, varying relatively little from one
section of the country to another.
Safety Features: Securitization offers investors a diversification of risks, since the exposure is to a pool of
assets. Most issuances are highly rated by independent credit rating agency and have credit support built into
the transactions. Investors get the benefit of the payment structure closely monitored by an independent trustee
which may not always be in the case of traditional debt instruments.
Performance track record: Securitization instruments have demonstrated consistently good performance with
no downgrades or defaults on any instrument in India.
 Yields: Yields of ABS/MBS/CDO are higher than those of other debt instrument with comparable rating.
Spreads of securitized instrument are typically in the range of 50-100 basis points over comparable AAA
corporate bonds.

For property developers/owners/companies (originators)

Off-balance-sheet financing: Securitization offers an alternative and viable way of securing long term
productive capital at attractive terms. By transferring the property off the-balance-sheet, it injects liquidity back
to the company and indirectly reduces the gearing of a company with heavy borrowing liability.
Efficient Financing: This is also an effective way by which property developers/owners/companies can
diversify their financing risks. They are insulated against the floating interest rate risks by diverting from the
traditional source of funds in the financial market.
Lower capital requirement: Securitization enables banks and financial institutions to meet regulatory capital
adequacy norms by transferring assets and their associated risks off the balance sheet. The capital supports
the assets is released and the proceeds from securitization can be used for further growth and investment.
Efficient capital recycling: Another important motivation for property developers/owners/companies to
consider securitizing their real estate is the advantage where they can free up the capital locked-in in the
holding of low yield properties. They can reinvest the capital to improve the yields and efficiency of the capital.
Profit on sale: Securitization helps in up-front profits. This would otherwise accrue over the tenor of the loans.
Profits arise from the spread is booked as profit, leading to increased earnings in the year of securitization.
Liquidity management: Tenor mismatch due to long term assets funded by short term liabilities can be rectified
by securitization as long-term assets are converted into cash. Thus, securitization is a tool of asset liability
management.

For banks and financial intermediaries

Banks and financial intermediaries with a high concentration of real estate mortgages can mitigate their real
estate market risks through securitisation.
The securitisation process unbundles roles of financial intermediaries into a range of specialised activities,
including packing/pooling of assets, restructuring of cash flows into tradeable securities, credit rating, debt
servicing, underwriting, credit enhancement and grantor trust.
While the roles of banks and lending institutions as intermediaries of capital are diminished, specialised types
of fee-based services are created, which include credit rating and enhancement, and distributing asset back
securities to investors.
The new structure through divisional and specialisation of duties in the secondary market enhances
the efficiency and reduce transaction costs of financing over time.
For lenders
Lower cost of funds
o Securitization is attractive to borrowers because it gives them increased financing flexibility. Borrowers
can time the issuance of their securities to coincide with their financing needs. In addition, because
more investors are willing to purchase debt securities than participate in syndicated or term loans,
borrowers have more financing options available. This lowers the overall cost of financing, provided
that the issuer can sell the securities at an acceptable price.
Competitive rates and terms nationally and locally.
o Securitization tends to increase the number of specialised participants competing at various stages of
the lending and funding process and encourages new entrants and price and product competition.
Funds available consistently.
Increased buffet of credit forms through credit enhancement (internal and external)

Buy-back option (CMBS deals)

An American call option that is structured into the securitization deal, a feature that is unique to the Singapore market,
allows the owners to retain the upside potential of the price appreciation of the property. The contractually binding
buy-back options are explicitly incorporated in the securitization deal of all the major commercial buildings in
Singapore. It gives the originator the right to buy-back the property any time after 3 years of the origination of the
security at a price that is equal to the original price plus a fraction of between 25% to 35% of the capital appreciation.

o This feature further enhances the attractiveness of the securitization deal. These options are valuable,
especially when the market is volatile.

o Recognising and valuing the economic benefits of these strategic options are important, because there should
be no free lunch in a fair and equitable ABS/securitization transaction.

o In other words, the originator should compensate the SPV and bondholders for bearing the price volatility of the
securitized buildings.

o Premiums of the buy-back options should be adequately reflected in the prices of securitized real estate, to
maintain a risk-neutral position between the originator and the bondholder. Pricing the embedded buy-back
options is therefore of theoretical and practical significance.

The investors/bondholders will be entitled to a percentage share of any capital appreciation of the
property when the originator exercises the option to buy-back the property.

- If the option is not exercised at maturity, there is an American put option provided in the ABS contract that
requires the originator to buy back the building at the original sale price plus a premium, upon exercised by the
SPV at the end of the bond maturity.

- This option is built-in to protect the bondholders interest in a down market when the securitised real estate price
may drop below the original price. The put option embedded in the ABS gives the option holder the right to
hedge against the fall un underlying asset prices. In a liquidity strapped market, it also provides the SPV the
right to enforce specific performance.

- However, in a favourable market condition, the SPV and bondholders are worse-off if thy exercise the option
and sell the securitised property back to the originator at a below market price.

- Alternatively, the SPV can decide to keep the building and issue new bonds to fund the redemption of the
expiring tranches.

Lease-Back option
Under the ABS agreement, the originator is required to lease back the property wholly or partially for a period not longer
than the bond maturity. In return for the lease, the originator will guarantee and pay the SPV rentals and other income,
which will be equivalent to or exceed its interest obligations under the bonds.
Value of embedded options
The options embedded in the securitization agreement are valuable. The complex buy-back options incorporated in the
ABS contract work to the advantage of the originators, because the options allow them to claim the future capital
appreciation of the securitised commercial real estate. The originators are also assured of the first rights to repossess
the prime commercial buildings, which have been a stable long-term income source for them prior to securitization.

Therefore, if these embedded options are not fairly reflected at the initial asset injection stage, an adverse selection
problem exists, which will undermine the gross investment yield of the bondholders.

Concerns with these options

The exotic options embedded in the ABS deals might not be fairly reflected in the prices when the asset is transferred
off the originators balance sheet to the SPV.

The Joint Prepayment and Default Option Value (RMBS)

The value of mortgage debt to the lender is reduced by the option to prepay or to default because the borrower
may prepay or default, but not both, at any time. Furthermore, when default occurs, the borrower not only surrenders
the house but also terminates the prepayment option, which has value. Similarly, by prepaying, the borrower foregoes
the default option. Therefore, the default and prepayment options should not be valued independently.

A numerical example extends the model to include prepayment penalties. The mortgage value is lower to the lender
and greater to the borrower than the value of an equivalent option-free mortgage, even at origination. Using a
well-accepted set of parameters specications, the value of joint default and prepayment option is about 6.8% of the
unpaid outstanding balance at origination, assuming a down-payment of 20%. Lowering the down-payment percentage
further reduces the mortgage value to the borrower, implying higher default risk for lending banks.

Predictability of Cash Flows for MPTs

In the case of fixed interest rate mortgage pools, the impact of prepayment on cash flows passed through to investors
will vary according to the:
- Number of mortgages in the pool
- Distribution of interest rates in the pool
- Number of seasoned mortgages included in the pool
- Geographic location of borrowers
- Household (borrower) characteristics
- Unanticipated events (flood, earthquakes)
Although the above sources of risk are important to issuers and investors, information available on mortgage pools is
usually limited to very general borrower and mortgage characteristics.

Real Estate Securitization Products (Loans)

2) Mortgage Pass Through (MPTs)
- Represents an undivided ownership interest in a pool of mortgages all the investors get paid accordingly
without any subordination.
- It is a pool of mortgage loans, where monthly payments are collected by the intermediary from the issuers, after
deducting a servicing fee, passes it through to the holders of MPTs.
o Each mortgage in the pool is serviced by originator, but all payments are passed through to investors.
- Modified Pass Throughs: Makes payment of interest on the underlying pool of mortgages regardless of
whether this has been collected
- Fully Modified Pass Throughs: Makes payment of interest and principal on the underlying pool of mortgages
regardless of whether this has been collected.
- Risks associated:
o Default risk: Failure to pay on the debtors part results in lower returns. Should enough debtors default, the
securities can essentially lose all value
o Prepayment risk: Also, can affect returns. Should a large number of debtors pay more than minimum
payments, the amount of interest accrued on the debt is lower. Ultimately, these prepayments result in lower
returns for investors.
Prepayments are being modelled to predict short-term prepayment movements and anticipate
reactions to change in mortgage rates so that can better price these prepayment options for the
users of funds. (Higher Price, Lower Yield with shorter maturity)
 Improve predictions of cash flows under different market scenarios
- To provide a better margin of safety

- Why need to model prepayment in pricing the cash flows?

Because investors realise that there is also a strong likelihood that some prepayment will occur
while they own these securities, issuers usually take into account some assumed prepayment
pattern when pricing these securities.
This is necessary to provide a more accurate estimate of cash flows (hence, yield to investors),
rather than assuming that all borrowers will repay loans in accordance with a stated amortization
schedule.
- Components of prepayment model
Housing turnover (existing home sales)
- Family relocation due to changes in employment and family status (ie: change in family
size, divorce)
- Trade-up and trade-down activity attributable to changes in interest rates, income and
home prices.
Cash-out financing
- Means refinancing by a borrower in order to monetize the price appreciation of the property.
Rate/term refinancing
o Interest rate risk: If interest rates fall, there is a higher likelihood that current debts may be refinanced to
take advantage of the low interest rates. This results in smaller interest payments, which means lower
returns for pass-through securities investors.

