The Financial Crisis 2007-08 Focus on Mortgage-Backed Securities

Vipul Garg (235)

Nishad Farooqui (237)

What is a Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or
collection of mortgages.
How are they created?
Let's assume you want to buy a house, so you get a mortgage from XYZ Bank. XYZ Bank transfers money
into your account, and you agree to repay the money according to a set schedule. XYZ Bank may then
choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over
the next several years) or sell it.
If XYZ Bank sells the mortgage, it gets cash to make other loans. So, let's assume that XYZ Bank sells your
mortgage to ABC Company, which could be a governmental, quasi-governmental, or private entity. ABC
Company groups your mortgage with similar mortgages it has already purchased (referred to as pooling
the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates,
maturities, etc.).
ABC Company then sells securities that represent an interest in the pool of mortgages, of which your
mortgage is a small part (called securitizing the pool). It sells these MBS to investors in the open market.
With the funds from the sale of the MBS, ABC Company can purchase more mortgages and create more
MBS.
When you make your monthly mortgage payment to XYZ Bank, they keep a fee or spread and send the
rest of the payment to ABC Company. ABC Company in turn takes a fee and passes what's left of your
principal and interest payment along to the investors who hold the MBS.
Prepayment Risk
Prepayment risk is a large concern for MBS investors. When people move, for example, they sell their
houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When
interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate
mortgages and pay off their higher-rate mortgages with the proceeds. Like bonds, changes in interest
rates affect MBS prices, but the change is exacerbated by the fact that MBS investors are more likely to
get their principal back early. They might have to reinvest that principal at rates below what their MBS
were yielding.
The Role of the Government in MBS
Although several private institutions (brokerage firms, financial institutions, and even construction
companies) create and sell MBS, the Federal National Mortgage Association (FNMA, or "Fannie Mae")

and the Federal Home Loan Mortgage Corporation (FHLMC, or "Freddie Mac") purchase a very large
portion of mortgages. Freddie Mac and Fannie Mae (both government- sponsored entities) guarantee
the timely payment of interest and principal on the MBS they issue -- that is, if the borrowers do not
make their mortgage payments on time, Freddie Mac and Fannie Mae will still make their payments to
their MBS investors. It is important to note that the U.S. government does not guarantee Freddie Mac or
Fannie Mae. That is, if these entities cannot fulfill their obligations to their MBS investors, the federal
government has no responsibility to rescue them. However, both entities have lines of credit with the
government, and investors generally believe that the government would not actually let them default on
any of their securities.
The Government National Mortgage Association (GNMA, or "Ginnie Mae"), on the other hand, is a
governmental entity that does not purchase mortgages but does guarantee (with the full faith and credit
of the U.S. government) the mortgage-backed securities of certain MBS issuers. GNMA MBS have the
lowest risk of the three, because they carry an explicit guarantee from the federal government
What Role Did Mortgage-Backed Securities Play in the Recent Recession?
Before the 21st century, U.S. banks conducted due diligence when making mortgage loans. They asked
for and verified a borrower's income, debt, and credit rating before lending money for a home purchase
or refinance. Essentially, lenders used to limit their risk as much as possible before lending money.
Mortgage-backed securities allowed banks to pass the risk of real estate loans to the agencies and
investors who purchased shares in them, so the need for strict underwriting to reduce risk was relaxed
as time went on.
When the highly qualified mortgage loan applicants started drying up, banks turned to subprime
borrowers. They had lower credit ratings and posed a higher credit risk. Banks charged a higher interest
rate to offset these risks. At first, mortgage-backed securities for subprime loans performed well
because the first subprime borrowers were more likely to make their mortgage payments - at a higher
interest rate - than later subprime borrowers closer to the 2008 global financial crisis.
The chart below outlines the subprime mortgage market as a share of the entire mortgage origination
market from 1996 to 2008. During the year 2003, the subprime mortgage market sky rocketed from
8.3% market share to nearly 21% only one year later. The peak was reached in 2006 at nearly 24% of the
entire mortgage market. This year also coincides with the peak of the housing bubble, just before the
market crash.

