Securitization as a Way to Financial Crisis

Securitization refers to the financial practice of pooling different classes of contractual debt and selling them as securities to third-party investors who benefit from their cash flows. Examples of such debt include residential and commercial mortgages. The practice has been criticized because of its complexity, the difficulty in monitoring risk, and the possibility of quick declines in underwriting standards. One of the main weaknesses of securitization is that it can transfer risk from financial institutions to outside investors, and as a result, spread financial risk across the economy.

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The 2008 financial crisis began in the United States’ real estate market. The bubble originated from several factors: low-interest rates, relaxed lending requirements, and an ineffective house ownership policy enacted by the government (Buchanan, 2017). The banks were motivated by the securitization of non-performing loans held by borrowers who had failed to repay them because they had no jobs or assets.

The banks and mortgage brokers disregarded the poor credit scores of borrowers because of the lure of huge profits (Baig & Choudhry, 2013). They securitized mortgages into mortgage-backed securities (MBS) and collateral debt obligations (CDOs) that were attractive to investors because of their high returns (Buchanan, 2017). In that regard, the interest rates of mortgages held by subprime borrowers increased. Moreover, the banks and mortgage brokers issued more adjustable-rate mortgages to borrowers with poor credit ratings. Subprime lending resulted in the availability of mortgages to borrowers who had poor credit scores (Deku & Kara, 2017).

Private lenders earned huge profits by selling subprime mortgages because many people could afford houses. The relaxation of credit standards by the government increased the risk of foreclosure (Buchanan, 2017). Lenders sought to make more profits, and so, they pooled their subprime mortgages into MBS and CDOs (Baig & Choudhry, 2013). Private institutions such as Fannie Mae and Freddie Mac issued higher-risk mortgages because they lacked the government’s financial backing (Deku & Kara, 2017).

Credit agencies gave high ratings to MBS and CDOs. Therefore, investors considered them as safe financial options. Portions of these securities were sold to investors who were oblivious of the high risk that they attracted. The losses incurred from mortgage defaulters were absorbed by these securities, and the investors lost their money (Deku & Kara, 2017). The value of the securitized mortgages was less than promised, and the situation was made worse by the declining value of houses. The loans that borrowers had taken were higher than the value of the houses they had bought (Baig & Choudhry, 2013).

Therefore, they were unable to repay the mortgages. This affected the banks’ balance sheets and affected their liquidity. The value of MBS and CDOs declined as default rates rose. Repossessions and foreclosures depressed property values more, and the real estate market collapsed (Deku & Kara, 2017). Many banks owned reduced-value assets that compromised trust between banks, and as a result, lending was canceled. This led to a situation where even the banks’ customers could not get access to credit. Moreover, bankruptcies, bailouts, and inflation affected the economy as the effects of the subprime mortgage crisis had spread to the rest of the economy.

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In conclusion, securitization of mortgages was one of the contributing factors that led to the US subprime mortgage disaster that caused the 2008 economic crisis. Banks gave mortgages to borrowers who could not service their loans. The banks securitized mortgages into mortgage-backed securities (MBS) and collateral debt obligations (CDOs) that had high risk and high returns. However, the value of these securities dwindled as loan default rates increased. Investors incurred huge losses, many banks and financial institutions collapsed, and customers had no access to credit services.

References

Baig, S., & Choudhry, M. (2013). The mechanics of securitization: A practical guide to structuring and closing asset-backed security transactions. New York, NY: John Wiley & Sons.

Buchanan, B. G. (2017). Securitization and the global economy: History and prospects for the future. New York, NY: Palgrave Macmillan.

Deku, S. Y., & Kara, A. (2017). Securitization: Past, present and future. New York, NY: Palgrave Macmillan.

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Paperroni. "Securitization as a Way to Financial Crisis." November 5, 2021. https://paperroni.com/securitization-as-a-way-to-financial-crisis/.

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Paperroni. 2021. "Securitization as a Way to Financial Crisis." November 5, 2021. https://paperroni.com/securitization-as-a-way-to-financial-crisis/.

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Paperroni. (2021) 'Securitization as a Way to Financial Crisis'. 5 November.

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