3) Collateralized Mortgage Obligations (CMOs) RMBS and CMBS

- Multiple security class, mortgage pay-through security.
- Refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as
an investment.
- Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act
as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors
based on predetermined rules and agreements.
o To provide certainty in cash flows to provides more protection against prepayment risk than MPTs
and MPTBs, but less than that of an MBB.
- Waterfall payments set the motion on how the market responds to the specific risk-return profile of each tranche.
- CDOs and the GFC: The use of CMOs has been criticized as a precipitating factor in the 2007-2008 financial
crisis. Rising housing prices made mortgages look like fail-proof investments, enticing investors to
buy CMOs and other MBSs, but market and economic conditions led to a rise in foreclosures and payment
risks that financial models did not accurately predict.
- Unbundling, Specialization and Value Creation
o Basic concept behind CMO is the redistribution and reallocation of risk. (unbundling, partitioning of
mortgage credit risk creates different securities that better match the needs of specific investor group
clienteles and hence create value)
o The senior/subordinate structure, along with the stripping of excess mortgage interest, creates 3 unique
classes of securities that clearly differ in terms of default risk, and possibly maturity risk.
o FOR SECURITIZATION TO BE PROFITABLE, it must be that the value of the securities sold to investors
is greater than the par value of the mortgage pool (value creation)
o Tranching has stratified and concentrated the default risk and maturity in the pool, resulting in different
classes of securities that present investors with a wider variety of different levels and types of risk that is
available in the undifferentiated pool of underlying loans.
This will reduce prepayment risks (and coincidentally reinvestment risk)
Sum of parts is worth more than the whole. WHY?
- Because the greater variety of securities in the CMBS tranches may be more useful to
investors of different types than the undifferentiated whole loans. As noted, CMBS present
investors with a range of different maturities, default risks, and sensitivity to interest rate
changes.
- The ability of relatively passive or distant investors to place their capital into the more senior
tranches. For these investors, the need for local real estate expertise to help them understand
the amount of default risk has been replaced by bond ratings.
 - Increased liquidity for some tranches as compared to the underlying whole loans. (easier to
dispose since easier to match investors risk profile.)
- Efficiency gains cost reductions due to specialization by participants typically involved
and standardization of process in specific components of the securitization process.

4) Residential Mortgage-Backed Securities (RMBS)

- Investing in a residential-mortgage backed security can expose the investor to prepayment risk and credit risk.

5) Commercial Mortgage-Backed Securities (CMBS)

- Bonds backed by pools of commercial mortgages.
- Provide claims to components of cash flows of the underlying mortgages.
- Structured slightly different from RMBS (but underlying structure of subordination of CFs is similar to RMBS)
- Higher default risk as people value their own homes more than commercial buildings to not default on their
loans.

6) Mortgage Backed Bonds (MBBs)

- Issuers of MBBs bear prepayment risk by virtue of the overcollateralization requirement.
- As prepayment accelerate and mortgages are prepaid, more mortgages must be replaced in the pool.
- For MPTs, security holders bear prepayment risks because all prepayments are passed through to investors.
o This means that MBBs should be priced lower to provide lower yields than MPTs because the MBB issuer
bears prepayment risk and as market interest rates change, the price of MBB will not reflect accelerated
prepayment rates.

7) Mortgage Pay Through Bonds (MPBT)

- Hybrid of MBB and MPT
- Pass-through characteristics of CFs similar to MPTs
- Unlike MPTs, MBPT is a bond and not an undivided equity ownership interest in a mortgage.
- Act as a debt instrument (Issuer retains ownership rights of the mortgage pool)
- Because of the pass-through of amortization and prepayments, the market value of the collateral is not as
important as it is with MBBs.
o Hence, there is usually not a need to mark the collateral to market or to provide for replenishment of
collateral as long as the amount of overcollateralization is adequate.
o Overcollateralization as a credit enhancement is not as great as compared to MBBs.
o Cash flow patterns are similar to MBBs and MPTs.

Differentiation between the mortgage-related securities

With the exception of MPTs, which represents an undivided ownership equity interest in a pool of mortgages, all other
securities (MBBs, MPTBs, CMOs) are actually debt securities. An MPT should be viewed as a standalone investment
that is placed in trust after it is sold to investors in a securitized form.

The securities may be differentiated based on:

1) Who bears the prepayment risk;
2) The extent and type of overcollateralization or the use of credit enhancements

Issuers of MBBs bear all of this prepayment risk; hence the extent of overcollateralization or credit enhancements for
these securities must be the greatest.

Conversely, to the extent that the investor bears prepayment risk or to the extent that the pass-through of principal
flows directly to investors the need for overcollateralization or credit enhancements is reduced. This is true because
as prepayments accelerate on MPTBs and CMOs, maturities are reduced, whereas the maturity for MBBs remain
constant regardless of the prepayment rate on the underlying pool.

Therefore, in anticipation of the possibility of prepayment for MBBs with the same maturity, the issuer will have to provide
more collateral than with the other 2 debt securities. (MPTBs and CMOs). This means that in each case, the use of
overcollateralization and credit enhancements and the extent to which the investor bears prepayment risk must all be
taken into account when assessing the relative attractiveness of each type of security.
Securitization terms and concepts

1) Loan Workout (agreements) debt restructure

- A mutual agreement between a lender and borrower to renegotiate terms on a loan that is technically in default,
so as to avoid foreclosure or liquidation. The renegotiated terms will generally provide some measure of relief
to the borrower in terms of reducing the debt-servicing burden through accommodative measures provided by
the lender, such as extending the term of the loan, rescheduling repayments and so on.

- A workout agreement is only possible if it is in the interest of both the borrower and the lender to work things
out. While the benefits to the borrower of a workout agreement are obvious, the advantage to the lender is
that it avoids the expense and effort of recovery efforts such as foreclosure.

2) Overcollateralization
- The process of posting more collateral than is needed to obtain or secure financing. Overcollateralization is
often used as a method of credit enhancement by lowering the creditor's exposure to default risk.
- Often done in order to get a better debt rating from a credit rating agency.

3) Mark to Market
- Trustee must periodically mark the mortgage collateral to market to determine whether the overcollateralization
requirements of the bond issues are being maintained.

4) Excess Interest
- Collect more than they require to pay out the coupons to ensure coupons are paid.
- In whole life insurance, the return on the policy over and above the death benefit that the policy guarantees.
The amount of the excess interest (if any) depends on the performance of the portion of the premium that is put
in a cash value account and is invested.
5) Spread Accounts
- Spread between what you receive from your mortgage pool VS what you pay off
- Linked to excess interest

6) Tranching
- Separating and structuring debt securities such as MBS into different slices of debt, with each tranche having
different levels of subordination of principal and interest payments based on the different tranches.
7) Burnout rate
- A period of slowing mortgage prepayment within a mortgage backed security (MBS).
- This usually occurs after the mortgages start to mature. When some percentage of the underlying loans fail to
prepay after an interest rate cycle, this is known as burnout. Those borrowers who did not refinance during the
first interest rate cycle are less like to do so if interest rates drop again.

8) Principal-Only strip (PO strip)

- Is created by splitting a MBS into its interest and principal payments. The principal payments create a string of
cash flows which are sold at a discount to investors.
- Yield on PO strip depends on the prepayment speed of the underlying loan.
- The faster the principal is prepaid, the higher the yield
- Protected from contraction risk Investor will benefit from decrease in interest rate

9) Interest-Only strip (IO strip)

- Interest portions of mortgage, which is separated and sold individually from the principal portion of those same
payments.
- IO strips can be part of a larger CMO/CDO structure.
- The higher the interest rate, the higher the yield
- The slower the principal is prepaid, the higher the yield.
10) Defeasance
- A provision that voids a bond or loan when the borrower sets aside cash or bonds sufficient enough to service
the borrower's debt. The borrower sets aside cash to pay off the bonds; therefore, the outstanding debt and
cash offset each other on the balance sheet and do not need to be recorded.

- Unlike home mortgages, commercial loans may have significant prepayment penalties due to the obligations to
bondholders with a stake in the commercial mortgage-backed security (CMBS) that contains the loan.

- To avoid penalties, but functionally complete an early payoff, the commercial property buyer can build a portfolio
with an equal value to the remaining obligations. The most common security within these portfolios is high-
quality bonds with a yield that covers the interest rate associated with the loan. This allows bondholders to
continue receiving payments but the buyer to functionally pay the loan off early.

Impacts/Issues of RE Securitization on Real Estate Market

Asset securitization is certainly making its inroad to the secondary market in Singapore. Property developers with skills
and experience in property development should better utilize their capital and efforts in the development activities rather
than locking-in their productive capital on low-yield prime properties. In other words, more productive capital could be
re-injected into the real estate market via securitization of the prime commercial properties.

Investors are also open to more avenues in which they could diversify their investment portfolio into the property markets
without having to assume the risks associated with the management and leasing of the physical properties.

For an active securitization market, there are still many practical and institutional issues that are yet to be resolved.

1. The pricing of the ABS instruments and the premiums associated with the embedded buy-back and lease-
back options, the rating of the instruments, the tax implications on the off-the-balance-sheet transfer of the
property and the effectiveness of the pay-through structure for the SPV are some important questions that needs
future analysis to determine its value for the respective market players.

2. Another critical issue is related to the information asymmetric of investors, i.e. a scenario where the originator
has more knowledge of the properties selected for securitization than the investors. If the originators choose to
securitize only the less desirable assets, the investors may end up with lemon, a term that is used in economics
to describe a product that is inferior in quality given the price.