By August 2008, one out of every 416 U.S. households had a foreclosure filed against it. As more and
more subprime borrowers defaulted on their loans, mortgage-backed securities started performing
poorly for the investors. The ones that consisted primarily of subprime mortgages eventually became
worthless, causing huge losses and write downs to the investors.
At the same time, new home construction was far greater than the demand for it, creating excess
inventory. Housing prices dropped. Many homeowners learned their homes were worth less than their
loans and walked away from them increasing the number of foreclosures further. Huge investment
banks with portfolios full of these underperforming subprime MBS found their net worth's sinking. Bear
Stearns was bought by J.P. Morgan for $2 per share. Just one week before its stock price was $70 per
share. Lehman Brothers also went under.
Fannie Mae and Freddie Mac, which owned $3 trillion in mortgage investments at that time, asked for
and received help from the federal government. The mortgage crisis was in full swing. Fannie Mae and
Freddie Mac were unable to lend money or purchase loans from lenders. As a result, direct lenders like
banks and mortgage companies stopped lending their money to consumers due to the instability of the
market as a whole.
With limited loans, consumers stopped buying goods and services and the markets further crashed. The
companies making and providing those goods and services started laying off employees making the
situation even worse. The economy went into a tail spin resulting in the worst recession since the Great
Depression.
Why MBS turned out to be bad?
The pooled mortgages were used to back securities known as collateralised debt obligations (CDOs),
which were sliced into tranches by degree of exposure to default. Investors bought the safer tranches
because they trusted the triple-A credit ratings assigned by agencies such as Moodys and Standard &
Poors. This was another mistake. The agencies were paid by, and so beholden to, the banks that
created the CDOs. They were far too generous in their assessments of them.
Investors sought out these securitised products because they appeared to be relatively safe while
providing higher returns in a world of low interest rates. Economists still disagree over whether these
low rates were the result of central bankers mistakes or broader shifts in the world economy. Some
accuse the Fed of keeping short-term rates too low, pulling longer-term mortgage rates down with
them. The Feds defenders shift the blame to the savings glutthe surfeit of saving over investment in
emerging economies, especially China. That capital flooded into safe American-government bonds,
driving down interest rates.
Low interest rates created an incentive for banks, hedge funds and other investors to hunt for riskier
assets that offered higher returns. They also made it profitable for such outfits to borrow and use the
extra cash to amplify their investments, on the assumption that the returns would exceed the cost of
borrowing. The low volatility of the Great Moderation increased the temptation to leverage in this
way. If short-term interest rates are low but unstable, investors will hesitate before leveraging their
bets. But if rates appear stable, investors will take the risk of borrowing in the money markets to buy
longer-dated, higher-yielding securities. That is indeed what happened.

How it spread?
When Americas housing market turned, a chain reaction exposed fragilities in the financial system.
Pooling and other clever financial engineering did not provide investors with the promised protection.
Mortgage-backed securities slumped in value, if they could be valued at all. Supposedly safe CDOs
turned out to be worthless, despite the ratings agencies seal of approval. It became difficult to sell
suspect assets at almost any price, or to use them as collateral for the short-term funding that so many
banks relied on. Fire-sale prices, in turn, instantly dented banks capital thanks to mark-to-market
accounting rules, which required them to revalue their assets at current prices and thus acknowledge
losses on paper that might never actually be incurred.
Trust, the ultimate glue of all financial systems, began to dissolve in 2007a year before Lehmans
bankruptcyas banks started questioning the viability of their counterparties. They and other sources
of wholesale funding began to withhold short-term credit, causing those most reliant on it to founder.
Northern Rock, a British mortgage lender, was an early casualty in the autumn of 2007.
Complex chains of debt between counterparties were vulnerable to just one link breaking. Financial
instruments such as credit-default swaps (in which the seller agrees to compensate the buyer if some
third-party defaults on a loan) that were meant to spread risk turned out to concentrate it. AIG, an
American insurance giant buckled within days of the Lehman bankruptcy under the weight of the
expansive credit-risk protection it had sold. The whole system was revealed to have been built on flimsy
foundations: banks had allowed their balance-sheets to bloat, but set aside too little capital to absorb
losses. In effect, they had bet on themselves with borrowed money, a gamble that had paid off in good
times but proved catastrophic in bad.
Global Credit Crunch- The banking system is internationally linked. When some banks started to lose
money, they became reluctant to lend to other. Therefore, the international banking system became
affected and banks stopped lending to each other and therefore it became difficult for firms and
consumers to borrow from banks. This decline in bank lending contributed to a fall in aggregate
demand. Even countries which didnt have any exposure to subprime lending were affected by the
global credit crunch.
Global Trade. With the US entering recession, their demand for exports fell. So many countries
experienced a decline in exports. This decline in global trade contributed to the global recession.
Global Stock Markets. The financial problems of US and UK banks hit stock markets around the world
2007 and 2008 saw large fall in share prices which led to lower wealth and confidence. Leading to lower
growth.
Typically, there is a weak correlation between stock markets and consumer spending. Only 20% of
consumers have direct exposure to stock markets, and the wealth in stocks is not directly linked to
spending. But, the sheer size of the stock market falls meant it did start to effect consumer spending and
business investment.

