So if you were like me, you probably didn’t really know too much about what was going on and why the market crashed so hard in 2008. I was a sophomore in college during the height of the market crash so I really didn’t have any money to be concerned about. But my dad did. Many of my classmates’ parents did too. Some of you who had 401k’s and retirement funds in 2008 were hit too when the market came tumbling down. Some not only lost their retirement, but they lost their homes too. And at the center of it all was initially considered to be a “simple” investment instrument called the Mortgage Backed Security, or MBS.
Mortgage Backed Securities (MBS) are essentially mortgages sold to a government agency or investment bank in order to package them up to create an investable security. That security is then passed to a ratings company to evaluate the credibility of the borrowers in the MBS portfolio to pay back the loan they have been given. When you buy a share of a MBS, you are essentially lending the borrower money. Just like when you buy a share of a company you are giving them money to invest in growth and building equity in the company, by buying a MBS you are doing the same for a homebuyer. The MBS was created under the assumptions that:
- The average person will always pay their mortgage
- The mortgage price is going to be a fair valuation of the land and property included.
- The lender will do credit checks and background checks to make sure the borrower will be able to make the payments toward a mortgage.
- The ratings companies will fairly evaluate each mortgage backed security and its underlying mortgages and give the appropriate rating.
But unfortunately between 2000 and 2007, lenders were simply giving away mortgages without insurance that the borrower could actually afford the mortgage for these houses with insanely high price tags. Many of these mortgages had variable interest rates, where the initial teaser rate was low and manageable, but after the teaser period ended, the insanely high interest rates kicked in and often times the borrowers were unable to pay. Eventually the borrower would be forced in to foreclosure or bankruptcy and were evicted. And this on top of the fact that some banks were requiring ratings companies give them a higher rating for an MBS that it deserved, you have a recipe for disaster that showed its ugly head in 2007-2008.
Now fast forward to 2016, after a bailout on American tax payer dime, now you’re starting to see stories like this and this pop up in the news. These recent movements probably add fuel to the fire of breaking up big banks for the current presidential candidates. I’m interested to see what they say about their plans for financial institutions and their functions in the future.