Question

During the 2008 Financial Crisis MBS, CDOs and CDS had a certain relationship. Discuss how banks, insurance companies and rating agencies were involved with MBS, CDOs and CDS. (you can also watch The Big Short to support your response)

Answer 1

My answer will be based on the Big Short Movie only:

• The concept of MBS or Mortgage Backed security strated long before the 2008 financial crisis. It was started by Lewis Renerie. He came up with concept of MBS whcich is nothing but a bundle of various loans or mortgages such as vehicle loan, student loan, home loan. It was believed that people will not default on their mortgages. Therforem, it was considered to be one of the safe instrument.
• Then came the concept of Collateralized Debt Obligation or CDOs whcih is a also combo of MBSs but the one which are subprime or not of good quality. During the 2008 and years before that, banks started lending aggresively to people at lower FICO scores and started lending to sub prime people and they collected all these loand and securitized them to form a new pool.
• These securitized loans were further rated by rating agencies as good one although it was a combination of lowe trance securities. People started buying these securities based on their higher rating.
• Then came the concept of Credit Default Swap, when Michael Burry ad few other people realized that the housing market will collapse. So, they created this new instrument with the Insurance companies.
• Under the CDS, the owner of the CDS will continue to pay the premium if the housing market goes up and if it collapse, then the holder will receive the insurance on that paricular portfolio of MBS(if it defaults)

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