Types of risks involved in RE securitization

1) Prepayment risk
- Call risk (Bonds)
- Higher possibility of refinancing the mortgage loan due to cheaper market interest rates from borrowers
(than the contracted rate)
- Encompasses contraction and extension risk
2) Contraction risk
- A component of prepayment risk that increases as interest rates decline.
- Cash flow might be reinvested at a lower rate.
3) Default risk
- The risk that companies or individuals will be unable to the required payments on their debt obligations.
Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the
impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk.
A higher level of risk leads to a higher required return.
- Consist of 2 components of the default option: the right to stop making payments and the right to give up
property via foreclosure.
4) Liquidity risk (Bonds, MBS in general)
5) Balloon risk (CMBS) / Refinance risk
- Borrower must be aware of refinancing risks as there's a risk the loan may reset at a higher interest rate.
- Risk that borrower is unable to come out with the funds for the balloon payment at maturity
6) Extension risk (CMBS) opposite of prepayment risk (contraction risk)
- Risk that borrowers wont be able to refinance their properties when the loan matures.
- Risk of a securitys expected maturity lengthening in duration due to the deceleration of prepayments
(mainly due to higher interest rates likelihood of prepayment decrease as people will less likely to
refinance the loans)
7) Interest rate risk (Bonds)
- Higher interest rate, Higher yield (discount rate), lower bond price
8) Reinvestment risk (Bonds)
- The risk that future coupons from a bond will not be reinvested at the prevailing interest rate from when
the bond was initially purchased
- The higher the interest rates and the longer the maturity, the higher the reinvestment risk
- Zero coupon bonds no reinvestment risk
- Am I having a better rate of return when I buy back the bonds?
9) Credit risk (Bonds, MBS in general) result of subprime crisis
- Ability for the bondholder to pay back
10) Volatility risk (Bonds)
- Fluctuation in bond prices

Basic Requirements for Real Estate Securitization

1. Bankruptcy Remoteness

Bankruptcy remoteness in real estate securitization is a term that represents the measures that are taken to prevent
the underlying asset from being impacted by the bankruptcy of the originator and will prevent the securitization
vehicle itself from being impacted by any bankruptcy proceedings.

The originator transfers the underlying real estate asset into an SPE in the first stage of the securitization process.

However, if the originator were to go bankrupt after transferring the asset to the SPE and the bankruptcy
administrator or creditors were to reject the validity of the transfer of said securitized asset or call for its cancellation,
a very unstable situation would arise where investors would not receive the earnings they expected and the
redemption of the principal would be impossible. Therefore, it is important to establish each SPV as bankruptcy
remote from the originator so that investors do not suffer needless loss.

True Sale: The genesis of securitization lies in giving the investors rights over specific assets of the
originator, such that the investors are not affected by the performance, or bankruptcy of the originator.
o This means that it is necessary for the SPV (a conduit on behalf of investors) to have legally
acquired the assets.
o Why is a true sale required?
 To allow investors an unqualified right over the assets being securitised. True sale forms
the very line distinction between securitization and collateralised lending.
o The true sale question is also the foundation of off-balance sheet accounting treatment, regulatory
relief, etc.

Even if the asset that is securitized is remote from any bankruptcy proceedings of the originator there is still the risk
that the securitization vehicle goes bankrupt and a default occurs. Consequently, it is essential to have some
bankruptcy prevention measure in place for the vehicle.

2. Credit Enhancement for controlling risk

Real estate securitization also confers(bear) the risk of owning the assets from the originator to the investors. In
exchange for bearing the risks the investors receive the profits generated by the real estate, therefore the asset
owner must control the risks and reflect these controls in the product design after considering the risk-return
characteristics the investors expect. Where there are uncertain risks in the future for securitized assets, it is
necessary to structure the investment so that the investors are not hit with catastrophic losses if such an event
occurs.

When structuring a real estate securitization product, it is common to include a form of credit enhancement to
increase the credit worthiness of the security and to better meet the demands of investors.

Internal credit enhancement features that use the cash flow of the securitized asset include creating a split capital
structure (tranches) that will include preferred and subordinated securities that will have different rights to the assets
cash flow.

It may also include a seller reserve whereby the seller will leave a cash reserve from the sales proceeds in the
securitization vehicle. (Residual Tranche owned by the issuer)

- Purpose of owning a residual tranche held by issuer/owner

o To help issuers manage the prepayment risk on the other tranches.
o This is to compensate for the reinvestment risk (in addition to the servicing fees)

External credit enhancement measures include cash collateral and guarantees provided by third parties. (FHA
Mortgage Insurance, VA Insurance, GNMA, FNMA, FLHMC)

A. Preferred/Subordinated Structures - Internal Credit Enhancement

This structure divides capital structure so that the securities that are issued have different rights to the assets cash
flows, the preferred securities will have first priority on the cash flows and assets of the assets in the securitization
vehicle and only once the obligations to the preferred securities have been fulfilled will the subordinated securities
receive any payments from the vehicle.

Thus, when cash flow fails to meet projections the first investment loss will be taken by the investors who own the
subordinated securities, which provides greater certainty of the performance of the preferred security investors.

The existence of a subordinated tranche of securities in any capital structure enhances the creditworthiness of the
preferred securities. (senior tranches)

B. Cash Collateral (from Residual Tranche) Internal Credit Enhancement

Cash collateral is used in a similar manner to the sellers reserve in case the asset cash flow is insufficient for
operations. There are different approaches but most commonly either the originator provides the collateral or the
collateral is withheld from funds generated by financing from financial institutions.

C. Guarantees from Third Parties (Government Agencies) External Credit Enhancement

This refers to guarantees from a third party, and may take the form of an insurance policy, that non-life insurance
companies and banks may provide. This field of guarantees and insurance has not developed in Japan as far as it
has in the U.S. and the UK but has recently become a new field of operation for many participants with the expansion
of the securitization market.

3. Providing Liquidity
Investors in real estate securitizations do not necessarily want to own or use the real estate themselves and usually
do not intend to become the main management body of the property. Their emphasis is on the potential of the
investment product to generate returns and see that potential converted into money through the receipt of cash
flows from the underlying real estate.
The key point is how to provide liquidity for real estate securitization products so that it is easier to participate as an
investor. Liquidity is established for the investment product from the product design stage and at the market level
by preparing a market for the investment products and a system for distributing products to it.

4. Information Disclosure for Investors

In any securitization, the funds invested by investors are the foundation for the deal and sufficient information is
necessary for investors to make an informed decision. Therefore, for the real estate securitization market to grow
there must be a robust system that ensures sufficient information is provided to the investor to make an informed
investment judgment, as well as provides protection to the investor against unjust losses.

There are already regulations provided for in various laws that protect investors in real estate securitization products.
However, it is important that not only legal requirements are met but also that information disclosure be consistently
maintained so that investors can continually make informed decisions and take responsibility for their investments.

The rating requirement and monitoring mechanism of bond markets in Singapore improve information efficiency in
the secondary real estate market.

Real Estate Securitization Market Participants

One characteristic of real estate securitization is that it fuses the real estate business and finance but makes a
clear distinction between the various functions and has created a further division of functions.

In response to this trend for clear distinction between the functions there is a need for increasingly greater
specialization or unbundling of the various services that is driven principally by the diversity of laws and ordinances
that are relevant to each transaction and the differing structures utilized in each securitization project. Thus, the
greater division of roles now compared to earlier real estate transactions has led to an increasing number of
participants in each transaction.

A. Originator
The term Originator commonly refers to the original owner of the real estate that is being securitized. The first step
is that the real estate that is to be securitized is transferred from the originator to the securitization vehicle. An
originator can be anyone who owns real estate and typically includes developers, ordinary companies and financial
institutions.

B. Investors
In exchange for receiving the investment returns from the securitized real estate, the investor accepts the economic
risks of owning the real estate. Investors can be subdivided into debt investors and equity investors and each
investor group has specific risk-return characteristics they aim for when investing in real estate securitization
products.

C. Lender
Lenders fall under the category of debt investor and are primarily financial institutions that provide non-recourse
loans to securitization vehicles. Individual institutions may provide loans or many financial institutions may together
provide the loan through a syndicated loan. Non-recourse loans can be subdivided into various tranches that have
varying rights about receiving principal and interest, which are called senior and subordinated tranches.

D. Arranger Investment Banks

The arranger assumes overall responsibility for the overall structure of the real estate securitization and provides
the knowledge and administrative functions needed to create the securitization framework and implement the
securitization, which includes liaison between the originator, investors, lenders and other related parties.

The arranger must be able to accurately understand the needs of each party of the transaction as well as have the
skill to coordinate the logistics of the securitization and specialist knowledge to negotiate effectively with lawyers,
tax attorneys and accountants when necessary.

The arranger is responsible for supporting and coordinating with third party consultants and contractors for preparing
due diligence reports, engineering reports etc. and advises in the selection of various professional service providers
including accountants, lawyers, real estate appraisers, trust banks and securities firms.
After the asset is in the securitization vehicle the arranger may select the underwriter for the sale of public securities,
if applicable, as well as the financing counterpart who will provide the non-recourse loan and finally provide advice
when considering disposing of the real estate. Generally, arrangers are securities firms, city banks, trust banks,
other financial institutions, real estate companies and consultants.

E. Underwriter - Banks
Underwriters are most commonly securities firms. They underwrite the securities derived from real estate
securitization, handle the public issuance of securities in the capital markets and conduct investor surveys to
determine how receptive investors will be to various products.

Their primary responsibility to the investors is to ensure that the investors understand the concerned securitization
products. There are cases where securities firms have acted both as arranger and underwriter.

F. Trust Banks
One of the most common real estate securitization structures in Japan involves the originator entrusting the real
estate to a trust bank and then transferring the beneficiary interest in trust to the securitization vehicle.

Establishing the beneficiary interest in trust enables the trust bank to apply its knowledge of the management,
operation and sale of real estate assets to improving the performance of the securitization as well as reducing the
real estate acquisition tax that is payable on the transfer of the asset.

The trust bank is a specialized institution that can handle a variety of functions for a real estate securitization; a trust
bank can act as the arranger, lender, bond manager and asset custodian when the securitization vehicle issues
corporate bonds, and it can handle administrative duties.

G. Rating Agencies
Ratings are a simple method of assessing the creditworthiness of the debt instruments issued by a securitization
vehicle (corporate bonds, commercial paper, borrowings, etc.). An independent third party assesses the ability of
the securitization structure to meet its principal and interest obligations, which are then made available to investors
by the ratings agencies. Obtaining a rating from a ratings agency increases the transparency of the securitization
structure and improves the marketability of the securities that are issued, thus the fund raising becomes easier.

