Question

Briefly explain mortgage securitization and how it contributed to the economic crisis.

Answer 1

We will explain the meaning of mortgage securitization with the help of an example.

Suppose there is a bank called Bank A. Bank A wants to distribute home loans worth 100 crores in the market. It uses up the entire 100 crores to issue home loans. So now the bank has 100 crores worth of assets but they are all illiquid assets. In order to re-instate its liquidity and enable it to have more money to use, it will create an SPV( Special Purpose Vehicle) which will convert these illiquid assets( receivables) into securities and then sell these securities to investors. This will give the SPV money which will be given back to the bank. Now, in case the debtors default on their payment, the bank can use up the mortgage on the loans to pay the investors. Thus they are also known as mortgage backed securities.

During a financial boom, this does not occur as a problem. But during a period of slowdown, the amount of defaults went up and the mortgages were not being sold at the value attributed to them. This increased the rates of default to investors and thus higher default interests as also the banks and other financial institutions began incurring losses and the govt had to intervene to shut them down.