Question

10. Historically, Fannie Mae and Freddie Mac went to banks and other mortgage originators, firms that loaned money to homebuyers, and buy their mortgages. This allowed the banks and other originators to make still more mortgage loans. Fannie and Freddie and investment banks would combine mortgages and sell them to individuals and businesses in the form of mortgage-backed securities (MBS).

In financial investing, there is generally a tradeoff between risk and reward. Greater returns usually come with greater risks. Financial investors interested in investing in the U.S. housing market while prices were still rising, sometimes at double-digit annual rates (“Flip This House”), became interested in U.S. mortgage-backed securities issued by Fannie and Freddie and major investment banks

a. How did private markets evaluate the default risk of MBS and why were risks so underpriced prior to the 2007-09 recession?

b. Conservative investors in MBS could buy a form of “insurance,” from other firms including traditional insurance companies (AIG) called credit default swaps, against potential mortgage defaults. When MBS became toxic assets, what happened in the market for these insurance-like contracts?

Answer 1

Ans A) The private market consists of banks, institutions who sell their portfolio of investments and investors who buy them after evaluation. Before the Great Recession, the hedge funds created a demand for the Mortgage-backed securities and guaranteed them through the credit default swaps. Plus the banks who kept on creating demand for the MBS even if the borrowers were the subprime ones. This mix of the borrowers made the MBS very fragile but not many investors knew that.

Even the credit rating companies falsely listed the ratings of these securities. This high demand made the interest rates very low, thus inviting more investors. However, this great bubble burst open as the liquidity started rising in the market and after the fed raised the interest rates. And what happened after that was loan payment default because the interest rates went up and the borrowers weren't able to pay them off. The value of the assets crumpled and the Great recession took place.

This way the risk was really undermined before the great recession hit the economy. The transparency was not there and for the profits, MBS selling institutes broke the trust of the investors. The situation was also couldn't be controlled properly because of the deregulation in the market.

Ans B) The credit default swap or other insurance-like contracts became a part of the toxic asset after the economy collapsed and the Great Recession took place. They became a threat to the solvency of the banks and the institutes that owned them. They lost their value and couldn't be used to back with the MBS or investments thus making it difficult to sell them at all. This created fear in the minds of the investors and their demand fell more and more.