Mortgage Backed Securities and their role in the economic crisis - Essay Example

Mortgage Backed Securities and their role in the economic crisis Introduction Mortgage Backed Securities (MBS) refers todebt responsibility that stands for claims to the cash flows from pools of mortgage loans, most commonly on residential property. These are loans that are normally purchased from mortgage companies, banks and originators and then they are assembled into groups by a private entity, a governmental or a quasi governmental. The securities are then offered by the entity. These securities are offered in a process called securitization that represents the claims on the principal and interest payments made by borrowers on their loans in the group. Most of the mortgages are offered by a U.S. Government agency known as the National Mortgage Association (Ginnie Mae) or the U.S government-sponsored agencies which comprises of the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). The key driver of mortgage rates will continue to be the outlook for economic growth and not the modest selling that Treasury is undertaking," said Greg McBride, senior financial analyst at Bankrate.com. He noted that rates sank to a three-month low last week amid concerns about an economic slowdown due to the disaster in Japan (wall street journal MARCH 22, 2011)Mortgage bonds or mortgage-backed securities were secured by a mortgage on one or more assets. They are generally backed by real property or real estate holdings such as equipment. The mortgage bondholder has a claim to the underlying property and can sell it off to compensate for the default if the homeowner paying their mortgage defaults. Mortgage Backed Securities display a range of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. Collaterized mortgage obligations or mortgage derivatives are more complicated MBSs and may be designed to protect investors from or expose investors to various types of risk. Economic crisis Economic crisis refer to a situation where the economy of a nation or a country undergoes a sudden downturn which is brought about by financial crisis. This will normally lead to a fall in the countries’ GDP, a rising and falling of prices because of inflation and deflation and a drying up of liquidity. It normally can take a form of recession or a depression. The economic crisis began with bursting of the united states housing bubble and high default rates on subprime adjustable rate mortgages (ARM),and variable rate mortgages beginning around 2005 to 2006(Wall Street Journal, December 4, 2007). Prior to the crisis, the government policies and competitive pressures encouraged high risk lending practices for several years. The role of Mortgage Backed Securities in the economic crisis The financial crisis was highly felt in the market in 2008. The civil fraud charges was filed against several major credit rating agencies for their role in developing mortgage bond that helped bring about the financial crisis in 2008. The Wall Street Journal reported that the U.S. Securities Exchange Commission (SEC) is currently looking at the role these companies played in the crisis and exploring the possibility of holding them accountable. The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other. As the crisis deepened, more and more financial firms either merged, or announced that they were negotiating seeking merger partners. (Wall Street Journal. Online, May 2008). Credit risk arises because the borrower has the option of defaulting on the loan one owes. In the real sense, the lender is the one who bore the credit risk on the mortgages issued. It was made possible for lenders to sell the right to receive the payments on the mortgages they issue through the process called securitization which are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). This led to several risks in the financial sector including credit risk, the asst price risk, the counter party risk and liquidity risk. The aggregate effect of these risks finally damaged the entire financial system when formerly financial system uncorrelated risks shift and became highly correlated. The payments received by MBS declined due to homeowners default and this led to the contemplated high credit risk. The entire mortgage industry and investors felt a significant adverse effect. This effect can be seen by the high levels of debts that that the businesses and households have greatly experienced in the recent years. Since the major consequences of MBS is a closer integration of the U.S. mortgage market and housing with global financial markets, American lending mortgage have a global impacts. On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Through 2008, large daily drops became common, with, for example, the KOSPI dropping about 7% in one day, although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis. (Wall Street Journal, July, 2007). Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments. According to Wall street Journal According, the SEC is reviewing the conduct of specific credit rating agencies, including McGraw Hill’s Standard and Poor’s and Moody’s Investors Service owned by Moody’s Corp., in relation to at least two mortgage-bond deals. Conclusion Mortgage Backed Securities (MBS) refers to debt responsibility that stands for claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage backed securities have played a major role in the financial crisis and are not very popular as a result. The securitisation of mortgage-related debt has played a major role in the surfacing and explosion of the current economic crisis. Justifiably, this led to extensive usefulness of such instruments for assigning macroeconomic risk. It is now obvious that the repackaging of mortgage debt in Mortgage-Backed Securities can have huge cumulative costs, but so far there is no one who has empirically established the macroeconomic reimbursement of these instruments. Works cited Lahart, Justin (2007). Egg Cracks Differ In Housing, Finance Shells, Wall Street Journal, December 24. Jason Zweig (Oct. 11, 2008, p.1), What History Tells Us about the Market Retrieved on July 21, 2011 from http://online.wsj.com/article/SB122368241652024977.html Wall Street Journal, Oct. 11, 2008, p.1 The Wall street Journal (June 18, 2011) SEC to Hold Top Credit Rating Agencies Accountable for Role in Mortgage Crisis. Retrieved on July 21, 2011 from http://www.gobankingrates.com/mortgage-rates/sec-top-credit-rating-agencies-accountable-mortgage-crisis/ Wall Street Journal, ( July, 2007),Stock Futures Follow Commodities Higher. Retrieved on July 21, 2011 from http://wallstreetrun.com/stock-futures-follow-commodities-higher-2.htm Wall Street Journal. Online, (May 2008). Retrieved on July 21,2011 from http://www.google.com/search?hl=en&source=hp&biw=1024&bih=602&q=The+Wall+Street+Journal+Online The Wall Street Journal Online - Featured Article". 2008. Retrieved on July 21,2011 from http://opinionjournal.com/editorial/feature.html?id=110010981. Retrieved 2008-05-19. . Jon Hilsenrath and Mark Gongloff (MARCH 22, 2011) Treasury to Sell MBS Portfolio. Financial-Crisis Purchases Could Bring $20 Billion in Profit; Fed to Follow? Retrieved on July 21,2011 from http://online.wsj.com/article/SB10001424052748703858404576214411406471314.html Wall Street Journal Wall Street Journal,(December 4, 2007). NBER Makes It Official: Recession Started in December 2007Retrieved on July 21,2011 from http://blogs.wsj.com/economics/2008/12/01/nber-makes-it-official-recession-started-in-december-2007/ Read More