Question

To explain the role securitisation played in the 2008 crisis,

1,Brief description of the US household market.

2,Explain the originate to distribute model

3,Explain of the securitisation process

Answer 1

The securitization of subprime mortgages into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) was a major contributing factor in the subprime mortgage crisis. Subprime MBS and CDOs were attractive to investors due to the higher interest rates they offered versus assets backed by prime mortgages. Subprime borrowers with less than perfect credit had higher interest rates on their mortgages due to the increased risk of default. Further, many loans with adjustable-rate mortgages were made that later added a great deal of fuel to the mortgage crisis.

During this time, lenders pooled the subprime mortgages into MBS and CDOs. These financial products often received high ratings from credit agencies. Tranches of these securities were then sold to unsuspecting investors, who were not aware of the risk associated with them. The lower-quality tranches offered higher interest rates but absorbed the first losses associated with defaulting mortgages before the senior tranches.

Subprime lending caused a dramatic increase in available mortgage credit. Many loans were made to borrowers who would have previously had difficulty obtaining mortgages due to below-average credit scores. Private lenders made a lot of money by pooling and selling the subprime mortgages. However, the risk of foreclosure increased with the relaxing of credit standards. Lenders and buyers incorrectly assumed that real estate values were impervious to a downturn. Private-label MBS provided a lot of the necessary capital for the subprime mortgages. Around 80% of subprime loans were made with private-label MBS in 2006. In March 2007, the value of subprime mortgages was valued at around $1.3 trillion. The mortgages issued by private lenders had greater risk since they were not backed by the government, like those from Freddie Mac and Fannie Mae.

The real estate market boomed, with more buyers bidding up the prices of available houses. The real estate markets in Florida, Arizona and the Las Vegas area were very hot during this time. At first, subprime borrowers who fell behind could refinance their mortgages based on higher property values or could sell homes at a profit. The amount of risk for subprime mortgages was not an issue at this time.

Only when property values began to decline did issues begin to appear. Adjustable-rate mortgages began to reset at higher rates, and mortgage delinquencies grew substantially. The default on subprime mortgages led to more problems. By August 2008, around 9% of all mortgages in the U.S. were in default. MBS and CDOs began to lose value with the higher default rates. Freddie Mac and Fannie Mae were seized by the government in 2008 as they began to realize large losses. Foreclosures and repossessions increased, with more properties being placed on the market as banks attempted to liquidate their inventories. This depressed property values even more, leading to a downward spiral for the real estate market. Some borrowers attempted short sales for their underwater mortgages, but they often found lenders difficult to work with or unwilling to negotiate.

• The housing sector did not rebound, as was the case in prior recession recoveries, as the sector was severely damaged during the crisis. Millions of foreclosures had created a large surplus of properties and consumers were paying down their debts rather than purchasing homes.
• Credit for borrowing and spending by individuals (or investing by corporations) was not readily available as banks paid down their debts.
• Restrained government spending following initial stimulus efforts (i.e., austerity) was not sufficient to offset private sector weaknesses

An originate-to-distribute (OTD) model of lending, where the originator of a loan sells it to various third parties, was a popular method of mortgage lending before the onset of the subprime mortgage crisis. We show that banks with high involvement in the OTD market during the pre-crisis period originated excessively poor quality mortgages. This result is not explained away by differences in observable borrower quality, geographical location of the property or the cost of capital of high and low OTD banks. Instead, our evidence supports the view that the originating banks did not expend resources in screening their borrowers. The effect of OTD lending on poor mortgage quality is stronger for capital-constrained banks. Overall, we provide evidence that lack of screening incentives coupled with leverage induced risk-taking behavior significantly contributed to the current sub-prime mortgage crisis.

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. It is process of separating certain assets from the balance sheet and using them as collateral for the issuance of securities.