A Brief Overview of the US Financial Crisis

By Colin (Huaizhi) Chen

The link between the subprime mortgages and the current crisis in the US financial market lies in the mortgage backed securities that had flooded Wall Street. These securities are simply claims to pools of mortgage loans. An investor would purchase these Mortgage-Backed Securities (MBS), and receive the interest and principal payments of the original loans. Any risk of potential default by the mortgage borrowers will be accounted by the premium placed on the required interest yield of these securities.

Still follow? Good. It’s a great setup; I mean why wouldn’t it be? Mortgage lenders loved it because the packaged mortgage loans became a liquid asset that could be sold off on demand in the global securities market. Investors liked it because MBSs offered a new source of diversification and investment. Mortgage borrowers liked it because MBSs allowed another layer of credit lenders to finance their new house. Finally, the US government liked it because happy house owners equal a satisfied electorate. In fact, everyone was so glad of the liquidity of MBS's that various other financial products were created based on the values of MBS.

While this all nice and good, the mushroom cloud over the skies of Financial New York clearly indicate that something had gone wrong. What happened!?! To answer this, we have to look into the exact origin of most MBS’s.

In the old 1930s, grandpa FDR in his New Deal created an organization known as the Federal National Mortgage Association (Fannie Mae) to oversee the mortgage market. Over the years, she was joined by two siblings - The Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These entities together issued, you guessed it, mortgage-backed securities as a way of making mortgage assets trade-able. Furthermore, because they were government sponsored entities, these issues are implicitly (and in the case of Ginnie Mae explicitly) backed by the full faith and credit of the US government.

Good? That’s what most bond rating agencies believed. As such, agencies like the Standard & Poor and Moody’s assigned outrageous triple A ratings to a subdivision of MBSs that are backed by subprime mortgages (mortgages with the highest default risk). In addition, because of the shiny untarnished reputation of these MBSs, other MBSs issued by your friendly neighborhood investment bank, were assigned that respectable looking AAA rating as well.

So that brings us into to the present. When subprime borrowers found out that the housing market isn't going up any further, and they can’t afford that 30% annual interest rate on their loans, they invariably defaulted, vaporizing the value of mortgage backed securities that their loans were pooled in. Investors of these subprime MBSs and their derived products, the ones who were initially lured by those near risk-free triple A ratings, balked from the US MBS market in groves, leaving a huge liquidity crunch in its wake. Finally, financial institutes that most depend upon the leverage powers of credit are forced into cupping their own pants.

In all of this, you might be asking where is the government intervention that Moody’s and S&P had bet on? Bear Stearns probably knows.

- H