What role did securitization play in the global financial crisis?

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What role did securitization play in the global financial crisis?

Securitization and the Financial Crisis

One of the main causes of the global financial crisis in 2007–2008 was securitization, more especially the packaging of mortgage loans into financial products that resembled bonds. When the U.S. real estate bubble burst, securitization encouraged excessive risk-taking that contributed to the collapse of several significant Wall Street and international financial institutions.

Key Takeaways

  • The financial crisis was largely brought on by the securitization of mortgage debt into bonds-like assets like mortgage-backed securities and collateralized debt obligations.
  • Home mortgage securitization encouraged excessive risk-taking throughout the financial industry, from Wall Street banks to mortgage originators.
  • Mortgage delinquencies increased as U.S. property values fell, causing Wall Street banks to suffer significant losses on their mortgage-backed securities.

How Securitization Works

The packaging of assets into a financial product is known as securitization. The securitization of mortgage debt, especially subprime mortgages, in mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), was a significant factor in both the early and mid-2000s real estate boom in the United States and the subsequent financial chaos.

Mortgages provided by banks and other lenders to homeowners were later sold to larger banks for repackaging into CDOs and mortgage-backed securities.

Mortgage Securitization and Risk

Over time, the lenders who issued the loans were no longer at danger if the homeowner failed since they were transferred to large banks for securitization. Thus, lending criteria drastically decreased. This resulted in a large number of subprime borrowers, which are borrowers who are either unqualified or underqualified, being able to get riskier loans.

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Subprime mortgages eventually contributed to the MBS and CDOs’ attractiveness to large investors since they produced better returns as a result of the higher interest rates subprime borrowers were required to pay. At the same time, the assets obtained continuously excellent ratings from credit rating agencies, which was thought to lower investors’ risk. As a result, the assets were utilized as leverage to control enormous sums of money that were many times the underlying assets’ face value.

The Music Plays On

Since the real estate market was booming and buyers were actively driving up the prices of available homes, this scenario was very advantageous for everyone. As more and more easy money entered the market, real estate prices rose by stratospheric amounts in places like California, Florida, Arizona, and Las Vegas.

Subprime borrowers who first fell behind on their payments had the option of refinancing their mortgages based on rising property prices or selling their properties for a fast profit. As long as prices were going up, the system’s level of risk was unimportant. Subprime mortgages made up about a third of the whole mortgage market by 2005, up from 10% only two years before.

The Music Stops

When the economy started to falter and housing values started to fall down to earth, things started to change. Mortgage delinquencies increased sharply when adjustable-rate mortgages started to reset at higher rates.

The value of subprime mortgages has risen to over $1.3 trillion by March 2007. A little over a year later, in July 2008, 29% of adjustable-rate mortgages were substantially overdue, and more than a quarter of subprime mortgages were in arrears. The mortgage-backed securities that banks held were in serious difficulties and desperately trying to sell them as their value plunged due to the collapse of the housing market. The global financial crisis was at its height.

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Advisor Insight

Paul McCarthy, CFAKisco Capital, LLC, New York, NY

Because I’ve worked in the industry for a long time and had a significant short on myself at a hedge fund during the financial crisis, I could write a book on the subject.

Since the 1980s, loans or leases have been packaged and sold as securities. In terms of issue volume, securitization truly got off in the 1990s and ballooned in the 2000s. It may be a highly efficient source of funding for those that underwrite loans and leases when used appropriately (auto, mortgage, credit cards, etc.).

The subprime mortgage loans that ultimately went into default and brought on a financial crisis were held by the securitizations. Due to the real estate bubble that existed in the United States between 2000 and 2006, an exceptionally high number of loans were generated during that time. Banks that had invested in these securitizations lost tens of billions of dollars, virtually bringing down the US financial system. The US government’s bailout funding helped maintain the current banking system.

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