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Topic: Mortgage-Backed Securities

Question: What are the perceived advantages of


mortgage backed securities? How did these securities
contribute to the global financial crisis of September
to October 2008?
4/20/2009
Mortgage-Backed Securities (MBS) are a relatively new phenomenon. The U.S. Securities and
Exchange Commission defines them as “debt obligations that represent claims to the cash flows
from pools of mortgage.”(sec.gov, 2008). The creation of MBS is described by Salman Khan as
a simple process, starting with several mortgagers being bundled into a ‘mortgage pool’ by a
mortgage institution. The mortgagers’ payments will then be transferred to an investment bank
which pays the mortgage institution a fee for this mortgage pool. The investment bank would set
up an entity which has the responsibility of accepting these payments. To increase profits, this
entity would issue shares to the public based on the perceived rate of payments by mortgage
borrowers. This ensures that the owners of shares receive some return on their funds either from
mortgagers or, should a default occur, the sale of the building. These shares are called Mortgage
Backed Securities (Salman Khan, CNN News Network, 2008).

There are a number of advantages and disadvantages stemming from Mortgage Backed
Securities. First, there is a fairly high rate of return, low risk and high liquidity for investors as,
whether or not mortgagers repay, the sale of the asset will guarantee that the value of the
property is recovered (How Can Mortgage- Backed Securities Bring Down the US Economy?,
Josh Clarke, 2008). The fee from sale and transferral of transaction costs is a bonus for banks
that create the mortgage pools. Also, borrowers have greater access to national markets
(Financial Markets and Institutions, Mishkins and Stanley, 2006, pg 299). On the other hand,
MBS are highly exposed to credit, asset price, liquidity and counterparty risks. Moral hazard is
another draw back as the threats of default payments and prepayments are often passed from one
institution to another.

During the period 2007-2008, Americans had easy access in obtaining a mortgage. Due to the
great demand investors had for MBS, financial corporations tried to increase supply by issuing
mortgages to persons who under normal circumstances would not have been given a loan. This
led to the creation of “sub-prime” mortgage pools. The interest rates for sub-prime MBS were
higher than other MBS due to the increased risks involved. This high interest rate caused demand
to be even higher thereby precipitating this cycle of easy loan grants. The securitization of sub-
prime mortgagers is therefore the chief reason for the current Financial Crisis (Alan Greenspan,
2008).

Mortgage Backed Security’s rate of return is based on mortgagers ability to repay. In October
2008, the Financial Crisis reached its peak: the value of American homes had devalued, interest
rates fell and a larger number of mortgagers tried refinancing their loans. Refinancing became
difficult; consequently, mortgagers were forced to default on payment. There are two scenarios
that took place when this occurred: the price of the MBS fell resulting in assets and equity
declining (this arises from the accounting equation whereby assets are equal to liabilities and
equity) and the returns that banks received from the sale of the property were less than the
present value of the asset. This resulted in the need for banks to be “bailed out”.

The Financial System is a global network and as such has been impacted greatly by the mortgage
crisis. International banks and governments that had assets in these ‘sub-prime mortgage pools’
have lost substantial equity. The term ‘Global Financial Meltdown’ is an ample description of
this anarchy of rapidly devaluing funds caused by Mortgage Backed Securities.