Question

Explain what it is a mortgage backed security (MBS) and how it is functions. Discuss how these securities caused 2008 USA financial crisis?

Answer 1

A mortage backed security is an investment similar to bonds but consists of many different home loans brought from banks. Like bonds MBS also receive periodic payments. These MBS are issued by banks and brought by Investment companies and periodic payment is received from customers who have taken home loans from the banks.

The entire process of MBS is:

Step 1 : Customer approaches bank to take home loan against the asset (Home) he wants to purchase.

Step 2 : Bank after taking into account the credit worthiness of borrower, grants home loans against the security of the asset and charges periodic payments.

Step 3 : Bank approaches Investment company to sell these home loans at a discount to reduce their risk and turns into a middle man for borrower and investment company.

Step 4 : Investment company receives periodic paments from the banks who collects these payments from the original borrowers.

Reasons for crisis of 2008 in USA:

1. The growing demand of home loans encouraged the banks to reduce their lending standards and a large number of MBS were created that had no assets backing or the backing they had was no adequate enough to cover the MBS amount, these were known as Sub-pime MBS and since MBS were so high in demand that the rating of credit agencies became meaning less.

2. SInce most of the MBS had no or inadequate assets backing, the borrowers started backing away from their periodic payments (Mortgage payments) since their homes were worth less than their borrowing, this started the chain of non payment which drove the market down.

3. Since most of the people were not paying their mortgages, the losses for investment companies starting increasing since their cashflow stopped and the assets against which they loans were secured were of no value. this eventually lead to insolvency for many large investment companies like Lehman brothers, and lead to the collapse of the entire market and lead to 2008 USA financial crises.