Introduction

It is widely believed that the practice of securitization is one of the causes that led to the 2007–08 financial crisis.¹ Krugman (2007) summarizes the issue as follows: “in the later stages of the great 2000–2005 housing boom, banks were making a lot of dubious loans. For a while, the risks of subprime loans were masked by the housing bubble itself. Yet the banks making the loans weren't stupid: they passed the buck to other people. Subprime mortgages and other risky loans were securitized.”² However, it turns out that the financial institutions that held a large amount of subprime-related securitized products recorded tremendous losses. As discussed in Diamond and Rajan (2009), it is surprising that these institutions held on to so many mortgage-backed securities (MBS) in their portfolios, given that the originators would have sensed the deterioration of the underlying quality of mortgages.

The financial statements of some banks revealed large holdings of these “toxic” securitized products. Citigroup disclosed that, at the end of September 2007, the total amount of their subprime-related direct exposures in securities and banking, which comprised net collateralized debt obligation (CDO) super-senior exposures and gross lending and structuring exposures amounted to US$54.6 billion. This amount decreased to US$19.6 billion one year later; at the end of March 2009, there was still US$10.2 billion in these investments. Although Citigroup claimed that much of its holdings were in “super-senior” tranches, its performance was far from expectations. UBS was another company that was heavily exposed to the risk of CDOs—which were mainly backed by subprime-related structured products—and recorded huge losses. According to the report of the Swiss Federal Banking Commission (2008), in 2007 and through the first half of 2008, UBS (including Dillon Read Capital Management) suffered high write-downs totaling approximately US$42.8 billion, out of which US$21.7 billion was a result of investments in super-senior CDOs. The bank's investment in these super-senior CDOs increased in the first half of 2007 and amounted to US$50 billion before the onset of the subprime crisis.

American International Group (AIG) was heavily exposed to underwriting credit default swaps (CDSs) on subprime-related CDOs. According to its published documents, at the end of March 2008, the AIG's exposure to the risk of super-senior CDS amounted to US$469.5 billion on a notional amount basis. The CDS contracts on multi-sector CDOs were transferred to a special purpose company called Maiden Lane III LLC, co-funded by the Federal Reserve Bank of New York, to restructure AIG's balance sheet.

Since the amounts of MBS held seemed to be too high to be purely inventory, Diamond and Rajan (2009) suspect that investment in MBS seemed to be part of a culture of excessive risk taking, possibly brought about by incentives for the top executives to compete with their rivals, flawed internal compensation and control systems, and/or short-term debt financing, or a combination of these. Under an incentive scheme based on short-term risk-adjusted performance, writing insurance on infrequent events (and thereby taking on what is termed “tail risk”) and treating most of the insurance premium as income, instead of setting aside a significant fraction as a reserve for an eventual payout, is a very attractive option for asset managers. It is difficult to precisely estimate the tail risk, and therefore, it may not be possible to fully control the situation. Further, the so-called Greenspan Put may have encouraged banks to take on the risk of illiquidity.

In the context of the Asian economy, the subprime-related direct exposures of Asian financial institutions were substantially lower than those in the United States (US) or Europe. According to Kato (2008), Asia's exposure (excluding Japan) was estimated to be in the range of US$20–30 billion as of spring 2008. He suggested that this limited exposure in Asia reflects “profitable domestic activities” that limit the “search for yield” elsewhere.

In this paper, I simulate the cash flow exercises of hypothetical MBS and CDOs and show that these securitized products are particularly vulnerable to systematic risk and tend to show higher tail risk. These characteristics, in turn, are closely associated with joint failures and systemic risk. In order to make the financial system more stable, it is important to prevent the recurrence of the collapse of specific markets, as this may result in the collapse of other components of the financial system. I discuss some of the financial regulations that should be applied to these problematic financial products and their relation to possible systemic risks.

The remainder of the paper is organized as follows. Section 2 provides a brief description on the development of the securitization and CDO markets. Section 3 uses simulation examples to illustrate the problematic aspects of the current securitization market, focusing on CDOs backed by asset-backed securities (ABS). Section 4 discusses the possibility of banning these problematic assets. Since the real issue lies in the systemic nature of the securitized products, Section 5 discusses the issue relating to macroprudential regulations. Section 6 presents the concluding remarks.

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