H. Asset Manager
The asset manager specializes in the management and operation of the securitized real estate. The asset manager
is responsible for developing the financial strategy of the asset and providing advice on its purchase and sale at the
end of the securitization period.

The asset manager is also responsible for providing direction to the property manager regarding attracting tenants
and general property management policy, as well as supervising the property managers performance managing
and operating the property.

The asset manager is ultimately responsible for the performance of the asset and has a fiduciary duty to maximize
the value of the asset. In situations where investors invest in an asset management securitization, the asset
manager is responsible for investing the funds invested by investors in real estate related assets and in such a case
the asset manager may be referred to as the fund manager.

I. Property Manager
The property manager is responsible for the day-to-day management of the real estate asset and is focused on
maximizing the earnings of the real estate asset. The property manager is usually a third-party contractor chosen
by the asset manager and contracted with the real estate owner or asset manager. The property managers duties
include tenant management (tenant attraction and leasing management) and building management work
(maintenance).

The property manager also provides detailed reports on its work to the client. There are cases where the asset
manager also acts as the property manager or building and facility management firms that manage other buildings
locally provide these services under contract.
 J. Servicer
The source of the cash flow generated by real estate is the rent paid by the tenants and the servicer is responsible
for the collection and accounting of these monies.

Benefits of CMBS (in Singapore)

For users of funds:
The CMBS market offers an alternative avenue for REITs to tap on capital outside of Singapore, especially the
European money markets that have strong demand for these senior rated RE-backed instruments.

REITs can secure a stable long-term source of funding via CMBS and hedge against interest rate fluctuations by
matching their asset cash flows with coupon obligations of CMBS bonds. The funding option is attractive when the
spread between long-term senior bond yield and the risk-less instrument is small. Economies of scale can also be
created via mortgage pooling, which further reduces the funding costs.

For institutional investors:

CMBS broaden the investment options in real estate assets with fixed income characteristics.

RMBS in Singapore
The US-version of RMBS does not exist in Singapore because banks are not prepared to dispose their home
mortgages off their books, as the banks have excess liquidity and existing good business relationships established.

On Bond Prices
Why bond prices and yields move in opposite direction?

Bond Yield (Discount rate) = Coupon/Bond Price

The bonds are traded in the open market, where prices and yields are always changing.
- As a result, yield converges to the point where investors are being paid approximately the same yield for the
same level of risk Priced to perfection, no arbitrage opportunities
o Based on demand and supply mechanism

- This means that where there is a bond with a more attractive yield (higher yield), the bond price will decrease
accordingly to match up with the higher yield, since coupon payments are fixed based on the coupon rate of
the bonds par value.
o Investors will always choose the option with the highest rate of return (highest yield)

- Also, the bond yield is the discount rate used to discount the cash flows of the bond.
- With a lower discount rate used, this will drive the bond prices up with a higher present value.

The discount rate (bond yield) is also directly correlated with the market interest rate.

- Higher interest rate, higher yield (for new issue of bonds), lower bond price.

Bond Issuer/ Borrower Perspective

- As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for
lower yield bonds will drop, causing their prices to drop.
- As interest rates fall, it becomes easier to borrow money, and many companies will issue new bonds to
finance its expansion. This will cause the demand for higher yielding bonds to increase, forcing bond prices
higher.

Price-Volatility Characteristics of Option-Free Bonds

Although the prices of all option-free bonds move in the opposite direction from the change in yield
required, the percentage price change is not the same for all bonds.
For a very small change in the yield required, the percentage price change is roughly the same, whether
the yield required increase or decrease.
For large changes in the required yield, the percentage price change is not the same for an increase in
the required yield as it is for a decrease in the required yield.
For a given large change in basis points, the percentage price increase is greater than the percentage
price decrease.
An explanation for these 4 properties of bond price volatility lies in the convex shape of the price-yield relationship.

Effects of Yield to Maturity

The higher the yield to maturity at which a bond trades, the lower the price volatility.
The higher the initial yield, the lower the price volatility.
For a given change in yields, price volatility is greater when yield levels in the market are low, and price
volatility is lower when yield levels are high.

Characteristics of a bond that affect its price volatility

1) Coupon: For a given term to maturity and initial yield, the lower the coupon rate, the greater the price volatility.
2) Term to maturity: For a given coupon rate and initial yield, the longer the term to maturity, the greater the price
volatility.
Measures of bond price volatility:
1) Price value of a basis point (PVBP)
- The change in the price of the bond if the required yield changes by 1 basis point
- Indicates the dollar price volatility as opposed to percentage price volatility (price change as a percent of the
initial price)
- Typically, the PVBP is expressed as the absolute value of the change in price.
- Price volatility is the same for n increase or decrease of 1bp in required yield.
2) Yield Value of a price change
3) Duration
Using Duration and Convexity to measure bond risk:
Duration is key in fixed-income portfolio management for the following 3 reasons:

1. It is a simple summary statistic of the effective average maturity of a portfolio.

2. It is an essential tool in immunizing portfolios from interest rate risks.
- Immunizing: A strategy that matches the durations of assets and liabilities, thereby minimizing the
impact of interest rates on the net worth.
3. Duration is an estimate of the interest rate sensitivity of a portfolio (of bonds)
Equation 4.8 states that the modified duration is related to the approximate percentage change in price for a given
change in yield. Because for all option-free bonds modified duration is positive, Equation 4.8 states that there is an
inverse relationship between the modified duration and the approximate percentage change in price for a given yield
change. This is to be expected from the fundamental principle that bond prices move in the opposite direction of the
change in interest rates.
Properties of Duration
The modified duration and Macaulay duration of a coupon bond are less than the maturity.
o Macaulay duration of a zero-coupon bond is equal to its maturity.
o Modified duration of zero coupon bond is less than its maturity.
o The lower the coupon, generally the greater the modified and Macaulay duration of the bond.
Consistent with the properties of bond price volatility and the properties of modified duration.
o When all factors are constant, the longer the maturity, the greater the price volatility.
Value of Convexity

For a bond with greater convexity (Bond B), when market yield rises or falls, it will have a higher bond price. That is, if
the required yield rises, the capital loss on Bond B will be less than that of Bond A. A fall in the required yield will
generate greater price appreciation for B than for A.

Generally, the market will take the greater convexity of B compared with A into account in pricing the two bonds. That
is, the market will price convexity. Generally, the market will require investors to pay up (accept a lower yield) for the
greater convexity offered by Bond B.

If investors expect the market yield to change very little (low interest rate volatility), the advantage of owning Bond B
over Bond A is insignificant because both bonds will offer approximately the same price for small changes in yield. In
this case, investors should not be willing to pay much for convexity.

In contrast, if investors expect substantial interest-rate volatility, Bond B would probably sell at a much lower yield than
A.

Properties of Convexity
1) As the required yield increases, the convexity of a bond decreases. (Positive convexity)
2) For a given yield and maturity, the lower the coupon, the greater the convexity of a bond.
3) For a given yield and modified duration, the lower the coupon, the smaller the convexity.

Duration for Gap Management (Duration Gap Analysis)

(Difference in liabilities (gap) to be accounted with higher/lower interest rates.

Many banks have a natural mismatch between assets and liability maturities. Bank liabilities are primarily the deposits
owned to customers, most of which are very short-term in nature and of low duration. Bank assets by contrast are
composed largely of outstanding commercial and consumer loans or mortgages. These assets are of longer duration
and their values are more sensitive to interest rate fluctuations.

A maturity gap occurs when an investors assets have greater weighted average duration than his liabilities. The
maturity gap problem is exacerbated in lending institutions using leverage.
- Duration of assets and liabilities of 1 and 10 year respectively gives a maturity gap of 9 years.
- This means that when interest rates (and hence yield) goes up, the assets cannot be matched to pay off
the matured liabilities.
The combination of a maturity gap and leverage can greatly magnify interest rate risks.

Solution to maturity gap:

1) To make more short term and fewer long term loans.
2) Banks to issue floating rate or adjustable rate loans.
 - Such loans values are not sensitive to changes in the market interest rates, because their contractual
cash flows rise and fall with these rates. The interest rate sensitivity of a long-term adjustable rate loan
may be no greater than that of a short-term fixed rate loan.
3) Sell long-term loan assets into the secondary market rather than holding it into the asset portfolio

Convexity:
Because all duration measures are only approximation for small changes in yield, they do not capture the full effect of
the convexity of a bond on its price performance when yields change by more than a small amount.

Duration only calculates the linear relationship between price and yield changes in bonds. In reality, the relationship
between the changes in price and yield is convex.

In general, the higher the coupon rate, the lower the convexity.

* The graph of price-yield relationship for bonds shows positive convexity. (positive correlation)

- Yield decrease, price-yield curve increase (higher duration as seen from the gradient)
- Coupon rate decrease, convexity increase (higher duration with more curvature)
o As more weight is being put on the par value of the bond upon maturity.
Debating on Real estate securitization

Has the securitization of mortgages been a great boon or a terrible curse? Assets backed by American mortgages
enable global risk-sharing, but securitization may also have weakened lenders incentives to screen out bad borrowers
and to renegotiate bad loans. And should the government continue to subsidize securitization through entities such as
Fannie Mae and Freddie Mac?

Public agencies like Fannie Mae and Freddie Mac insured those mortgages against default, which helped make
mortgage-backed securities far more palatable to investors. Until 2006, securitization seemed to be a great leap forward,
enabling borrowers to get cheaper loans and making banks less vulnerable to the vicissitudes of interest rates and
housing prices.

(-)

Since the crash, a counter-narrative has emerged that emphasizes the dark side of securitization. If mortgage issuers
passed along the default risk to Freddie Mac and Fannie Mae or to the buyers of mortgage-backed securities, those
issuers would have little incentive to screen borrowers properly. While issuers often do have some skin in the game, the
enormous amount of both securitization and sloppy lending during the boom made it natural to link the two phenomena.

