Basel III and Asset Securitization

Asset securitization via special purpose entities involves the process of transforming assets into securities that are issued to investors. These investors hold the rights to payments supported by the cash flows from an asset pool held by the said entity. In this paper, we discuss the mechanism by which low- and high-quality entities securitize low- and high-quality assets, respectively, into collateralized debt obligations. During the 2007–2009 financial crisis, asset securitization was seriously inhibited. In response to this, for instance, new Basel III capital and liquidity regulations were introduced. Here, we find that we can explicitly determine the transaction costs related to low-quality asset securitization. Also, in the case of dynamic and static multipliers, the effects of unexpected negative shocks such as rating downgrades on asset price and input, debt obligation price and output, and profit will be quantified. In this case, we note that Basel III has been designed to provide countercyclical capital buffers to negate procyclicality. Moreover, we will develop an illustrative example of low-quality asset securitization for subprime mortgages. Furthermore, numerical examples to illustrate the key results will be provided. In addition, connections between Basel III and asset securitization will be highlighted. 1. Introduction Asset securitization involves the process by which securities are created by a special purpose entity (SPE)—hereafter, simply known as an entity—and then issued to investors with a right to payments supported by the cash flows from a pool of financial assets held by the entity. There is broad-based usage of entities by financial institutions of many types, in various jurisdictions, and for many purposes (see, e.g., [1]). Securitization has been popular as an alternative funding source for consumer and asset lending in market economies. Its main objective is to improve credit availability by converting hard-to-trade and nontradable assets into securities that can be traded on capital markets. The categorization of the payment rights into “tranches” paid in a specific order and supported by credit enhancement mechanisms provides investors with diversified credit risk exposure to particular investor risk appetites (see, e.g., [2, 3]). Immediately prior to the securitization market collapse in 2007-2008, structured asset products (SAPs) such as asset-backed securities (ABSs) and collateralized debt obligations (CDOs) as well as covered bonds provided between 25 and 65% of the funding for new residential assets originated in