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This chapter discusses the design and valuation of non-traditional asset-backed securities (ABS) and derivatives. Non-traditional ABS and derivatives provide a new source of diversification, have attractive yields compared to conventional securities, and enable pension fund managers to take positions in risk-return tranches. However, securities are also characterised by highly skewed returns such that traditional capital asset pricing model benchmarking may give misleading results.

This chapter provides an overview of the regulation of information used in analyzing the creditworthiness of fixed-income securities. It begins with a discussion of credit analysis with respect to government and corporate debt and asset-backed securities, with a focus on how credit rating agencies generate credit ratings. It then discusses regulatory concerns with undue reliance on credit ratings and the tradeoffs in mandating more granular disclosure and encouraging independent credit analysis to obviate such reliance. It ends with a discussion of the US and EU regulatory framework for the professionalization of credit rating agencies, for the publication of asset-level information, and for eliminating mechanistic reliance on credit ratings in financial regulation.

This chapter examines the tool of securitization used to pool various forms of loans for sale to private investors, thus refreshing the capital available to primary lenders. Long available in the standard capital markets, securitization has recently come to be used as well in the social-purpose capital markets to make it possible for primary lenders in these markets to extend additional loans in support of low-income housing, community development, charter school construction, and other purposes. The chapter provides a detailed description of the complex process involved in bringing a “rated” security to market and the role of various credit enhancements in generating the needed private-sector interest in social-purpose securitizations.

This chapter assesses the new regulations that have sought to increase transparency in the market for securitized assets and to better align the incentives facing different classes of market participants. The financial crisis of 2007–9 revealed problems with underwriting standards in mortgage markets that spread to the mortgage-backed securities (MBS) and asset-backed securities (ABS) markets more broadly. In 2010, the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to answer these issues. The Act extended beyond the securitization and offering process for the issuance of ABS, creating requirements for ongoing disclosures, some applying to ABS issuers and others to the credit rating agencies that periodically assess the credit quality of ABS and other fixed-income assets.

Consumer credit supply arises through a production process called financial intermediation. Intermediation involves transfer of funds from consumer savers to consumer borrowers through institutions that serve as financial intermediaries. Intermediaries make the transfer more efficient than a direct transfer by managing information processing, risk intermediation, monitoring, temporal intermediation, and size intermediation. Although these aspects of production reduce overall costs, they cannot reduce costs to zero, and remaining costs vary among classes of institutions. The chapter reviews the production process and these costs and then discusses how risk costs lead to the possibility of credit rationing. Finally, the chapter begins discussion of how consumer credit granting institutions have attempted to reduce costs through technological means such as statistical credit scoring and obtaining funds to lend through new kinds of financial market instruments collectively known as asset-backed securities (ABSs).

This chapter provides evidence that credit card securitizations do not transfer as much risk as a literal interpretation of such structures might imply. It is argued that the existence of special purpose vehicles (SPVs) depends on implicit contractual arrangements that avoid accounting and regulatory impediments to reducing bankruptcy costs. It outlines the significant features of securitization SPVs. Securitization is a significant and growing phenomenon. The simple model of off-balance sheet financing has the unique ability to find high-quality projects for the bank by making an effort. It is suggested that the risk of a sponsoring firm should impact the risk of the asset-backed securities that are issued by its SPVs. Riskier firms are more likely to securitize though the effect is not always monotonic, depending on the specification. The efficient use of off-balance sheet financing is facilitated by an implicit arrangement, or contractual relations, between sponsoring firms and investors.

Like the credit boom of the 1920s, the toxic credit bubble of the 2000s precipitated a devastating global financial crisis. The desire to earn quick profits from originating and securitizing subprime loans corrupted the risk management practices of large financial conglomerates and the credit review practices of credit ratings agencies that assigned investment ratings to mortgage-related securities. By the end of 2006, U.S. credit markets resembled an inverted pyramid of risk, in which multiple layers of financial bets depended on the performance of high-risk subprime loans held in securitized pools. When housing prices began to fall and subprime loans began to default in large numbers in 2007, the leveraged bets on top of that pyramid of risk blew up and inflicted devastating losses on financial institutions and investors in the U.S. and Europe. Officials on both sides of the Atlantic were slow to recognize and respond to the severity of the crisis. The Federal Reserve Board and the Treasury Department missed multiple warning signs that should have caused them to increase their oversight of major U.S. banks and other large financial institutions during 2007 and early 2008.