The anti-securitization view also argues that securitization makes it more difficult to renegotiate loans that have gone
into default. Loans that become seriously delinquent are more likely to lead to a foreclosure if they are securitized.
Renegotiation is often just not in the interest of the lender.

(+)

When the smoke clears, my bet is that the consensus will be that securitization did a bit to encourage lax lending and
to discourage renegotiation, but that securitization was hardly the only or even the prime villain in the great housing
convulsion. Lots of lenders, borrowers and home buyers did, or would have done, foolish things without the aid of
securitization.

If we end up in that middle-of-the-road consensus, then securitization looks pretty good, because it did much to mitigate
the costs of the crisis. Plenty of lenders would have gotten caught up in the exuberance of the boom even if they were
holding onto the loans as the savings and loans did 20 years ago. When the bubble burst, without securitization the
banks would have been in far worse shape, because they would have been holding all the risk themselves. Securitization
meant that the downturn in the American housing market was felt from Stockholm to Shanghai, which sounds bad except
that it would have been a lot worse for us, and for our banking system, if the entire seismic shock had struck only banks
in the United States.

That relatively positive view of securitization does not imply that the government should subsidize securitization, as it
implicitly did through Fannie Mae and Freddie Mac. I didnt like the Fannie and Freddie model before the bust, and I
dont like it any more today. If these agencies are to continue, they need to be far more conservative, charging high fees
and taking few risks, and they need to be purely public agencies. Securitization has a role to play, but that role doesnt
merit vast public support.

Real estate securitization model helps to balance flow of funds between capital-deficient and capital-excess regions so
as to make the real estate capital market more efficient.

Liquidity and Deleveraging are the main issues of risk in a volatile market.
Deleveraging when a company or individual attempts to decrease its total financial leverage.
o Most direct way for an entity to deleverage is to immediately pay off any existing debt on its balance
sheet. (prepayment risk)
Securitization 2.0

For generations, the strength of the U.S. housing market was due in part to securitization of mortgages with guarantees
from the government-sponsored companies, Fannie Mae and Freddie Mac . Following the savings-and-loan debacle of
the late 1980s, securitization--which has been defined as "pooling and repackaging of cash-flow-producing financial
assets into securities that are then sold to investors"--helped bring capital back to battered real estate markets.

Today, securitization of subprime real estate loans is blamed for the global liquidity crisis, but Wharton faculty
say securitization itself is not at fault. Poor underwriting and other weaknesses in the market for mortgage-
backed securities led to the current problems. Securitization, they say, will remain an important part of the way real
estate is funded, although it is likely to undergo significant change.

"Securitization, in the long run, is a good thing," says Wharton finance professor Franklin Allen. "We didn't have much
experience with falling real estate prices in recent years. The mechanisms weren't designed for that." He explains that
economists were concerned about the incentives and accounting that shaped the private mortgage securitization market
in recent years, but as long as real estate prices kept rising, the weaknesses in the system did not become clear. Now,
after credit markets seized up and prices have declined sharply, those problems have been exposed.

Allen believes financial markets will get back into the business of securitizing mortgage debt, but only after making some
major changes. One new feature of future securitization deals, he says, could be a requirement that loan originators
hold at least part of the loans they write on their books. Before the current crisis, loans were bundled into complex
tranches that were passed through the financial system and on to buyers with little ability to assess the real value of the
individual assets.

"The way the collateralized debt obligations [CDOs] and other vehicles are structured will change. They are too
complicated," says Allen. "I'm sure the industry will figure out how to do it. There will be a lot of industry-generated
reform and the industry will prosper. This is not, in my view, something that should be regulated."

Privatizing Securitization

According to Wharton finance professor Richard J. Herring, for decades, mortgage securitization was backed by
government guarantees through Fannie Mae and Freddie Mac , and it worked well. Of course, these agencies were
regulated and bound by less-risky underwriting standards than those that ultimately prevailed in the subprime market
(which was also potentially more profitable). Indeed, default rates were so low in the mortgage-backed securities market
that banks and other private financial institutions were eager to take a piece of the residential business.

At first, the transition to private securitization worked, because investors were willing to rely on three substitutes for the
government guarantees; these included ratings agencies, new business models and insurance designed to guarantee
specialized mortgage-backed bonds. Positive experience with private securitization led to an alphabet soup of
innovations that sliced and diced the cash flows from pools of mortgages in increasingly complex ways.

Now the subprime crisis has undermined confidence in all three pillars of private securitization. Ratings proved unreliable
as even highly rated tranches experienced sudden, multiple-notch downgrades that were unknown in corporate bonds.
Models developed by the most sophisticated firms selling mortgage-backed securities, including Bear Stearns , Merrill
Lynch , Citigroup and UBS , failed. Monoline insurers, it turned out, were inadequately capitalized.

"There has been a highly rational flight to simplicity," says Herring. Over time, he believes, the real estate
securitization market will re-emerge, as investors regain confidence in the ratings agencies, new models evolve and
monoline insurers are able to increase their capital. "But I think that it will be a long time before the market will be willing
to accept the complex, opaque structures that failed," continues Herring. He adds that recovery will be delayed until
investors are confident house prices have bottomed out.

Wharton real estate professor Susan M. Wachter points out that many recent and historic international financial
problems originated in real estate. The nature of real estate finance and incentive structures is more to blame than
securitization this time around.

"The most recent crisis is coming through the securitization market, but this isn't the only real estate crisis," Wachter
notes, adding that the fundamental problem in real estate finance is that there is no way to bet against the industry. Real
estate is essentially priced by optimists--and rising prices themselves justify even higher values as assets are marked
to market, creating new incentives for investors to overpay.
Wachter points to real estate investment trusts, publicly traded bundles of real estate assets, as an example of how
securitization can help provide liquidity, but also a chance for short-sellers to correct against overly optimistic pricing.
Research indicates that REIT prices may not have increased as much as other sectors of real estate finance because
the industry has at least 200 analysts looking at the underlying assets in each REIT with the ability to point out faulty
pricing to investors. "REITs have performed fluidly relative to the overall market, and that is a good thing," says Wachter.

Fee-Driven Lending

Another problem was that much of the subprime lending was fee-driven, giving banks incentive to write loans
to earn the fees that would allow them to pass the risky assets along to securitized bondholders. And even bank
shareholders had no way to limit their real estate exposure, because banks invest in various kinds of economic activity,
not just in real estate.

Biased pricing and bubbles also arise because the supply of real estate is not elastic. By the time the market recognizes
supply has outstripped demand, construction has already begun on many more projects that will continue to be built
out. This tends to exacerbate oversupply and create downward pressure on prices for years.

With the forbearance of regulatory authorities and the intervention of governments, banks may be bailed out, mitigating
the consequences for shareholders. Nonetheless, the fundamental factor which explains why episodes of bank under-
pricing of risk are likely to occur is the inability of banking shareholders to identify these episodes promptly and
incentivize correct pricing.

Secured bondholders have been badly burned. They discovered to their dismay that all kinds of problems are connected
to mortgage-backed securities, which they hadn't anticipated. The failure of ratings agencies are already being
revamped. The methodologies used to determine ratings were flawed. They used historic performance over a period
that simply wasn't representative."

"CDOs are Doomed"

In the future, ratings agencies will need to operate on the assumption that a triple-A-rated security should be able to
withstand a shock as great as the current crisis.

That will mean that under the best of circumstances, it will be harder to get a triple-A rating, which will reduce the
profitability of securities. Some forms of securities will die. CDOs are doomed, he says--because the market has seen
they are extremely difficult to value. In the short term, the prospects are dismal. The market will recover, but I don't think
we'll ever see CDOs again, and the standards will be tougher, so the comeback will be gradual.

The Democratic presidential candidates have focused on using the Federal Housing Administration (FHA) to refinance
loans in default. The idea is similar to what happened during the Great Depression of the 1930s with another agency,
called the Home Owners' Loan Corp., which was created specifically for that purpose.

The problem is that the FHA is not designed as a bailout agency. The FHA's core mission is predicated on it being a
solvent operation, actuarially sound, charging an insurance premium large enough only to cover losses. How they would
reconcile that is not clear.

Guttentag says attempts may be made to create a separate bailout agency within the FHA with different accountability.
"But the devil is in the details," he warns, "and the details have to do with exactly who is going to be helped, what the
requirements are, what the nature of the assistance is going to be and myriad other factors that have to be worked out."

The Bush administration has taken some steps to ease the crisis, including encouraging lenders to modify contracts to
avoid foreclosure. A strong case can be made for these measures, Guttentag says. "The cost of foreclosure is often
greater than the cost of modifying the contract and keeping the borrower in the house." One downside is that once some
loans are modified for those truly on the brink of foreclosure, other borrowers who would be able to avoid foreclosure
may demand the same modifications, short-changing investors.

In testimony before the U.S. House of Representatives' Committee on Oversight and Government Reform, Wachter laid
out a proposal developed with the Center for American Progress to resolve the current crisis. Under the so-called SAFE
loan plan, the U.S. treasury and the Federal Reserve would run auctions in which FHA originators as well as Fannie
Mae and Freddie Mac and their servicers, would purchase mortgages from current investors at a discount determined
at the auction.

Investors would take a reduction in asset value and yield in exchange for liquidity and certainty, and the auction process
would price pools and bring transparency back to the market. The FHA, Fannie Mae and Freddie Mac could then arrange
for restructuring of loans.

Meanwhile, Allen notes the Federal Reserve has taken some dramatic steps with interest-rate policy to resolve the
current economic crisis, but that could lead to tension with Europe and Japan over currency valuations. As the dollar
continues to fall, U.S. companies are increasingly more competitive overseas. "The Fed cut the rate at the beginning,
and that was fine, but now things are getting way out of line," he says.

Furthermore, it is not clear that cutting rates is going to solve the basic problem. As rates continues to drop, foreigners
may begin withdrawing their money from dollar-denominated investments, driving rates up.

