The recent financial crisis which started in April 2007 has its roots in asset price bubbles mainly originated from new financial instruments which have been strongly criticized for their complexity, lack of transparency and rating quality deterioration [2] . These new financial instruments, which were perceived as successful innovations during the good times, led to more securitization of various economic assets, particularly mortgages. More securitization meant more liquidity, and more leverage for the financial institutions, creating a new source of funding for the banks. However, lack of planning for adverse effects and underinvestment for the design of the system resulted with a tremendous meltdown of the securitization market which triggered the worst global financial crisis since 1930s - particularly atypical in terms of its depth and outspread. This essay aims to focus on the way the securitization markets work and to present key measures for strengthening the securitization markets; with a hope that this time, regulators would tailor their future policies to the experience of the recent crisis.
Securitization is defined as a process that involves "pooling of assets and the subsequent sale to investors of claims on the cash flows backed by these asset pools" [3] . Put simply, securitization is the process of pooling of loans and creating securities backed by the loans. Specifically, securitization of mortgages is carried out by pooling of several real estate loans and then breaking them into smaller pieces to be sold to investors (See Flow Chart, explained in detail later). Securitization was first initiated by the public sector. Government Sponsored Enterprises, GSEs (Fannie Mae and Freddie Mac) were created for the new system to work. GSEs provided government guarantee to these securities against credit risk. Combined with attractive yields during a period of relatively low interest rates [4] , GSE guarantee made these securitized assets even more attractive investments, thus facilitated mortgage lending.
Flow Chart: Securitization process of mortgages
Individual Mortgages
.
.
.
Pooled and sold to SPV
AAA
Credit Allocation
Aaa
BBB
etc
Sold to investors and pension funds, insurance companies
Source: Modified from Martin Neil Bailey, Robert Litan and Matthew Johnson "The Origins of the Crisis" (Brookings Institution, November 2008), Anatomy of an MBS, Page 25
Looking from the finance perspective, securitization is a financial innovation. It was innovated as a solution for the liquidity constraint of the balance sheets of the mortgage lenders [5] . Securitization allowed the banks to turn illiquid loans into liquid assets, hence allowing the banks to sell off loans, take them off their books, and use that money to make even more loans [6] . Moreover, securitization allowed lenders to sell their risks. The benefit to the borrowers was that increased access to the capital markets reduced the funding costs. Institutional investors benefited as well by being offered diversification opportunities. Hence, this innovation in the structured credit market shifted the banking system to a new business model from "originate and hold" to "originate-to-distribute" model. [7] While commercial banks still had a significant role in the mortgage origination and distribution process, they were no longer the leading originators or holders of residential mortgages [8] . This new model ensured that the mortgages were moved out of the balance sheets of the originators to the investors which included investment banks, pension funds and a host of other investors, as mentioned above. Accordingly, securitisation market involves a relatively large number of parties. [9] The major parties are loan originators, arrangers/issuers and the credit rating agencies [10] . The process starts with the loan originator. After buying the receivables of thousands of mortgage loan, an issuer transfers them into a special purpose vehicle (SPV), an off-balance sheet legal entity which holds the receivables in a pool and issues the securities [11] . These securities are separated into tranches which are prioritized in how they absorb losses from the underlying portfolio [12] . The repackaging of these securities into tranches reduces the overall risk of the mortgage pool; hence tranching or pooling redistributes the risk according to risk appetite of the investors [13] .
Some of the tranches from one mortgage pool were combined with tranches from other mortgage pools, resulting in Collateralized Mortgage Obligations (CMO) [14] . Other tranches were combined with tranches from completely different types of pools, based on commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and even corporate loans that had been combined into Collateralized Loan Obligations (CLO). The result was a highly heterogeneous mixture of debt securities called Collateralized Debt Obligations (CDO). The tranches of the CDOs could then be combined with other CDOs, resulting in CDO2.
In this process, credit rating agencies are the ones that assess the risks of these securitised instruments. Put simply, the securitized products are rated by the credit rating agencies in order to ensure the quality of the assets backing it. The investor confidence to the assessment of the rating agencies in the securitization process was so high that investors were even willing to buy securitised products based on subprime mortgages [15] . In other words, there was an over-reliance on ratings.