Key Players
Mortgage originators
Lax regulation allowed banks to stretch their mortgage lending standards and use aggressive tactics to
rope borrowers into complex mortgages that were more expensive than they first appeared.
Ameriquest then the nations largest subprime lender forged documents, hyped customers'
creditworthiness and juiced mortgages with hidden rates and fees.
A similar culture existed at Washington Mutual , which went under in 2008 in the biggest bank collapse
in U.S. history.
Countrywide, once the nations largest mortgage lender, also pushed customers to sign on for complex
and costly mortgages that boosted the companys profits.
Merrill Lynch and Deutsche Bank both purchased subprime mortgage lending outfits in 2006 to get in
on the lucrative business.
Mortgage securitizers
Washington Mutual, Bank of America, Morgan Stanley and others were securitizing mortgages as well as
originating them. Other companies, such as Bear Stearns, Lehman Brothers, and Goldman Sachs, bought
mortgages straight from subprime lenders, bundled them into securities and sold them to investors
including pension funds and insurance companies.
The people who created and dealt CDOs
A hedge fund named Magnetar worked with banks to fill CDOs with the riskiest possible materials, then
used credit default swaps to bet that they would fail.
American International Groups London-based financial products unit was among the entities that
provided credit default swaps on CDOs
Merrill Lynch, Citigroup, UBS, Deutsche Bank, Lehman Brothers and JPMorgan all made CDO deals with
Magnetar.
Merrill Lynch and Citibank, bought each others CDOs, creating the illusion of true investors when there
were almost none.
Goldman Sachs and Morgan Stanley also made similar deals in which they created, then bet against,
risky CDOs. The hedge fund Paulson & Co helped decide which assets to put inside Goldmans CDOs.
The ratings agencies
Standard and Poors, Moodys and Fitch gave their highest rating to investments based on risky
mortgages in the years leading up to the financial crisis.
The regulators
The Financial Crisis Inquiry Commission concluded that the Securities and Exchange Commission failed
to crack down on risky lending practices at banks and make them keep more substantial capital reserves

as a buffer against losses. They also found that the Federal Reserve failed to stop the housing bubble by
setting prudent mortgage lending standards, though it was the one regulator that had the power to do
so.
Fannie Mae and Freddie Mac
The government-sponsored mortgage financing companies Fannie Mae and Freddie Mac bought risky
mortgages and guaranteed them. In 2007, 28 percent of Fannie Maes loans were bought from
Countrywide.
The SEC slammed Fannie Mae for improper accounting

Guidelines related to MBS in India

NHBs Regulations
The RMBS segment is regulated by National Housing Bank (NHB), a wholly owned subsidiary of Reserve
Bank of India and is mandated to regulate, supervise and provide financial support to the housing
finance companies registered with NHB. The development of secondary mortgage market in India was
dependent on the introduction of securitization and NHB played a critical
role in evolving securitization transaction to gain acceptability in the market within the existing
regulatory framework.
The home loans should satisfy the following standards for being considered for selection in the
Mortgage Pool offered for securitization:
a. The borrower should be individual(s).
b. The home loans should be current at the time of selection/securitization.
c. The home loans should have a minimum seasoning of 12 months (excluding moratorium period).
d. The Maximum Loan to Value (LTV) Ratio permissible is 85%. Housing loans originally sanctioned with
an LTV of more than 85% but where the present outstanding is within 85% of the value of the security,
will be eligible.
e. The Maximum Instalment to (EMI) to Gross Income ratio permissible is 45%.
f. The loan should not have overdues outstanding for more than three months, at any time throughout
the period of the loan.
g. The Quantum of Principal Outstanding Loan size should be in the range of Rs.0.50 lakh to Rs.100 lakhs.
h. The pool of housing loans may comprise of fixed and/or variable interest rates.
i. The Borrowers have only one loan contract with the Primary Lending Institution (PLI).
j. The loans should be free from any encumbrances/charge on the date of selection/securitization. The
sole exception to this norm being loans refinanced by NHB (In such cases, the loans may be securitised

subject to the originator substituting the same with other eligible housing loans conforming with the
provisions of the refinance schemes of NHB).
k. The Loan Agreement in each of the individual housing loans, should have been duly executed and the
security in respect thereof duly created by the borrower in favor of the PLI and all the documents should
be legally valid and enforceable in accordance with the terms thereof.

The Reserve Bank of India (RBI) is the regulator of the major players in the Indian financial system
(banks, financial institutions and NBFCs) and has to ensure that financial intermediaries engage in
Securitization prudently. The Reserve Bank issued the first set of comprehensive guidelines applicable to
banks, financial institutions and non-banking financial companies (NBFCs) on Securitization in India way
back in February 2006. The guidelines covered following aspects relating to Securitization transactions:

