Question

However, economists now believe mortgage backed securities had contributed to property inflation in the US before the sub-prime crisis. Explain.

Answer 1

What is an MBS ?

Mortgage Backed Securities are bond like instruments which are issued by smaller banks to bigger banks. The underlying asset in an MBS are home loans that these smaller banks issued to individual home-owners. SO esentially the home loans that the small banks issued to common people were repackaged and rebudnled in such a way that they attain bond like features and bigger banks would invest in those bond like instrukents called Mortgage backed secuirties.

These MBS paid the most important central role in the sub prime lending crisis that crushed Lehman brothers and shook the world financial markets.

How did that happen:

Securitization and Risk:Because the smaller banks could repackage and sell MBS to bigger banks, they were no longer carrying the risk of default by the home-owners. Since there was no longer any risk, these smaller institutions reduced the standard of lending. That is they would give loans to under qualified or even unqualified people. These underqualified homeonwners are otherwise termed as subprime borrowers.

Why bigger banks invested in these MBS: These subprime mortgaged in time started paying very high and attractive returns as most poeple were able to secure loan and willing to pay higher returns. Also, it was beleived that the investor's risk is reduced because there is a mortgage backing to the bond instrument. For these 2 reassons, the credit rating was always high.

Why were people paying higher interests. Because home loans were now easily available, more indivisuals bidded to buy homes and therby increasing the real estate market boom. Individuals were able to refinance their houses for a higher value now and even if that did not work out, they could sell their houses for a higher value now and create a quick profit.

What happened then: Everything changed when slowly the demand went down and the real estate market started to go down. The home owners gave up their homes instead of repaying the loans. What would the banks do with all those houses and no one to buy !! The whole market went down resulting in a financial crisis.

Hope this helps. Rephrase accrding to your understanding.