This chapter investigates the mechanics of the origination process and the main characteristics of asset-backed securities (ABSs). In particular, it provides an overview of why and how unencumbered assets, such as loans, may be pooled into special legal entities, such as trusts, that are isolated from potential bankruptcy proceedings that may involve the issuer of the assets. The discussion also explores the cash flow structures that are typical of securitization as applied to ABSs. Special attention is given to the role played by the rating process in determining the value of ABSs and hence to credit enhancement mechanisms and the typical rules of allocation of default losses. The second part of the chapter is devoted to a detailed analysis of the key features of the most important categories of ABSs, namely, auto loans and leases, credit card receivables, student loans, and residential ABSs.

The Glass-Steagall Act created a decentralized financial system composed of three separate and independent financial sectors—commercial banking, securities markets, and insurance. The Bank Holding Company Act of 1956 reinforced Glass-Steagall’s policy of structural separation by prohibiting bank holding companies from engaging in any activities that were not “closely related to banking.” Glass-Steagall’s structural barriers prevented the occurrence of systemic financial crises for more than four decades. During that period, federal regulators could deal with problems arising in one financial sector without need to rescue the entire financial system. Despite Glass-Steagall’s success, federal agencies and courts undermined its prudential buffers during the 1980s and 1990s by opening loopholes. Those loopholes allowed banks to convert their loans into asset-backed securities and to offer derivatives that functioned as synthetic substitutes for securities and insurance products. Regulators and courts also allowed money market mutual funds and other nonbanks to issue short-term financial claims that served as deposit substitutes, despite Glass-Steagall’s prohibition against deposit-taking by nonbanks.

Universal banks arose in the U.S. during two periods in the past century—the 1920s and the late 1990s. On both occasions, universal banks in the U.S. and Europe promoted intense boom-and-bust cycles that led to global calamities—the Great Depression of the early 1930s and the Great Recession of 2007–09. Universal banks received extensive bailouts on both sides of the Atlantic during both crises. Three core features of universal banks cause them to generate destructive boom-and-bust cycles. First, pervasive conflicts of interest prevent them from acting as objective lenders or as impartial investment advisers. Second, bonus-driven cultures encourage their insiders to take speculative risks to produce short-term profits. Third, their ability to convert loans into asset-backed securities allows them to package risky loans into securities sold as purportedly “safe” investments to poorly informed investors. The Glass-Steagall Act of 1933 broke up universal banks and established structural buffers that prevented spillovers of risk between the banking system and other financial sectors. The U.S. avoided systemic financial crises after World War II until Glass-Steagall was undermined by regulators and ultimately repealed by Congress. Congress failed to adopt similar structural reforms after the Great Recession. As a result, universal banks continue to dominate our financial markets and pose unacceptable systemic dangers. We urgently need a new Glass-Steagall Act to break up universal banks again and restore a more stable and resilient financial system.

This chapter explores recent trends in student loan debt, particularly the for-profit educational corporation Corinthian Colleges’ scandal, in order to define the key terms financialization and neoliberalism. Finance is playing an expanded role in higher education and securitization is being employed to capitalize off of students’ loan debt. Students are increasingly taking on debt and bearing responsibility for a capitalist economy that is stacked against them. Banks and lenders bundle and sell this debt to wealthy, white investors as securities. Given that Black and Brown borrowers take out more student loans, repay their debts plus interest over longer periods of time, and experience higher default rates compared to their white counterparts, these securities are racialized just like the individual lines of debt from which they were created.

