ECON30005 · Money and Banking
The Global Financial Crisis: Securitisation and Shadow Banking
Week 9 dissects the global financial crisis. It sets out the mechanics of securitisation — origination, transfer to a special purpose vehicle, tranching into senior/mezzanine/equity, credit enhancement, ratings and the cash-flow waterfall — and how the shift from originate-to-hold to originate-to-distribute weakened lending standards. It covers shadow banking and wholesale funding (repo, asset-backed commercial paper, haircuts), how falling prices and counterparty fear froze funding markets, and the policy responses. Expect true/false on wholesale-funding stress and short essays on how securitisation changed banking.
What this chapter covers
- 01Why banking innovated: deposit-rate deregulation, competition from commercial paper and money-market funds squeezed traditional banking
- 02Securitisation mechanics: origination → transfer to an SPV → tranching (senior/mezzanine/equity) → credit enhancement → rating → issuance → cash-flow waterfall
- 03Re-securitisation into CDOs and CDO-squared, and the resulting opacity and interconnectedness
- 04Originate-to-hold vs originate-to-distribute: selling loans weakened screening and monitoring incentives
- 05Shadow banking: credit intermediation outside the regular, regulated banking system
- 06Wholesale funding: repo (repo rate, haircuts) and asset-backed commercial paper as short-term, run-prone funding
- 07The crisis chain: subprime defaults → MBS/CDO losses → solvency fears → wholesale-funding stress (rising haircuts) → fire sales and contagion → major failures
- 08Policy responses: near-zero rates, liquidity facilities, QE, fiscal stimulus, and Basel III (micro- and macroprudential)
A run on repo: how rising haircuts freeze funding
- +1Repo mechanics: the lender advances the collateral value less a haircut, so amount borrowed = collateral × (1 − haircut). The haircut is the lender's cushion and must be funded by the borrower's own equity.
- +1(a) Normal times, 4% haircut: borrowing = 200 × (1 − 0.04) = 200 × 0.96 = $192m. The dollar haircut is 200 − 192 = $8m, which the borrower must finance itself.
- +1(b) Crisis, 25% haircut: borrowing = 200 × (1 − 0.25) = 200 × 0.75 = $150m. On the same collateral, rollover funding falls from $192m to $150m — a funding gap of $42m the borrower must plug immediately.
- +1Why self-reinforcing: to cover the $42m gap the entity sells assets into a falling market (a fire sale), which pushes prices down further, which raises haircuts again and widens the gap — a wholesale-funding doom loop. This 'run on repo' is how solvency fears in opaque securitised products froze funding markets in 2007-08.
Key terms
- Securitisation
- Converting illiquid loans (such as mortgages) into tradable securities by pooling their cash flows in a special purpose vehicle and selling claims to investors. It provides liquidity and transfers risk but can weaken lending standards.
- Tranching
- Slicing a securitised pool into senior, mezzanine and equity tranches that absorb losses bottom-up (equity first) and are rated top-down (senior often AAA), so investors with different risk appetites can be matched.
- Originate-to-distribute
- The model in which a bank makes loans intending to pool, tranche and sell them rather than hold them. Because the originator no longer bears the credit risk, its incentive to screen and monitor borrowers is weakened.
- Shadow banking
- Credit intermediation involving entities and activities outside the regular, regulated banking system (SPVs, money-market funds, dealers funded via repo and ABCP). It performs bank-like maturity transformation without a deposit-insurance backstop.
- Repo and the haircut
- A repurchase agreement is short-term collateralised borrowing; the repo rate is its interest and the haircut is the collateral value minus the amount borrowed. A rising haircut cuts available funding on the same collateral — the run-on-repo mechanism.
- Collateralised debt obligation (CDO)
- A structured product backed by a pool of debt (including MBS/ABS tranches); re-securitisation into CDOs and even CDO-squared multiplied complexity and opacity and increased interconnectedness before the GFC.
The Global Financial Crisis: Securitisation and Shadow Banking FAQ
How did securitisation change banking before the GFC?
It shifted banking from originate-to-hold to originate-to-distribute. Traditionally a bank kept the loans it made, bore the credit risk, and therefore screened borrowers carefully. Securitisation let banks pool loans, tranche them, and sell them as MBS and CDOs, which freed funding, transferred risk to investors and cut regulatory capital. But because originators no longer held the risk, their incentive to screen and monitor weakened, and strong investor demand for highly rated products fuelled lax underwriting and excess lending — especially subprime — setting up the crisis.
What is a 'run on repo' and why did it matter?
Wholesale-funded institutions borrow short-term in the repo market against securities, subject to a haircut. When fears about the value of opaque securitised products rose in 2007-08, lenders demanded much larger haircuts and refused to roll over funding. On the same collateral an institution could suddenly borrow far less, opening a funding gap that forced fire sales, which lowered prices and raised haircuts further. This self-reinforcing run on short-term funding — not classic depositor runs — was the core mechanism that froze markets.
How does tranching allocate losses and ratings?
A securitised pool is sliced into tranches with a strict priority. Losses hit the equity (most junior) tranche first, then mezzanine, and only reach the senior tranche if losses are large, so the senior tranche is protected by the subordination beneath it and is often rated AAA. Cash flows run the other way through a waterfall: senior investors are paid first, then mezzanine, then equity. The design lets one pool serve investors with very different risk appetites, but it depends on the loss estimates being right.
Can AI help me with the GFC material in ECON30005?
Yes. Sia can walk through the securitisation waterfall, compute repo haircut and funding-gap numbers, and help you structure a mark-by-mark essay on originate-to-distribute or wholesale-funding stress. Use it to rehearse the mechanics and the crisis chain; it does not complete graded quizzes for you, and you should confirm assessment rules on Canvas.
Exam move
This week rewards being able to tell the story in the right order. Learn the securitisation pipeline as a labelled chain (origination → SPV → tranching → credit enhancement → rating → issuance → waterfall) and the originate-to-hold versus originate-to-distribute contrast, because the 'how securitisation changed banking' essay is a recurring six-marker. Then master the wholesale-funding mechanics: repo, haircuts and the run-on-repo spiral, and be able to compute borrowing = collateral × (1 − haircut) and the funding gap. Keep the crisis chain (subprime defaults → MBS/CDO losses → solvency fears → funding stress → fire sales → failures) as a one-line sequence, and note the policy responses and Basel III's micro- and macroprudential split. A favourite true/false concerns wholesale-funding stress rather than deposit runs. Confirm the exam structure on Canvas.
Working through The Global Financial Crisis: Securitisation and Shadow Banking in ECON30005? Sia is AskSia’s AI Economics tutor — ask any ECON30005 The Global Financial Crisis: Securitisation and Shadow Banking question and get a clear, step-by-step explanation grounded in how ECON30005 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