As the securitization market came to be dominated by the financial sector, it grew more complex and more opaque. In terms of complexity, two examples would help show the extent [16] : (i) If a CDO-squared holds 100 CLOs, each holding 250 corporate loans, the number of underlying securities is 25,000; (ii) If a CDO2 holds 100 CDOs, each holding 100 MBS, comprising a mere 2,000 mortgages, then we would need information on 20 million number of underlying securities in order to determine the value of the security. To this end, the key driver of complexity is the practice of tranching. More complicated links between tranche payoffs and pool performance increased the difficulty for final investors to obtain a clear picture of the risk and return profile of their stakes [17] . Overall, assessments of value and risk tended to become increasingly dependent on models, as small changes in assumptions could lead to major differences in the risk assessments [18] . Hence, complexity combined with failure of company risk management practices.
With respect to transparency, securitization assumed the reputational considerations to act as a control mechanism for the behavior of the originators, but the crisis illustrated that this did not work sufficiently [19] . This has also combined with the assumption of self-regulation of the financial markets [20] . However, the conflicts of interest in the rating agencies (they were both advising financial institutions on how to create new financial products and later on gave a favorable rating to the same products) caused them to be skewed towards producing risky and unsafe products.
Moreover, regulatory arbitrages caused increasing reliance on market-based sources of funding - instead of heavy reliance on retail deposits as in the traditional banking model. This made banks increasingly dependent on capital markets [21] . To the extent that more stable retail deposit financing was replaced by wholesale funding, banks became more exposed to market dynamics and perceptions, constituting a potential source of instability in the financial sector [22] . In addition, as regards the regulation, Elson (2009) [23] emphasizes that the pillars of the Basel I and II operated ineffectively during the run-up to the current financial crisis. He further points out that the response to the crisis revealed "the lack of a coordinated set of resolution mechanisms across countries for distressed banks and a lack of coordination in the application of deposit and investor protection across major countries."
For the securitisation system to work well again, several structural changes need to be made. First, in order to address the problems with regards to complexity, simpler structures which are less vulnerable to model risk and easier to analyze are required to be adopted. Simplicity could include increased standardization of structures, based on a smaller number of tranches and less reliance on structural features for credit enhancement [24] . Second, in terms of transparency, information flow along the securitisation chain should be improved, such as adopting standardised disclosure packages for MBS consisting of pool-level and loan-level information [25] . Moreover, disclosure of rating outcomes for all issues should be provided so that investors can better evaluate the track record of alternative suppliers of credit ratings [26] . Third, rating agencies should improve their rating methodologies. According to Mitchell (September 2009), the proposals include: (i) requirements to clearly distinguish structured product ratings from corporate debt ratings, (ii) provision of information on the sensitivity of structured product ratings to modeling assumptions, and (iii) changing the rating methodologies by for instance adopting more conservative assumptions regarding key parameters.
Along with these measures, bringing back the investor confidence into the market would require some regulatory arrangements as well. These might include [27] (i) Strengthening the capital requirements for exposures. (ii) Introduction of leverage ratio, and assurance of reasonable leverage ratios, by revising the Basel II's approach. (iii) Increasing the equity-to-asset ratio. (iv) Requirement on the originator and arranger for some portion of the securitization which would guarantee that they have some responsibility, providing an incentive for prudent behaviour. For instance, the originator can hold a share of the portfolio. Furthermore, according to Sacasa (2008) [28] , securitization contracts should make sure that originating and sponsoring institutions retain sufficient risks on the securitized assets, so that these institutions have an incentive to adequately screen and monitor individual loans.
In conclusion, the financial sector has undertaken tremendous innovations in which securitized instruments has taken the lead. By the crisis, it is understood that the ongoing business models are unsustainable, and the financial system is in need of a change towards sustainability. If nothing is done, the flaws of the system would build up again as the world economy recovers, simply leading to a new global financial crisis.
