Securitization, specifically the packaging of mortgage debt into bond-like financial instruments, was a key driver of the 2007-08 global financial crisis. Securitization fueled excessive risk-taking that brought many major financial institutions on Wall Street and around the world to their knees when the U.S. real estate bubble burst.
Key Takeaways
- Securitization of mortgage debt in bond-like investments such as mortgage-backed securities and collateralized debt obligations was a big cause of the financial crisis.
- Securitization of home mortgages fueled excessive risk-taking throughout the financial sector, from mortgage originators to Wall Street banks.
- When U.S. housing prices began to fall, mortgage delinquencies soared, leaving Wall Street banks with enormous losses on their mortgage-backed securities.
How Securitization Works
Securitization is the packaging of assets into a financial product. The securitization of mortgage debt, particularly subprime mortgages, in mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), was a major cause of both the U.S. real estate bubble in the early and mid-2000s and the financial havoc that resulted from the popping of that bubble.
Banks and other lenders who issued mortgages to homebuyers then sold those mortgages to bigger banks for repackaging into mortgage-backed securities and CDOs.
Mortgage Securitization and Risk
Over time, because lenders issuing the loans passed them along to big banks for securitization, they were no longer at risk if the homeowner defaulted. So lending standards fell dramatically. This meant that many unqualified or under-qualified borrowers—known as subprime borrowers—were able to secure risky loans.
Down the line, the subprime mortgages in MBS and CDOs made them attractive to big investors because they generated higher returns due to the higher interest rates subprime borrowers were paying.
At the same time, that bundling was believed to reduce investors' risk, and the assets consistently received stellar ratings from credit rating firms. So the assets were used as leverage to control many trillions of dollars—many times the face value of the underlying assets.
The Music Plays on
This situation was highly profitable to everyone as the real estate market boomed, with buyers aggressively bidding up the prices of available houses. Places such as California, Florida, Arizona, and Las Vegas saw astronomical home price increases as more and more easy money flooded the market.
At first, subprime borrowers who fell behind on their payments could refinance their mortgages based on higher property values or could sell their homes at a quick profit. The amount of risk in the system was not an issue as long as prices were rising. By 2005, subprime mortgages represented nearly a third of the total mortgage market, up from 10% only two years earlier.
The Music Stops
Things changed when the economy began to weaken and home prices began to drift back toward earth. Adjustable-rate mortgages had already begun to reset at higher rates and mortgage delinquencies surged higher.
By March 2007, the value of subprime mortgages had reached around $1.3 trillion. A little more than a year later, in July 2008, more than a fifth of subprime mortgages were delinquent, and 29% of adjustable-rate mortgages were seriously delinquent.
The housing market was in free fall and the banks holding mortgage-backed securities were in big trouble, scrambling to get rid of them as their value plummeted. The financial crisis was in full swing.
Advisor Insight
Paul McCarthy, CFA
Kisco Capital, LLC, Mount Kisco, NY
I could write a book on this topic because I worked in the business for many years and I had the big short on myself at a hedge fund I worked at during the financial crisis.
Securitization is the packaging of loans or leases and has been around since the 1980s. Securitization really took off in the 1990s and exploded in the 2000s in terms of issuance volume. Used wisely, it's a very effective form of financing for underwriters of loans and leases (auto, mortgage, credit cards, etc.).
The securitizations owned the subprime mortgage loans that eventually defaulted and caused a banking crisis. The number of loans originated in the 2000-2006 period was unusually large because we had a real estate bubble in the United States. The banks that held these securitizations as investments lost tens of billions of dollars which almost caused the US banking system to collapse. The bailout money provided by the U.S. government preserved the banking system that we have today.
How Did Securitization Cause the Financial Crisis?
Securitization involves the packaging of products, in this case, mortgages, into a financial asset that is similar to a bond, for investors to purchase and receive an income stream from the mortgage payments. Many economists and policymakers believe this led to the financial crisis because many of these mortgages were made to low-quality borrowers, with banks taking on excessive risk by making these mortgages. In addition, many of these securitized assets were incorrectly rated by the rating agencies, making them seem safer to investors, which adversely impacted the investors when borrowers started defaulting on their mortgages. Overall, the securitization process resulted in banks taking on excessive risk and passing that risk onto investors.
How Does Securitization Affect the Economy?
Securitization allows for more credit to be available in the economy, meaning banks can lend more. When banks make loans, there are only so many loans they can make that are supported by their balance sheet. Banks sell off these loans to other financial institutions, which then securitize them into a product to sell to investors. When banks sell these loans, it frees up their balance sheets, allowing them to make more loans.
Why Is Securitization Risky?
Securitization can be risky if there is little knowledge about the quality of the assets that make up the securitized products. Investors need to know the quality of the underlying assets in a securitized product so they can accurately gauge the risk they are taking on, understanding the possibility of default and their preparedness for it.
The Bottom Line
Mortgage securitization involves packaging multiple mortgages into bond-like investments for investors to purchase and gain exposure to the mortgage market, which would otherwise be difficult. This process led to the subprime meltdown as poorly reviewed mortgages began to default, impacting the income streams on these securitized products. It was a domino effect that impacted investors and loan originators, leading to the financial crisis.
