Question

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

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Answer 1

Answer-

Mortgage securitization is done by combining individual mortgages like property or real estate buildings which are of similar characteristics to form a pool of mortgages and these are sold as debt securities that are compensated by interest on principal payments from the pool of mortgages. The process of securitization helps in converting these illiquid assets like property and buildings or houses that are pledged as individual mortgages into securities and stocks that can be traded on stock exchanges in secondary markets.

There are different fed backed organizations like Fannie Mae, Freddie Mac which are registered agencies with Federal Housing Administration (FHA) which set guidelines to these organizations to help in pooling these individual mortgages and selling these mortgages.

The types of mortgage backed securities are Mortgage pass through securities and Collateralized mortgage obligations ( CMOs). The individuals who invest in mortgage pass through securities receive monthly payments in the form of interest and principal payments that are generated from the pool of mortgages. The CMOs are mortgage securities that are combined together and sold as one investment. These CMOs are categorized and separated into different tranches based on the maturity and level of risk involved in them.

The 2008 economic crisis also termed as the 2008 mortgage crisis and subprime crisis which pushed US into recession leading to bankruptcy of many investment banks like Lehman brothers and Bear stearns. This crisis engulfed all the financial services industry leading to turmoil of financial markets. This contagion had a ripple effect on many countries leading to financial crisis in many stock exchanges. This financial crisis was caused because of leniency by many entities like financial institutions like banks, regulators, credit agencies, lenient government housing policies, and finally the consumers who defaulted leading to crisis.

The origin of this 2008 mortgage crisis can be traced back to the creation of mortgage backed securities by many hedge funds and banks. The demand for housing increased and consumers started buying homes and other mortgage properties.

As there was spike in buying the financial institutions like Fannie Mae and Freddie Mac and other investment banks started lending loans to the consumers without due diligence and their credit worthiness. The banks sold too many mortgages to meet the demand for mortgage-backed securities sold through the secondary market.These buying was solely backed by mortgages as collateral. The insurance companies covered them with credit default swaps.

The fed started raising the interest rates and the demand for housing prices started declining in 2006 which triggered the default from the consumers. The decline in home prices led to default from consumers who in turn stopped paying the banks that they have borrowed. This caused a contagion effect on institutions like mutual funds, pension funds, and corporations who owned these derivatives. This triggered in massive fall in the demand and free fall of the banks and government backed mortgage institutions like Fannie Mae and Freddie Mac leading to heavy losses leading to bankruptcy of many private banks. This led to recession despite the efforts from federal reserve and treasury departments to avert the crisis.