Question

What are mortgage backed securities? It is believed that the instrument has contributed to the sub-prime crisis in the US and then the global financial tsunami. How do we explain this?

Answer 1

• A mortgage-backed security ( asset-backed security) is a kind of investment just like a bond. It is made up of a bundle of home loans which are issued by the banks and bought by the investors. Investors receive payments at regular intervals just like bond coupon payments.
• Initially hedge funds and banks created mortgage-backed securities and these securities were covered with credit default swaps by the insurance companies. Thereafter an asset bubble was caused in housing by the demand for mortgages.
• Upon increase in the federal funds rate by the Federal Reserve, the adjustable mortgage interest rates increase very steeply.
• Consequently, home prices dropped straight down at high speed and borrowers defaulted. Then the rest was done by the derivatives, which spread the risk into every nook and corner of the world.