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How can mortgage-backed securities bring down the U.S. economy?

        Money | Money & Ethics

Why the Mortgage-backed Security Went the Way of the Dinosaur
In July 2008, foreclosures (like these homes in Redmond, Calif.) rose 55 percent over July 2007.
In July 2008, foreclosures (like these homes in Redmond, Calif.) rose 55 percent over July 2007.
Justin Sullivan/Getty Images

Prior to the first decade of the 21st century, it was customary for a U.S. bank to exercise due diligence (an investigation into the applicant's history) when considering lending money for a mortgage. Banks wanted to know all about an applicant's financial stability -- income, debt, credit rating -- and they wanted it verified. This changed after the mortgage-backed security (MBS) was introduced.

Eventually, the most desirable, qualified customers dried up; they all had homes. So banks turned to customers they'd traditionally shunned -- subprime borrowers. These are borrowers with low credit ratings who pose a high risk of defaulting on their loan. But lenders of all stripes bent over backwards in the early 2000s to get this type of borrower into homes. The no-document loan was created, a type of loan for which the lender didn't ask for any information and the borrower didn't offer it. People who may have been unemployed as far as the lender knew received loans for hundreds of thousands of dollars. Why?

One answer is that, with the introduction of MBSs, lenders no longer assumed the risk of a loan default. They simply issued the loan and promptly sold it to others who ultimately took the risk if payments stopped. And since MBSs created early on were based on mortgages granted to the more dependable prime borrowers, the securities performed well. They performed so well that investors clamored for more. In response, lenders loosened their restrictions for mortgage applicants and borrowed heavily to create cash flow for loans in order to create more mortgages. Without mortgages, after all, there are no mortgage-backed securities.

The investors in MBS faced the same risk and reward system that the old lender-borrower relationship was subject to, but on a much larger scale due to the sheer volume of mortgages packed into a MBS. After MBSs hit the financial markets, they were reshaped into a wide variety of financial instruments with different amounts of risk. Interest-only derivatives divided the interest payments made on a mortgage among investors. If interest rates rise, the return is good. If rates fall and homeowners refinance, then the security loses value. Other derivatives repay investors at a fixed interest rate, so investors lose out when interest rates rise since they aren't making any money off the increase. Subprime mortgage-backed securities, comprised entirely from pools of loans made to subprime borrowers, were riskier, but they also offered higher dividends: Subprime borrowers are saddled with higher interest rates to offset the increased risk they pose.

A large amount of the mortgages taken out by subprime borrowers were hybrid adjustable rate mortgages (ARMs). These loans maintain a discounted (and usually affordable) fixed interest rate for a set number of years and then adjust to a higher rate. A homeowner with an ARM could find the monthly payments doubling after the rates adjusted. When the slew of ARMs that had been issued in a frenzy early on began to reset, the rate of foreclosures began to rise.

In just the month of August 2008, one out of every 416 households in the United States had a new foreclosure filed against it [source: RealtyTrac]. When borrowers stopped making payments on their mortgages, MBSs began to perform poorly. The average collateralized debt obligation (CDO) lost about half of its value between 2006 and 2008 [source: This American Life]. And since the riskiest (and highest returning) CDOs were comprised of subprime mortgages, they became worthless after the nationwide increase in loan defaults began.

This would be the first domino in an effect that spread throughout the U.S economy.