Securitization, Structured Finance, and Covered Bonds

I. INTRODUCTION II. SECURITIZATION'S ROLE IN THE GLOBAL FINANCIAL CRISIS III. ADDRESSING SECURITIZATION'S PROBLEMS A. Problematic Asset Type B. Originate-to-Distribute Moral Hazard C. Servicing Conflicts D. Overreliance on Mathematical Models E. Overreliance on Rating-Agency Ratings 1. Dual Credit Ratings 2. Investor Payment of Rating-Agency Fees IV. THE FUTURE OF SECURITIZATION A. General Observations B. Alternatives to Securitization 1. Covered Bonds 2. Comparing Covered Bonds with Chinese ABN 3. Commercial Trusts Under Chinese Law 4. Trust Indentures 5. Trusts Used as Business Organizations V. CONCLUSIONS I. INTRODUCTION The author was hosted by the Shanghai Institute of Foreign Trade to present a series of high-level lectures on financial law at that institution as well as at Shanghai Jiao Tong University, Fudan University, China University of Political Science and Law, Peking University, and Tsinghua University. These lectures, presented in December 2012, focused on securitization, structured finance, and covered bonds, and they included related concepts from commercial trusts and shadow banking. This Article integrates the substance of those lectures. II. SECURITIZATION'S ROLE IN THE GLOBAL FINANCIAL CRISIS The securitization of subprime mortgage loans is widely viewed as a root cause of the global financial crisis. (3) In the United States, there was significant government pressure on banks and other lenders to make home-mortgage loans to expand home ownership, even for risky borrowers. (4) These subprime loans were often made, for example, to borrowers with little de facto income, anticipating that home-value appreciation would enable the borrowers to refinance to lower-rate mortgages. (5) Historically, home prices had generally been increasing in the united States since the Great Depression. (6) But this model failed when, in 2007 and 2008, home prices fell significantly. (7) in one sense, the precipitous drop in home prices was unexpected--like Monty Python's skit, "Nobody expects the Spanish Inquisition." (8) In another sense, though, "the fall arguably should have been anticipated based on the [earlier] liquidity glut and artificially low interest rates, driving up housing prices artificially." (9) As a result of the fall in home prices, borrowers who were relying on refinancing for loan repayment could not refinance. (10) Furthermore, many subprime mortgage loans had adjustable rates, which increased after an initial "teaser" period. (11) Borrowers, some of whom could not afford the rate increases, had expected to refinance at lower interest rates. (12) Collapsing home prices stymied those expectations. (13) For these reasons, many risky borrowers began defaulting. (14) "These defaults in turn caused substantial amounts of low-investment-grade-rated mortgage-backed securities to default and [the highest] AAA-rated securities to be downgraded." (15) This frightened investors, who believed that "investment grade" meant relative freedom from default, and that "AAA" meant ironclad safety. (16) Investors started losing confidence in rating-agency ratings and started avoiding all types of rated debt securities. (17) Fewer investors meant that the price of debt securities began falling. (18) "Falling prices meant that firms using debt securities as collateral had to mark them to market and put up cash--requiring the sale of more securities--which caused market prices to plummet further downward in a death spiral." (19) The U.S. government's refusal in mid-September 2008 to save Lehman Brothers, and its resulting bankruptcy, added to this cascade. (20) Investors lost all confidence in debt markets, and even the short-term commercial paper market virtually shut down. (21) The lack of debt financing meant that companies could no longer grow and, in some cases, even survive. …