Securitization and the Financial Crisis

Securitization, specifically the packaging of mortgage debt into bond-like financial instruments, was a key driver of the 2007-08 global financial crisis. Securitization fueled excessive risk-taking that brought many major financial institutions on Wall Street and around the world to their knees when the U.S. real estate bubble burst.

Key Takeaways

  • Securitization of mortgage debt in bond-like investments such as mortgage-backed securities and collateralized debt obligations was a big cause of the financial crisis.
  • Securitization of home mortgages fueled excessive risk-taking throughout the financial sector, from mortgage originators to Wall Street banks.
  • When U.S. housing prices began to fall, mortgage delinquencies soared, leaving Wall Street banks with enormous losses on their mortgage-backed securities.

How Securitization Works

Securitization is the packaging of assets into a financial product. The securitization of mortgage debt, particularly subprime mortgages, in mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), was a major cause of both the U.S. real estate bubble in the early and mid-2000s and the financial havoc that resulted from the popping of that bubble.

Banks and other lenders who issued mortgages to homebuyers then sold those mortgages to bigger banks for repackaging into mortgage-backed securities and CDOs.

Mortgage Securitization and Risk

Over time, because lenders issuing the loans passed them along to big banks for securitization, they were no longer at risk if the homeowner defaulted. So lending standards fell dramatically. This meant that many unqualified or under-qualified borrowers—known as subprime borrowers—were able to secure risky loans.

Down the line, the subprime mortgages in MBS and CDOs made them attractive to big investors because they generated higher returns due to the higher interest rates subprime borrowers were paying. At the same time, that bundling was believed to reduce investors' risk, and the assets consistently received stellar ratings from credit rating firms. So the assets were used as leverage to control many trillions of dollars—many times the face value of the underlying assets.

The Music Plays On

This situation was highly profitable to everyone as the real estate market boomed, with buyers aggressively bidding up the prices of available houses. Places such as California, Florida, Arizona, and Las Vegas saw astronomical home-price increases as more and more easy money flooded in the market.

At first, subprime borrowers who fell behind on their payments could refinance their mortgages based on higher property values or could sell their homes at a quick profit. The amount of risk in the system was not an issue as long as prices were rising. By 2005, subprime mortgages represented nearly a third of the total mortgage market, up from 10% only two years earlier.

The Music Stops

Things changed when the economy began to weaken and home prices began to drift back toward earth. Adjustable-rate mortgages had already begun to reset at higher rates and mortgage delinquencies surged higher.

By March 2007, the value of subprime mortgages had reached around $1.3 trillion. A little more than a year later, in July 2008, more than a fifth of subprime mortgages were delinquent, and 29% of adjustable-rate mortgages were seriously delinquent. The housing market was in free fall and the banks holding mortgage-backed securities were in big trouble, scrambling to get rid of them as their value plummeted. The financial crisis was in full swing.

Advisor Insight

Paul McCarthy, CFA
Kisco Capital, LLC, New York, NY

I could write a book on this topic because I worked in the business for many years and I had the big short on myself at a hedge fund I worked at during the financial crisis.

Securitization is the packaging of loans or leases and has been around since the 1980s. Securitization really took off in the 1990s and exploded in the 2000s in terms of issuance volume. Used wisely, its a very effective form of financing for underwriters of loans and leases (auto, mortgage, credit cards, etc.).

The securitizations owned the subprime mortgage loans that eventually defaulted and caused a banking crisis. The number of loans originated in the 2000-2006 period was unusually large because we had a real estate bubble in the United States. The banks that held these securitizations as investments lost tens of billions of dollars which almost caused the US banking system to collapse. The bailout money provided by the US government preserved the banking system that we have today.