"What the Fed is doing is unprecedented," says Allen. "It is laudable that it is trying to stop a recession, but how many
risks should you take to do that? We're now moving into an area where the Fed is probably taking too many risks. If
inflation picks up and long-term rates go up, we'll be in a situation where we have to raise short-term rates as we go into
recession, which is not a happy thing."
Liquidity Issue in Securitization and what should be done?

What should be done?

Most (though not all) financial crises in recent decades have been caused by losses related to property lending. Lending
to the real estate sector enables rapid loan expansion with the appearance of tangible collateral. Real-estate lending is
not just riskier than previously believed (due to its significant systemic component). It is also the prime cause of the
maturity mismatch and excessive leverage that has made the banking system so fragile. We believe that to reverse this
transformation of banks, it is necessary to consider novel channels of long term funding, to move related long-term
assets away from bank funding, and to re-establish a separate category of specialist property financial intermediaries.

Land is scarce and its availability is fixed. In other words, real estate value has a large pure rent component. Thus, in
any expansion, real estate prices generally rise faster than consumer prices, and become prone to bubbles and busts.
To avoid socialising risk taking, what is needed is an intermediation process where the financing comes from investors
that assume the bulk of such risk.

We call for solutions that ensure such risk bearing by focusing on two principles: much greater maturity matching and
no insured deposit funding. These goals may be achieved by various means. One avenue is to securitise mortgages
with little maturity transformation, such as those funded by bond or pension funds. Another is to create new
intermediaries providing mortgage loans where the lender shares in the appreciation, while assuming some risk against
the occasional bust. This may be seen as a shift towards the principles of Islamic banking, but it is also a return to
tradition as in the early days of banking.

The shared responsibility mortgage (SRM) of Mian and Sufi (2014, Chapter 12) goes in the right direction, but would
need regulatory underpinning. First, during a long upswing in prices, borrowers may become unwilling to share in the
appreciation with a lender. Thus, we need some regulatory requirement that all mortgage related lending have a loan to
value ratio of less than 70%, while more funding may be raised by property lenders via equity participation of up to 25%.
This would still enable the minimum first time deposit to be as low as 5% of the value of the property. Property should
be revalued at regular intervals, with the house owner having the right to buy back (some of) the equity shares of the
lender at the new valuation, until the equity participation of the lender was exhausted.

An objection to the SRM is that such loans would vanish during a property price collapse. This would probably require
public intervention, as in the case of the UK governments Help to Buy scheme. This could ensure access to finance
during a crisis, while shifting state aid from Wall Street to Main Street.

Additionally, mortgages could be provided by property finance companies (PFCs), designed to differ from banks. PFCs
would not offer demand deposits, nor payment services. A PFC would have to back all its equity participation in SRMs
with equity of its own or other allowable Loss Absorbing (bail-enable) Capital. A PFC could borrow only modestly in the
interbank market, or other wholesale source of funds, and should hold a minimum ratio of liquid assets, supported by
increasing fines as its reserves declined. A PFC would be allowed to deal in derivatives, but only so far as it could be
shown to hedge its various risks. Besides its equity participation, PFCs could offer all varieties of mortgage (though
foreign currency mortgages should be banned, except for foreign residents). Property companies could raise remaining
funds by the issue of term deposits, with a tenor of 90 days or more, and from bonds, preferably issued along the Danish
model, designed to reduce maturity mismatch while controlling adverse section (for an account, see Berg and Bentzen
2014). Securitisation of these mortgages should be encouraged as admissible investment for specialised bond funds or
pension funds, eliminating mismatch of the last securitisation wave. Neither banks nor property finance companies
would be allowed to hold such collateralised mortgage obligations (CMOs).

Banks should be discouraged from making loans collateralised on property by severe restriction on their maturity. In
order to further contain mismatch, required stable funding ratios should rise as their maturity increases.

With banks carving out their mortgage business, they would revert primarily to the short-term finance of business, plus
short-term consumer credit. They would become smaller and thus more manageable, justifying their public guarantees.
On the other hand, other bank activities may be relieved. In support of corporate clients, banks could make markets and
deal in hedging derivatives. They could be allowed to hold equity in corporates and make long-term loans to them,
provided these assets were backed one-for-one by equity, or total loss-absorbing capacity (T-LAC) in excess of
regulatory requirements.
There should be no need to provide deposit insurance for property finance companies. The outstanding mortgages of a
failing company would be transferred to another asset management company. If there was a run on property companies
as a group, the central bank could decide which were worthy of support. Critically, this construction allows property
companies to fail with no effect on the payment system or credit provision to business.

The reform would validate the provision of deposit insurance and the process of resolving failing banks, having lessened
a critical component of liquidity risk and scaled down considerably public exposure.
ROLE OF ASSET SECURITIZATION
ABSTRACT
Banks, to get rid of illiquid assets they possess and to attain financial freedom in lending, searched for new innovative
techniques. This innovative method of converting these illiquid assets in to liquid assets technique is called asset
securitization. Banks pool up these illiquid assets like mortgage loans and sell it to agencies called as special purpose
vehicle (SPV). These special purpose vehicles convert these loans in to securities and sold to investors. Before agencies
sold these securities, they got it rated from rating agencies. Asset securitization as a process reduced information
asymmetries; increased financial slack; served as a lower cost of financing source; reduced regulatory capital; and
reduced bank risk. The process of asset securitization as a whole has many advantages but by the end of year 2007 it
started to crack with financial crisis. It is therefore necessary to study what went wrong in the process of asset
securitization that lead to financial crisis.

The study analyzes the role of asset securitization in financial crisis by analyzing the economics of asset securitization
process as whole. Then in-depth analysis of credit rating agencies methodologies and economics of how they rate these
securities is studied. As it is difficult to analyze the rating processes and methodologies of all rating companies in this
thesis I have decided to analyze Moody's investor service. Moody's has been selected because its name is synonym
with quality in the market.

The growth and fall of mortgage industry performance of mortgage industry have been analyzed. The factors that led to
financial crisis have been analyzed. The study analyze the moody's rating methodologies and rating models and updates
to rating models. The short comes in rating methodologies and rating process has been discussed. The rating models
updates effect on default rate of rating has been analyzed. Finally the effect of these default rates on financial crisis has
been studied and analysis of role of asset securitization in financial crisis is studied.

Introduction
The process of asset securitization started in the year 1870 when Government National Mortgage Association (GINNIE
MAC) purchased pools of loans and converted in to securities and sold these securities to investors. In the year 1970
special innovative technique called tranching were used to distribute losses involved in these pools of loans backed by
mortgages and sold to investors. Kaptan and Telang (2002) Asset securitization is the process of converting illiquid
assets in to cash flows. Both financial intermediates such as banks and investors benefited from this process. Banks
benefited with extra liquidity to lend more loans to able borrowers where as investors got opportunity to invest in capital
market for more returns.

In the process of asset securitization, rating agencies rating securities is crucial because rating influence the
marketability of the securities. There are many rating agencies which rate Residential Mortgage Backed Securities, of
these three largest credit rating agencies with overseas market that are based in United States are Moody's, Standard
and Poor (S&P) and Fitch. These rating agencies use statistical models to analyses risk involved. Rating agencies
constantly review performance of these securities and according to performance they upgrade or downgrade rating.

To lessen the effects of a mild recession in 2000, the Federal Reserve cut interest rates. This interest rate cut along
with increasing housing price made people to invest in housing this helped to drive growing demand for non-traditional
mortgages products. Banks have extra liquidity to lend more loans to borrowers and started to lend more and more
loans to non-prime borrowers, which led to poor performance of loans and in turn effected whole asset securitization.

This report will explore what is the role of asset securitization in financial crisis. To research what is the role of asset
securitization in financial crisis the following have done

1. Analysis of asset securitization process

2. Analysis of Evolution of financial crisis
3. Analysis of Rating agencies methodologies and procedures in rating process.

The details of analysis techniques are explained in methodology chapter. And extensive literature review is done to get
hold of the subject. Finally, in depth analysis has been done to reach the goal of the report.
CHAPTER-2
Professional And Academic Context
2.1 Asset Securitization

Kaptan and Telang (2002) defined Asset securitization as an innovative process which channelizes flow of funds from
investors to issuers in efficient manner. In simple words, the process of asset securitization starts with financial
institutions like banks which pools up individual loans and create securities against them. These securities are rated
and sold to investors. In words of these authors, asset securitization is the process of converting assets in to securities
and in turn in to liquid cash.

Origins of securitizations can be traced back to 1870`s where Government National Mortgage Association (GINNIE
MAC) started selling securities that are backed by pool of mortgage loans. These securities were named as mortgage
pass through securities.

This process of securitization has changed in 1970 where new innovative concept of tranching was introduced in issuing
the securities (tranched securities). These tranched securities are sold to investors. Kaptan and Telang (2002)

(Uzun and Web, 2007) makes understanding of asset securitization more simple through an illustration of the process
of asset securitization, banks which are financial intermediaries in capital market has various types of assets such as
mortgage loans, car loans, leasing contracts etc on their balance sheets. These assets are not marketable so these are
illiquid assets. Banks, to get rid of these illiquid assets and to attain financial freedom in lending search for new
techniques. This innovative method of converting these illiquid assets in to liquid assets technique is called asset
securitization. So asset securitization plays a major role in converting these illiquid assets in to cash flows (liquid assets).

Uzun and Web, also provide information on what kind of assets the banks securitize. These authors explain this as, the
process of asset securitization starts with banks deciding which assets they want to securitize for example mortgage
loans. Then bank pools these mortgage loans and sell it to trustee or separate entity which is called special purpose
vehicle. (Uzun and Web, 2007)

Role of Special purpose vehicle (SPV) is explained by the Securities and Exchange Staff (2008) as, SPVs either
government backed agencies or private agencies such as Fannie Mac, Friede Mac, Ginnie Mac buys these loan pools
and are entitled to interest and principal of underlying loans in the pools. Then SPV issues different classes of securities
known as tranched securities backed by pool of loans.

