Everyone has been affected in some way by the Global Financial Crisis of 2008, whether they realize it or not. And what led up to this bubble and crash was in large part due to Mortgage-backed securities. These securities were very attractive to the public, with higher interest rates and highly rated by credible credit rating agencies like Standard and Poor. And with the sudden market demand in the housing and real estate industry, many of these mortgage-backed securities had funding that was put into the market, which eventually built up a self-made cycle. People wanted to buy houses and so the mortgage was sold to banks by mortgage companies. This led to banks packaging the mortgage with other investments and the mortgage-back securities were sold to investors. The investors’ money was then used to create more money for mortgage lenders to therefore offer. Due to the contributing funds, the public that had lower credit scores started to skip on their mortgage payments. Many companies were sunk due to poor mortgage lending decisions.
But while inadequate mortgage and mortgage-back securities were a part of the downfall of the banks in the US, Credit default swaps were the true “nail in the coffin”. A credit default swap is a type of contract between two parties that ensures protection on a company’s loan or bond. The buyer gives to the seller a down payment and premiums for the seller to use to protect the buyer in the case that the company’s loan or bond were to default during the term. Although this contract sounds enticing to many, the contract itself is very volatile and susceptible to counter-party risk, making it essentially a hedging instrument.
Due to the large number of homeowners skimping on their loans because of the inability to pay their mortgages, mortgage lenders were forced to file for bankruptcy due to their losses. And while the banks took a hit from this, they were affected the most by the credit default swaps investors had in these mortgage-backed securities. Banks had to pay the investors who purchased these swaps when the lenders went bankrupt and the mortgage-backed securities’ ratings dropped. This led to many companies such as JP Morgan Chase, AIG, and Bear Stearns to give a couple of examples, forced to be bailed out by the Federal Reserve because of the state of bankruptcy they were in. This was all due to the insurance they owned to these investors.
Lucas Zhang was a Finance major at Ohio State University. He writes about finance, mortgages, and technology for Irish Mortgage Brokers.