Question

Consider the GFC of 2008
a/ Why were mortgage backed securities (MBS) considered toxic. Explain your working and answer in words.

b/ What caused MBS to rapidly lose value? Explain your working and answer in words.

Answer 1

Mortgage backed securities are the investments that are backed by assets like a home loan. in case of default, investor can sell the MBS and recover money. However, the sucess of any MBS depends on the market health of the asset that backs it up. For example, home loans are MBS because they are backed by the house. In case of default, bank can sell the house and recover its payment. A borrower will continue to pay the payments till the time they are sure that the value of asset is increasing and it is profitable to keep hold of the asset for future. However, if the price of assets starts falling such that borrower feels that the value of asset is lower than the repayment to be made on the loan, he will prefer to default. Since, the price of property is falling, Banks will not be able to find buyers who will be willing to put their money in a depreciating investment. Therefore, assets will turn toxic.

A toxic asset is an asset tha has no potential buyer due to its depreciating value. in GFC of 2008, because of shattering of housing price bubble, multiple defaults led to too much supply of properties in the market with no potential buyers leading to the financial crisis. Mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth. Therefore, MBS are considered toxic assets because the sucess of MBS depends on the security of the mortgage along with proper functioning of all the agents involved in the transaction, i.e. borrower pays the dues, rating agencies maintain due diligence on the health of the assets. if any of these factors crash, it leads to crashing of the system and converting MBS into toxic assets.

b) Housing prices were increasing by 2004 to peak levels and therefore, Fed tried to lower down the overheated market by raising federal funds rate. The subprime lending by the hedge funds and the banks along with increasing federal rates let to plummeting of house prices and defaults by the borrowers. As the home values increased over the years, houses were bought as investments due to low mortgage rates. Insurance companies guaranteed subprime mortgages along with loans to people who were not qualified to get loans. This led to GBC of 2008.