Mortgage-Backed Securities: A cog in the wheel of Global Financial Crisis
How the Great American dream shattered in the late 2000s.
The United States of America is synonymous with the term — The land of opportunities. People from across the globe come to the US to get a good life and one of the aspects of fulfilling this American dream is to own a house.
Generally, low and middle-income families aspire to own a house and so banks (commercial banks) offer housing loans to such customers in return for paying back the principal and interest amount on time. To make this process beneficial for both banks and potential homeowners, banks follow a strict rule of due diligence to determine which customers possess the highest and lowest risks. Banks then offer loans to those, who have great employment records, credit records, and educational backgrounds. After the tedious screening process, banks decide the value of customers before offering or not offering loans.
The Prelude
In the early 2000s, something was brewing under the tarmac of the American Economy. Banks and government agencies were unaware of a disaster that would shake the world economy in the coming years.
Generally, Banks offer loans to large sets of customers (after thorough screening of course) and get a steady cash flow as interest. If the due diligence was done properly, there is a very low chance of customers not paying (also called defaulting) and so there is always a factor of risk associated with this. But, sometimes investment banks (which are large corporate banks) propose the idea of buying all the housing loans from the said commercial bank in return for a huge payment. This eliminates the risk of defaults.
In the 1970s, The Government National Mortgage Association or Ginnie Mae coined the term “Mortgage Backed Securities”, which is bundling multiple home loans (or mortgages) into one single entity and dividing it into multiple shares. These shares are then sold off to investors similar to what investors purchase shares on wall street.
The investment banks started using mortgage-backed securities by selling off shares to investors which they initially purchased from commercial banks. But, as investment banks now carry the risk of some loans defaulting, they bifurcated the shares into segments (based on risk and maturity level) called tranches. A tranche having higher risk tends to also provide a higher yield, while a low-yield tranche would mean a lower return for investors. Investors can decide which share they wish to purchase based on their risk tolerance. This set of tranches (securities) combined with a pre-determined set of rules and agreements refers to “Collateralized Mortgage Obligation”. The CMO receives cash flows from borrowers paying their mortgages (regular payments) which act as collateral on these securities. CMOs distribute principal and interest amount to their investors based on a set of rules and agreement.
The concept of CMOs or Mortgage Backed Securities was looking great from a distance but the American dream was slowly sinking into the ocean just like the Titanic.
The onset of the Global Financial Crisis
In the early 2000s, commercial banks to receive huge payouts from investment banks started approving riskier and riskier loans. The banks were no longer applying strict due diligence to screen eligible customers and this led to the weakening of the foundation stone on which the entire mortgage market was standing.
At the same time, the interest rate reached its lowest at 1%, which led to an upsurge in the number of customers wanting to have a dream home. This meant that the lowest income groups can now have a home.
The situation turned worst when a new type of mortgage called “The interest-only, negatively amortizing adjustable-rate subprime mortgage” came into the picture (Source: New Money YouTube Channel). This meant that customers now do not need to pay the principal but the interest only. This attracted customers with almost zero income
Housing prices were continuously rising as more and more people were taking loans in hope of selling the houses at higher prices.
Rise of the Credit Default Swaps
Michael Burry, an American investor bet against the housing market, using an agreement called “Credit Default Swaps”. A Credit Default Swap is an agreement in which a person buys a contract from an investor and makes payments to the investor until the swap matures (the contract ends). In return, the seller (investor) promises that if the security fails, the seller will pay the value of the share as well as the due payments that the buyer was supposed to pay till the time of contract maturity.
Michael burry was able to visualize by analyzing publicly available datasets on government portals and came to realize that the housing economy which was then supporting the “Great American Economy” is going to collapse. This pattern of betting against the American economy was followed by other investors as well.
The Consequences
In 2008. the housing bubble finally burst as borrowers failed to pay their mortgages and the value of their potential homes hit rock bottom.
The world economy experienced a loss of $ 2.8 trillion. The U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% in 2008, reaching $10.5 trillion
(Source: https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008)
From 2008 through the first quarter of 2010, high-income countries endured seven consecutive quarters of employment loss, which amounted to over 14 million jobs, with 7 million jobs lost in the first half of 2009 alone
(Source: https://www.un.org/esa/socdev/rwss/docs/2011/chapter2.pdf)
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