The role of SPV is to separate risk of newly created securities from the origin bank loans. If these SPV are not there it
is very difficult to assess the risk involved with those securities underlying the loans. It is difficult to access risk because
risk involved is closely related to origination bank practices. Information of origination bank practices such as how they
lend loans what documentation they check before issuing loans and credit quality of loans. Securities and Exchange
Staff (2008) conclude that these securities issued from this SPV isolates the risk involved from origination bank.
Investors invest on these securities and investment risk is directly interrelated to credit quality of loan borrowers whose
loans are offered as collateral for the securities. To boost the demand for these securities the SPV enhances credit
quality by process called over collateralization and subordination.

Over collateralization, is the process in which credit quality is improved by giving payment guarantee by insurer. So if
there is any principal or interest default it is insured there by making investors clear in mind that there is no risk involved
in investing in these securities. Over collateralization is one way of credit enhancement but the principle way of credit
enhancement is done by subordination.

In subordination process SPV issues different layers of tranches (securities) such as junior, mezzanine, senior tranches.
If the trust experiences any loss in interest or principal payment, lower most tranches, junior tranche absorbs all the
losses and then mezzanine tranche absorbs any more remaining losses that are left over by junior tranche leaving top
most tranches, senior tranche safe from any kind of losses. So senior tranche is safe from all interest and principal
default. So by process of tranching top most tranches (securities) get more demand from investors and demand reduces
when it goes down the ladder up to junior tranches. Junior tranches are backed by over collateralization for its
marketability in capital market. The process of tranching differentiates structured finance from normal securitization
process.
In normal securitization process assets are converted into securities and sold. In structured finance these securities are
tranched so that at least one class of securities gets better rating when compared to average rating of all securities.

The asset securitization makes calculation of risk more complex using technique called tranching. The calculation of
risk is more complex because the risks involved in these pools are distributed.( Securities and Exchange Staff) (2008)

Asset securitization is the process of converting illiquid assets in to cash flows (liquid assets). Both financial
intermediates such as banks and investors benefited from this process. Banks benefited with extra liquidity to lend more
loans to able borrowers where as investors got opportunity to invest in capital market for more returns. Kaptan and
Telang (2002)

In brief benefits of asset securitization are reducing information asymmetries; increasing financial slack; serving as a
lower cost of financing source; reducing regulatory capital; and reducing bank risk (Greenbaum and Thakor, 1987)

(Kaptan, Telang (2002), (Uzun and Web, 2007) conclude that asset securitization is the process in which illiquid assets
of banks are converted into cash flows or liquid assets. (Greenbaum and Thakor, 1987) conclude these techniques of
asset securitization as benefits for banks as well as for investors in capital market. Securities and exchange staff
concludes the process of credit enhancement using process called subordination distributed risk of loss in the whole
tranche. And the process of over collateralization increased demand for these securities in capital market. Securities
and Exchange Staff (2008) concluded that the process of tranching evenly distributed risk and assessing this risk is a
complicated process.

2.2 Rating Agencies

The main role of rating agencies in capital market is to rate the bonds and securities in specific scale. Rating agencies
use qualitative and quantitative methods to access cash flows of these bonds or tranched securities. These ratings are
used by investors in capital market as bench mark in investing. Thus, rating agencies helped the investors in making
decision to invest in capital markets by reducing information asymmetries between issuers and investors. (Committee
on the Global Financial System), (2005).

2.2.1 Evolution And Role Of Rating Process

According to Ruth Rudden, the evolution of rating industry started when there was a big demand for the corporate bonds
in USA. The investors interested to invest in these corporate bonds were very sceptical about risk involved as they were
not provided with company's credit information that issued these bonds. So there was a pressing need for an
independent and third party institution to analyse credit risk of these bonds which helped the investors in making decision
to invest according to their criteria. Thus, credit rating agencies came into existence. (Ruth Rudden, 2007),

John moody was the first to introduce credit ratings in 1909. He used rating scale to rate the bonds. These ratings were
useful for investors to understand credit risks. Credit rating agencies (CRAs) stressed more on expected cash flow
generated by the issuer (special purpose vehicle) ongoing business in determining the rating. In general CRAs revenues
were generated from subscribes who subscribed to receive rating on debt securities. Rating agencies from the start has
been rating bonds on specific scale. Mason and Rosner, concluded that the rating doesn't give information on whether
particular bonds must be bought or sold. They give their opinion on relative safety of the bonds. (Mason and Rosner,
2007)

The main importance for the credit ratings rose in the capital market because of US treasury department. US treasury
department said the quality of the bonds rated by rating agencies is appropriate. Ruth Rudden, concluded that the
importance of credit rating agencies in the capital market became prominent and the investors relayed on these ratings
to invest on the bonds. (Ruth Rudden, 2007)

Then with the introduction of new structure finance products, rating agencies started to rate these products as well. In
one of the reports by the Committee on the Global Financial System, (2005), wrote about the Rating agencies, rated
the structured finance products like asset backed securities, CDOs, RMSBs etc, same as the traditional bonds. Rating
agencies performed the same function as with traditional bonds that was reducing information asymmetries between
issuers and investors. Committee on the Global Financial System, (2005)

Issuers of structured finance products wanted these securities to be rated on the same scale as traditional bonds so
that investors think structured finance has same kind of risk that of bonds. (Mason and Rosner, 2007) spoke about the
structured finance as, for past few years with the introduction of newly formed structure finance products; these CRAs
are chasing the agencies that issue these structured finance products instead of subscribers for revenue.

This lead to three-fold increase in the revenues by CRAs and effected the integrity and base source of the aim on which
rating industries are build. To meet the demand of these newly introduced structured finance products; CRAs have
introduced many new models and approaches to access these products for ratings. (Mason and Rosner, 2007) The
three largest credit rating agencies with overseas market that are based in United States are Moody's, Standard and
Poor (S&P) and Fitch.

2.2.2 Rating methodologies of RMBS

According to (Rousseau Stephane, 2009), all the rating agencies methodologies are almost same for rating RMBS
products.

First issuer of these securities approach rating agencies to rate their securities so that they can sell it in capital market.
And issuer provide all the data information of the assets underlying the securities like loan data, proposed capital
structure of SPV, proposed credit enhancement for each tranche of the securities.

Rating agency will assign an analyst to analyze the tranches for rating it. First probable loses incurred on all tranches
are calculated. Rating agencies used complex statistical models for analyzing loss. The loss analysis gives rough idea
of how much credit enhancement is required for each tranche to give a particular rating.

Then analyst analyzes proposed capital structure of SPV to check whether it meets particular rating. Then finally analyst
analysis the cash flow which gives information of interest and principal paid out of SPV and analyzes whether particular
asset which is under tranche meets payment obligation. Analyst then rates each tranche and submits his rating to
committee where they vote on the analyst view.

Once rating is confirmed they send the rating to issues rather than publishing it. If the issuer is satisfied with the rating
he makes it public. If issuer makes rating public, rating Agencies get paid if not they get breakup fee. (Rousseau
Stephane, 2009).

2.2.3 Concerns on models used in RMBS

According to (Danelsson J, 2002), Rating traditional bonds is much easier because of availability of historical data
whereas rating structural products like RMBS you need much more complex models than that of normal models.

As the financial system become more complex, the need for complicated statistical models becomes greater. More the
complexity, lesser the reliability on these models, so does these models tends to be less reliable. It is clear from the
credit crisis of 2007 that the rating agencies used over optimistic input data, inappropriate modelling and insufficient
checking of data quality and permitting gaming of models. Despite of advanced models, stress tests, and all the
numbers, risk models do have important role to play in modelling risk as long as its limitations are known. Risk models
are good at managing particularly trading desk but when asked to model whole institution it fails. So relying on such folly
statistical models to model risk is foolishness. And the numbers that these models give are inappropriate.

Financial models are not simple and do not have basic or fundamental thermos to build on. These models can easily
make you believe the results are accurate, the reason for these are;

1. Endogenous risk: In finance we can only model aggregate behaviour. Financial modelling changes the statistical laws
governing the financial system in real-time, leaving the modelers to play catch-up. This becomes especially pronounced
as the financial system gets into a crisis. This is a phenomenon is called endogenous risk.

2. Quality of assumptions: we can't take it to consideration all parameters in to model so it is important to take it to
consideration the main parameters that affect the outcome of the model. For example if we consider present situation
of financial crisis the main parameter is liquidity which has been be ignored by modelers while modeling risk.

3. Data quality: data quality is the most and foremost important thing in statistics because the accuracy of these models
depends up on quality of data. (Danelsson J, 2002)

To prove what Danelsson J, said Vanessa G. Perry proved, there is always dearth of data on subprime market. The
data that is available is proprietary lender data. And this data had drawbacks on analysis of market trends. To analyze
data properly we need property records which contain information on mortgagee and mortgager, transaction price,
property location, credit score, foreclosure rate of neighbourhood state.

This data was necessary for the rating agencies to analyze the market condition properly. Roughly to analyze loan
performance, three sets of data was taken into consideration, that is the Borrower data, loan data, property data.
Borrower data should contain income, FICO score, and demographics. The loan data should contain loan amount, LTV,
loan type, interest rate/fee, terms such as FRM/ARM, payment history. Property data should contain location, prices,
sales, foreclosure, and employment rate. One can predict the probability of default if and only if these data of loan is
available. (Vanessa G. Perry, 2008).

2.2.4 Concerns on rating in RMBS

According to (Committee on the Global Financial System, 2005), and (Mason and Rosner, 2007) there are many
concerns on rating agencies which rated the RMBS, they are;

1. Transparency- Given the role that is played by rating agencies in removing Asymmetries, it is important that they be
transparent on what they do. Rating agencies never disclosed completely their methodologies they use to rate RMBS
and key assumptions and rating criteria. Credit rating agencies never accepted that the data provided by issuer of
securities are not sufficient to rate. And rating agencies never provided historical performance data about their ratings.

