How Did Mortgage-backed Securities Bring Down the U.S. Economy?

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.

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.