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

How the Mortgage-Backed Security Brought Down the Economy

A protester opposes the federal bailouts of investment banks and mortgage buyers in Washington in September 2008.
A protester opposes the federal bailouts of investment banks and mortgage buyers in Washington in September 2008.
Scott J. Ferrell/Congressional Quarterly/Getty Images

When the foreclosure rate began to increase late in 2006, it also released more new homes on the market. New home construction had already outpaced demand, and when large numbers of foreclosures became available at deeply discounted prices, builders found that they couldn't sell the homes they'd built. Richard Dugas, CEO of Pulte Homes, a building company, said in September 2008, "We can't afford to compete with foreclosures at 40 percent to 50 percent off" [source: Builder].

The presence of more homes on the market brought down housing prices. Some homeowners found themselves in the precarious state of being upside-down in their payments; they owed more than their homes were worth. Simply walking away from the houses they couldn't afford became an increasingly attractive option, and foreclosures increased even more.

Had a situation like this taken place before the advent of mortgage-backed securities, it still would have created a ripple effect on the national economy. Home builders and lenders going belly-up still would have increased unemployment. Foreclosures still would have deflated housing prices. And with less cash flowing in, surviving banks still would have tightened credit. But the presence of MBSs created an even more pronounced effect on the U.S. economy.

Since MBSs were purchased and sold as investments, defaulted mortgages turned up in all corners of the market. The change in performance of MBSs took place rapidly, and as a result, most of the biggest institutions were laden with the securities when they went south. The portfolios of huge investment banks, lousy with mortgage-backed securities, found their net worth sink as the MBSs began to lose value. This was the case with Bear Stearns. The giant investment bank's worth sank enough that it was purchased in March 2008 by competitor JPMorgan for $2 per share. Seven days before the buyout, Bear Stearns shares traded at $70 [source: USA Today].

Because mortgage-backed securities were so prevalent in the market, it wasn't immediately clear how widespread the problem from the subprime mortgage fallout would be. During 2008, a new write-down of billions of dollars on one institution or another's balance sheet made headlines daily and weekly. Fannie Mae and Freddie Mac, the government-chartered corporations that fund mortgages by guaranteeing them or purchasing them outright, sought help from the federal government in August 2008. Combined, the two institutions own about $3 trillion in mortgage investments [source: AP]. Both are so entrenched in the U.S. economy that the federal government seized control of the corporations in September 2008 amid sliding values; Freddie Mac posted a $38 billion loss from July to August of 2008 [source: Reuters].

Fannie Mae and Freddie Mac are an example of how every part of the economy is related. When things are bad at Fannie Mae and Freddie Mac, things are bad for the housing industry. Lenders issue home loans and sell them to one of the companies or use the loans as collateral to borrow more money; the role of each giant is to infuse cash into the lending industry. When Mac and Mae won't lend money or purchase loans, direct lenders become less likely to lend money to consumers. If consumers can't borrow money, they can't spend it. When consumers can't spend money, companies can't sell products; low sales means lessened value, and so the company's stock price per share declines. Businesses trim costs by laying off workers, so unemployment increases and consumers spend even less. When enough companies lose their values at once, the stock market crashes. A crash can lead to a recession. A bad enough crash can lead to a depression; in other words, an economy brought to its knees.

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