Question

The rise of MBS, mortgage-backed securities, and other somewhat complex financial instruments is thought to be one the primary causes behind the Global Financial Crisis and the Great Recession following the crisis. Describe what securitization means and how incentives of all participants (i.e. borrowers, local banks, national banks, investment banks, insurers) led to the incredible rise of MBS in the leadup to the crisis.

Answer 1

Mortgage - backed securities are groups of home mortgages that are sold by the issuing banks and then packaged together into "pools" and sold as a single security. This process is known as "securitization."

The unique aspect of mortgage backed securities is the element of prepayment risk. This is the risk that investors decide to pay back the principal on their mortgages ahead of schedule. The result, for investors in MBS, is an early return of principal.

This means that the principal value of the underlying security shrinks over time, which in turn leads to a gradual reduction in interest income. prepayment risk is typically highest when interest rates are falling since this leads homeowners to refinance their mortgages. In this scenario, the owner of the MBS is forced to reinvest the returned principal at lower rates - a problem known as reinvestment risk.

Hedge funds, banks, and insurance companies caused the subprime mortgage crisis. Hedge funds and banks created mortgage backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing. When the Federal Reserves raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spreads the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the great Depression.

Mortgage- backed securities allow lenders to bundle loans into a package and resell them. In the days of conventional loans , this allowed banks to have more funds to lend. With the advent of interest - only loans, this also transferred the risk of the lender defaulting when interest rates reset. As long as the housing market continued to rise, the risk was small.

The advent of interest- only loans combined with mortgage-backed securities created another problem.They added so much liquidity in the market that it created a housing boom.