Decoding Mortgage Backed Securities and the Housing Bubble Burst

by 22 Jun 2012

(TheNicheReport) -- Tsunami?  Hurricane?  Apocalypse?  Choose your metaphor, but each of those doomsday words were used to describe the financial crisis that began in the United States in 2008 and spread worldwide like a contagion. Causing massive economic destabilization, unemployment and the worst recession since the 1930s. Most experts agree that it was the bursting of the U.S. housing bubble that began building shortly after the collapse of the Internet bubble in the early 2000s that triggered the crisis. Many believe that the single most important cause of the crisis was the rise, expansion and overuse of the mortgage backed security.

Naturally, when you get a mortgage, you assume the monthly payments you make are going to the bank. But often, what actually happens is your mortgage is bundled together with other mortgages and sold to institutional investors (pension funds, etc.) here and around the world. The bundled-together mortgages are known as mortgage backed securities (MBS). Institutional investors like the reliable income. You still send your check to the bank but the money gets passed through.

To understand this, let’s use a simple example, leaving out specific interest rates. If you borrow $100,000 for 30 years to buy your home, over time, with interest, you will end up paying more like $300,000. It’s for you because you can make low payments, build equity in your home while living in an asset you will eventually own. It’s good for the bank, because, well, they loaned you $100,000 and they get $300,000 back.

But even better for the bank is if they get the $300,000 now, which is why they bundle the mortgages into MBS and sell them to institutional investors. The bank gets the bulk of the $300,000 up front and the investors get the steady income. This generally makes it easier for more people to get mortgages, which is usually a good thing as long as credit standards are high. But if the bank gets paid up front, why ensure the people borrowing can actually repay? 

This, many believe, led to lower lending standards, which led to more people with questionable credit now being able to get mortgages. More people in the housing market meant higher home prices, which led to speculation (i.e., flipping homes for a quick profit) and lots of people buying second homes. This works fine as long as the economy is healthy and people can pay their mortgages.

But then the music stopped.  A recession began in late 2007; meaning people lost jobs, weren’t able to pay and defaulted on their loans. The same positive forces that fueled the bubble were now negative and pushing home values increasingly down forcing more and more people to default even if they could pay. Why pay $1,000 a month for a house you paid $100,000 for that’s now worth $50,000?

The ripple effect impacted MBS, which became less and less valuable as repayments stopped. It began to impact banks as they had created so many MBS and now couldn’t sell these “toxic assets.” The idea that the largest financial institutions in the world were broke caused a global panic. It caused the United States government to step in with the bank bailouts and other measures.

MBS can have a positive impact if credit standards are high, but can have profoundly negative effect if not closely monitored as demonstrated in 2008.
 

Roger Moore is a Real Estate Tax Accountant in the Pacific Northwest. He also writes for several  financial publications as well as about online accounting schools for PETAP.

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