How Mortgage-Backed Securities Caused the 2008 Financial Crisis and What We Can Learn from It

Mortgage-Backed Securities (MBS) Explained in One Minute: Did We Learn Our Lesson?

Mortgage-backed securities, or MBS, are bonds that are backed by a pool of mortgages, usually residential ones. They are created by banks and other financial institutions that originate and service the mortgages, and then sell them to investors who receive the interest and principal payments from the borrowers ¹

MBS are attractive to investors because they offer higher returns than other fixed-income securities, such as government bonds or corporate bonds. They also diversify the risk of default, since a single borrower’s failure to pay does not affect the entire pool of mortgages ²

However, MBS also have some drawbacks and risks. One of them is the uncertainty of the cash flows, since borrowers can prepay or refinance their mortgages at any time, reducing the expected maturity and yield of the MBS. Another risk is the credit risk, which is the possibility that borrowers will default on their mortgages, especially if the value of their homes falls below the amount they owe ³

This risk became evident during the 2007-2008 financial crisis, which was triggered by the collapse of the US housing market and the subprime mortgage sector. Subprime mortgages are loans made to borrowers with low credit scores or income, who are more likely to default or become delinquent. These mortgages were often securitized into MBS and sold to investors who were unaware of the true quality and risk of the underlying loans ⁴

When the housing bubble burst, many borrowers defaulted on their mortgages, causing the value of the MBS to plummet. Many financial institutions that held or traded MBS suffered huge losses and faced liquidity problems, as the market for these securities dried up. Some of them, such as Lehman Brothers, went bankrupt, while others had to be bailed out by the government or merged with other firms. The crisis spread to the global financial system and the real economy, resulting in the worst recession since the Great Depression ⁵

The financial crisis exposed the flaws and failures of the MBS market, such as the lack of transparency, regulation, and oversight, the misalignment of incentives and interests, and the excessive leverage and risk-taking. It also revealed the need for reforms and changes in the financial system, such as the Dodd-Frank Act in the US, which aimed to prevent another crisis by imposing stricter rules and standards on the MBS and other financial products and institutions ⁶

MBS are still a major part of the global financial market, as they provide funding and liquidity for the housing sector and offer opportunities and challenges for investors. However, they also carry lessons and warnings from the past, and require careful analysis and evaluation before investing in them.

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