Broad definitions on important securitization related concepts such as securitization, SPV, bankruptcy
remote, credit enhancement, first loss facility, liquidity facilities, service provider and
underwriting facilities.
Prescribed detailed true sale criteria and criteria to be met by originators and SPVs. Some important
criteria included that originators should not indulge in market making on securities issued by
SPV, originators shall not invest in more than 10% of securities issued by SPV, securities cannot
have any put option, etc.
Detailed policy for originators and third parties on provision of credit enhancements, liquidity
support/ facilities, underwriting facilities, servicing arrangements, etc.
Capital adequacy norms for Credit Enhancement - First loss credit enhancement is deducted from
capital and second loss facility is risk weighted according to the rating. Credit enhancement
cannot be withdrawn/ reduced by the provider throughout the life of the transaction except to
cover the losses suffered by SPV.
Prudential Norms for investment in the securities issued by SPVs.
Accounting treatment for securitization transactions - An important feature was that profit / premium
arising on account of sale should be amortized over the life of the securities issued or to be
issued by the SPV.
Due diligence framework for securitization transactions and disclosures to be made by the SPVs/
Trustee and originators.

Revised guidelines for securitization and direct assignment of loans

The important features of the May 2012 guidelines are as follows:
Prescription of the Minimum Holding Period (MHP): Minimum Holding Period varies from 3 months to
12 months depending upon the tenor of the loan and repayment frequency and is defined in
terms of number of installments paid. The criteria governing determination of MHP reflect the
need to ensure that i) the project implementation risk is not passed on to the investors and ii) a
minimum recovery performance is demonstrated prior to securitisation to ensure better
underwriting standards.
Prescription of Minimum Retention Requirement (MRR) 5 % for loans up to 24 months and 10% for
loans of tenor beyond 24 months. The MRR is primarily designed to ensure that the originating
banks have a continuing stake in the performance of securitised assets so as to ensure that they
carry out proper due diligence of loans to be securitised.
True sale criteria made applicable to assignment transactions also.
Liberalised recognition of cash profit received allowed in view of the mitigation of concerns on
Originate to Distribute models.
Disclosures requirements were strengthened and due diligence expectations were elaborated.
Stress testing requirements were laid for banks/FIs/ NBFCs in respect of their Securitisation positions.
The factors for stress tests could include rise in default rates in the underlying portfolios in a
situation of economic downturn, rise in pre-payment rates due to fall in rate of interest or rise in
income levels of the borrowers leading to early redemption of exposures, fall in rating of the
credit enhancers resulting in fall in market value of securities (Asset Backed Securities/
Mortgage Backed Securities) and drying of liquidity of the securities resulting in higher prudent
valuation adjustments, etc.
Outsourcing of credit decision is not allowed.
In case of non-compliance with the guidelines, as applicable to originators, no capital relief will be
available for originators. For investors, in case of non-compliance with guidelines as applicable
to investors, the asset will be risk weighted at 1111% (revised to 1250% in March 2015).
Certain forms of Securitization transactions / structures are not allowed - Complex structures such as
Re-Securitisation and Synthetic Securitisation is not allowed. Revolving credit facilities cannot be
securitized / assigned. Single asset Securitisation are not allowed as they do not fit into the
definition of Securitisation. Securitisation / assignment of loans where both interest and

principal are due only at maturity are not allowed as it is not possible to assess the repayment
track record.
Credit enhancement is not allowed in case of assignment transactions as the assignment deals are
generally carried out between two financial institutions. It is expected that the purchasing
institution will do its own due diligence while acquiring assets rather than relying on credit
enhancement.

Current Scenario of MBS in the US

The U.S. residential and commercial MBS markets exceed $7 trillion and make up about 30% of
the Barclays U.S. Aggregate Bond Index and 12% of the Barclays Global Aggregate Index,
according to the Securities Industry and Financial Markets Association and Barclays,
respectively, as of 30 June 2015. The largest and most liquid component of MBS exposure in the
Barclays Aggregate is mortgage bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.
There also are sizeable private label residential and commercial MBS markets.
Many experts say they're safer now and are worthy of a small part of the ordinary investor's
portfolio. Some funds holding non-agency securities yield upward of 10 percent. The number of
delinquent borrowers is now at a post-crisis low, U.S. consumers continue to perform quite well
from a credit perspective, and risk premiums are very attractive relative to the fundamental
outlook for housing and the economy. Home prices have appreciated nationwide by 5 to 6
percent over the last three years.
Not many private-label securities have been issued in the years since, and they accounted for
just 4 percent of mortgage securities issued in 2015, according to Freddie Mac.
Prices have been inflated by accommodative policies of the Federal Reserve, which owns over
$1.75 trillion in agency MBS. However, agency MBS have cheapened year-to-date and the
prospect of less Federal Reserve accommodation and higher interest rate volatility may create
the potential for better entry points.

While liquidity in agency MBS may be weaker than historical levels, on average the sector
continues to trade more than $200 billion per day (see Figure 3), according to the Securities
Industry and Financial Markets Association, and with minimal bid-ask spreads relative to many
other credit sectors.