This chapter discusses how to value and analyze asset-backed securities (ABSs) with an emphasis on mortgage-backed securities (MBSs). Valuation differs fundamentally from traditional fixed-income securities due to the risks presented by fluctuations in the securities’ monthly cash flows derived from unscheduled principal repayments. For an MBS, prepayments, which are largely a function of interest rates, housing turnover, refinancing sensitivity, burnout, and a host of borrower inefficiencies, can cause drastic fluctuations in the security’s theoretical or intrinsic value. Once an estimate of forecasted prepayment rates and default rates, if applicable, has been calculated, monthly cash flows are determined and discounted at the appropriate discount rate. Spread measures such as the zero-volatility spread (Z-spread) and the option-adjusted spread can be used to approximate the necessary discount rates applicable to monthly cash flows, the latter of which can be calculated via the Monte Carlo simulation method.

When the US financial crisis spilled over to Europe after 2007, investors shied away from the southern euro countries, declining to continue financing their current account deficits and even recalling some of the credit they had lent them previously. In this situation the ECB helped out with the printing press, allowing the local national central banks to provide generous refinancing credit as a replacement. To that end it, dramatically reduced the collateral requirements for such credit, accepting government bonds that did not qualify for investment grade, non-traded asset-backed securities composed of dubious credit titles, own bonds created by the banks themselves, and many other types of assets that it had not accepted previously due to their risky nature and poor quality. It also tolerated huge volumes of ELA credit, which the national central banks could grant formally on their own account, but actually at the Eurosystem’s risk.

During the 2000s, universal banks originated and securitized trillions of dollars of toxic subprime loans and sold the resulting debt securities to investors around the world. Governments on both sides of the Atlantic encouraged universal banks to engage in high-risk lending and securitization. Universal banks enjoyed unrivaled influence, and government officials ignored warnings about the dangers of subprime lending from consumer advocates and academics who did not hold “mainstream” views. Policymakers in the U.S. and Europe recognized that many households were becoming more deeply indebted and were relying more heavily on home mortgages and other types of consumer credit to cover their living expenses. Officials tolerated those developments because they viewed housing construction and household consumption as the primary drivers of economic growth in an otherwise challenging environment. The decision by policymakers to rely on housing credit as the main stimulus for economic growth in a period of stagnant incomes had catastrophic results.

Mortgage securitisations rose rapidly in the early 2000s through the private label securitisation vehicles that packaged subprime mortgages. The size of the asset-backed securities sector in the United States traces well the overall leverage of the financial system in the run-up to the Great Financial Crisis.

The securitization process has become an essential tool that provides liquidity to firms and borrowers while opening up the breadth and depth of the capital markets to previously underserved individuals and firms. Securitized products pool illiquid, idiosyncratic assets or contracts, turn those pools into claims (bonds) with a new capital structure with differing risk-return attributes, and sell those bonds to institutional investors. Securitization began in the housing market where single-family mortgages were pooled and sold to investors as mortgage-backed securities. The securitized market has increased in size and complexity to include many other asset classes such as commercial real estate loans in commercial mortgage-backed securities, student loans, credit card debt, auto leases, equipment leases, and aircraft leases in asset-backed securities. The purpose of this chapter is to describe the participants in and the general structure of securitizations.

The chapter shows that a sudden and sufficiently large contraction of bonds' liquidity could generate a fall in output, liquidity trap and price deflation, suggesting that there is no contradiction between Liquidity Crunch and Liquidity Trap, in line with the discussion in Chapter 2. The discussion is based on a simple model in which there are two types of liquid assets: fiat money and liquid bonds (e.g., Asset-Backed securities) under flexible prices. Fiat money is the liquid asset of choice for households, while under normal conditions firms have a preference for bonds. The model is employed to discuss quantitative easing (QE) in exchange for 'toxic' assets, and to show that the loss of bond liquidity could give rise to secular stagnation.

This chapter lays out the development and history of banking in the United States. It lays out the Diamond-Dybvig model of baning and explains how bank runs can arise. It closes by discussing various recent trends in banking and how they relate to investment banks and securitization