2. Quality of rating process- there is a huge growth in RMBS market because of ease in lending loans. And at the same
time these RMBS products started to get more complex. The rating agencies did not have enough staff to tackle
increasingly complex products and huge volume of these products. Because of shortage of work force these rating
agencies were not able to catch up with rating upgrades or downgrades accordingly with change in circumstances like
issuers principal or interest short fall.

3. Conflict of interest- the rating agencies main role is to act as an intermediate between investors and issuers. This
trust of being intermediate has been broken by rating agencies by charging issuers for rating products instead of getting
paid by subscribers who subscribe for these ratings to invest in these products. Because of shift in the axis of being
intermediate, these rating agencies got paid from issuer who in turn profited rating agencies by gaining millions of dollars.
This process of issuer paying for his rating created conflict of interest. So considering profits they incur from this new
role, rating agencies tend to rate products issued by these issuers a higher rating than they actually are. The issuer has
ability to adjust deal structure to get desired rating. And issuer has influence on rating process. (Committee on the Global
Financial System, 2005), (Mason and Rosner, 2007).

2.2.5 The role of rating agencies in the crisis

According Tom Bulford (2008), (Ruth Rudden, 2007) The credit rating agencies like Moody's, Standard and Poor's and
Fitch played a central role in growing the residential mortgage-backed securities, these credit rating agencies were titled
to rate these securities on behalf of the huge investment banks to sell to the investors.

The ratings of these securities were to identify the risk involved in the securities, they followed a three main flow in
calculating the risk rating for the investors, the first as to interest the investors on the securities, they provided portfolios
of RMBS which highlighted a certain level of risk involved in it, this was done through tranches which means, the different
level of risks involved securities were put into different groups called tranches. This helped the investors in deciding
whether to stay first in line during the event of default or down the queue. This was one point where the investors relayed
on the ratings to invest on the securities.

The other two things which they followed to rate the securities, one was data which was used in the financial models of
the rating agencies to rate these securities, the data contained here are the information about the mortgage loans that
are parceled by the investment banks. These mortgages came from the originators who provided all the information
about the mortgagees like their credit history, income, etc. hence these originators provided information was historical.

The information given source was not sure about as they stood by the words of the originators. Using this information
on the models they used in the rating would off course end up being inaccurate. This made the investors relaying on
the high rating given by these rating agencies and hence invested confidently.

The rating agencies assured that the portfolios of mortgage backed securities were stress tested by Monte Carlo
simulation of macroeconomics variables to create a loss distribution'. The assumptions were not wide enough because
the rating agencies relied upon historical data, and till now MBS were concerned the performance history that did exist
occurred under very benign economic conditions'. The reasons just don't stand on rating agencies following the historical
data for the calculations but also the workload and the conflicts when the interest rates rose which laid the investment
bank concentrate on getting the best ratings on the securities that is laid for sale.

This increased the competition between the agencies; they did not want to lose deals and hence gave ratings as
necessary with one initiative that was not to lose deals. One of the illustration proves the above comment, one of the
member in an rating agency who did not want to lose a deal wrote a mail which said I had a discussion with the team
leaders here and we think that the only way to compete is to have a paradigm shift in thinking, especially with the interest
rate risk. Another said We are meeting this week to discuss adjusting criteria for rating CDOs of real estate assets
because of the ongoing threat of losing deals. Tom Bulford (2008),

Tom Bulford (2008) concluded that the roles of these rating agencies in financial crisis are to be studied thoroughly.
Rating agencies main duty is reducing information asymmetries between issuers and investors but with the introduction
of structured finance products rating agencies deviated from their main role of reducing information asymmetries. In fact
they started to favour security issuer as they are paid for rating.

Committee on the Global Financial System, (2005) concluded that role of rating agencies in capital market is to rate
bonds or securities on specific scale. (Ruth Rudden, 2007), (Mason and Rosner, 2007) concluded that the importance
of credit rating agencies in the capital market became prominent and the investors relayed on these ratings to invest on
the bonds and the rating doesn't give information on whether particular bonds must be bought or sold. They give their
opinion on relative safety of the bonds. The rating agencies got paid by issuer of securities for rating structured finance
products on same scale as normal bonds.

Tom Bulford (2008) concluded that change of role by rating agencies as information intermediation between issuer and
investor got strained with the introduction of structured finance products. (Danelsson J, 2002) concluded that to rate
structured finance products rating agencies need more complex models. (Vanessa G. Perry, 2008) concluded that there
is no enough historical data on subprime market and in turn this dearth of data affects accuracy of the rating process.
Committee on the Global Financial System, (2005) concluded that there are some concerns relating rating process of
RMBS. Tom Bulford (2008) concluded rating agencies had played their role in financial crisis and need to be blamed for
their irresponsible behaviour.

2.3 Subprime Crisis

The roots of financial crisis are complex and obscure. The main culprits are mortgage banks brokers, rating agencies,
to some extent federal reserve and government. Financial crisis started with Federal Reserve slashing interest rates to
encourage spending and reduced 30-year bond issues to increase the prices. This along with American dream of home
ownership triggered housing boom. This housing boom has been used by many mortgage lending banks. The
introduction of FICO scores instead of traditional point based system and the off-balance sheet vehicle made lending
loans easy. Loans were given to people with low credit history (sub-prime loans) Souphala, C and Anthony, P.C, (2006)

1.3.1 Evolution of the crisis

According to Souphala, C and Anthony, P.C , (2006), the introduction of FICO scores instead of more traditional point
based system credit scoring. And the off-balance sheet vehicle (OBSV) made banks to lend loans to people with low
credit score. This type of lending is called subprime where these borrowers are who fail credit history requirements in
the standard (prime) mortgage market. The subprime lending is known as high cost lending and primarily driven by
credit history and down payment where as prime lending is driven by down payment only. People thought prime lending
is complicated but have great promise and great peril.

The subprime lending provided opportunity for homeownership to those who haven't passed credit history in the past.
Lower credit history of subprime lending which could have resulted in more delinquent payments and defaulted loans.

US mortgage market, which for decades was dominated by fixed rate mortgages, included nontraditional mortgages,
simultaneous second-lien mortgage, and no documentation or low documentation loans. Non-traditional mortgages
allow borrowers to defer payment of principal and sometimes interest and include interest only mortgages (IOs) and
adjustable rate mortgages (ARMs) with flexibility payment options. Interest rates are much higher than that of prime
loans, is the main reason of risk for borrowers.

Strong home price appreciation and declining affordability have helped drive growing demand for non-traditional
mortgage products that can be used to stretch home buying power. Souphala, C and Anthony, P.C , (2006).
1.3.2 Role of US federal government
National partners in home ownership in the largest private public partnership program whose solo aim is increasing
home ownership rate to all time high by the end of decade by increasing creative financing methods for mortgage loans.
In this program, retailer, home builders, Fannie Mac, Freddie Mac, mortgage bankers are the partners who came up
with innovative ideas such as using FICO score instead of point based system is introduced to ease the requirements
to lend loans to people whose credit history is not good to get mortgage loan. Another innovation is off balance sheet
vehicle which made lending loans easy. (Mason and Rosner, 2007)

According to Souphala, C and Anthony, P.C , (2006),The government and the quasi-government agencies were main
reason who influenced the US mortgage credit cycle by their legislative reforms and the mandates, the alternative
mortgage transaction parity act in 1982 eliminated regulatory disparities between state and federal chartered mortgage
by granting state chartered institutions the authority to issue alternative mortgage(sub-prime), including the use of
variable interest rates and balloon payments, regardless of state mortgage lending law. The tax reform act 1986. Then
stimulated demand for mortgage debt by retaining the deduction for home mortgage interest.

To lessen the effects of a mild recession in 2000, the Federal Reserve cut interest rates. Although the Fed has raised
interest rates past year, mortgage rates have largely been unaffected. This interest rate cut along with increasing
housing price made people to invest in housing. Home ownership is best way of making wealth in fact most households
find it difficult to invest in anything but their homes. These factors helped to drive growing demand for non-traditional
mortgages products that can be used to stretch buying power. Souphala, C and Anthony, P.C , (2006).

1.3.3 Financial Market Turmoil

Due to poor standard of lending there has been raise in subprime loans, the delinquency rate increased in the year
2006-2007 because of subprime loans issued in previous years. The overall rise in delinquency rate is sudden and
overwhelming. The market started to response to these high delinquency rates in the second half of 2006 and first half
of 2007. In spite of high delinquency rate, market had confidence on highly rated tranches of subprime RMBS (senior
tranches). In the second half of 2007 this confidence came to its low when credit rating agencies lowered their rating on
highly rated tranches. These downgrades created uncertainty and doubt on quality of rating these rating agencies
assigned. With more exposure to risk related to subprime debts, restricted liquidity of banks, the inter market for term
loans was effected so there was a sharp increase in risk premium. These authors concluded that banks lost confidence
and have less liquidity. This resulted in present financial crisis.

The result of this is freezing all structured finance products and cut down in non-conforming mortgages. This is because
of those agencies giving non-conforming mortgages had lots of loans and RMBS which were not sold. Several financial
institutions in the U.S. and abroad were hit with sizable losses owing to their exposures as sponsors of SPVs and
underwriters of other structured credit, as well as their direct exposures to subprime-related debt.

Souphala, C and Anthony, P.C , (2006). concluded that lower standard of the way the mortgage loans were issued is
the one of the main reasons of financial crisis. (Mason and Rosner, 2007) concluded that US federal government played
its role in financial crisis by easing many laws. Souphala, C and Anthony, P.C , (2006) also concluded that degrading
senior tranche ratings by rating agencies triggered financial crisis and banks lost confidence and have less liquidity to
lend loans.