Question

Explain the role of “securitization” as a cause of the financial crisis of 2008. Be sure to explain what mortgage securitization is and why it caused problems.

Answer 1

A major contributing factor in the subprime mortgage crisis was the securitization of subprime loans into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Subprime MBS and CDOs are attractive to investors as they offered higher interest rates than prime mortgage-backed securities. Due to the increased risk of default, subprime lenders with less than good credit had higher interest rates on their mortgages. In fact, most loans were made with adjustable mortgages, which later added a lot of fuel to the mortgage crisis.

Lenders pooled the subprime mortgages into MBSs and CDOs during this period. These financial products have often received high credit agency ratings. Then tranches of these securities were sold to unsuspecting investors who were unaware of their risk. The lower-quality tranches received higher interest rates, but before the senior tranches they suffered the first losses associated with defaulting mortgages.

With more buyers bidding up the prices of available houses, the real estate market boomed. During this time, the real estate markets in Florida, Arizona and the Las Vegas area have been very hot. At first, subprime lenders who fell behind were able to refinance their mortgages on the basis of lower property values and sell homes at a profit. At this time, the level of risk for subprime mortgages was not a problem.

Problems only started to appear when property values started to decline. Adjustable loans continued to reset at higher rates, and there was a substantial increase in mortgage delinquencies. There were more issues with the default on subprime loans. Roughly 9 percent of all U.S. mortgages were in default by August 2008. With the higher default rates, MBS and CDOs started to lose value. In 2008, the government seized Freddie Mac and Fannie Mae as they began to realize major losses.

The securitizations held the subprime mortgage loans, which eventually failed, triggering a banking crisis. The number of loans originating in the period 2000-2006 was unusually large because in the United States we had a real estate bubble. The banks holding such securitizations as securities lost hundreds of billions of dollars, nearly triggering the collapse of the US banking system. The U.S. government's bailout money has preserved the banking system we have today.