This is a write-up of my understanding of how the Global Financial Crisis played out. We first need some background of a couple of uncommon (or slightly more complex) jargon that played a key role here:

What are Mortgages?

They are real estate-backed contracts between a lender and property purchaser (borrower). The lender lends money to the borrower to purchase a property in full. In return, the buyer signs an agreement to make systematic payments (similar to EMI) to the lender in order to retain ownership of the property. In the event that the buyer fails to make any payment, the lender has the right to take the property. It is different from a traditional loan in that the collateral is the property the loan is purposed for. A conventional collateralized loan can be backed by any other collateral, e.g. jwellery. Mortgages are typically considered more secure as you cannot sell a property that is under a mortgage loan, but in traditional loans, a borrower may lose assets that a loan is collateralized against, posing a greater risk to the lending institution of losing their money.

There are different types of mortgages, one of which (of particular interest) is Adjustable Rate Mortgages (ARM). In the context of this topic, these are traps laid out to lure people into taking mortgages. They offer low introductory payments for the first few years and increased interest rates thereafter depending on market interest rates. These can seem useful if you think you will become a millionaire in a few years, but pay off only if you end up becoming one.

You may be wondering how pure mortgage lending companies retain liquidity. Because unlike a bank, they don’t hold customer deposits and have acquired considerable real estate by selling ARMs. Well, at a high level, they sell these contracts (mortgages) to companies like Fannie Mae and Fredric, who then bundle these into derivatives, which are then sold to investors to make money. We will talk about these derivatives next.

Mortgage Backed Securities (MBS):

As the name suggests, these are derivatives built upon bundles of mortgages. Fannie Mae enables mortgage companies to continue operating by providing them liquidity in return of these contracts. Well, why would they buy these contracts and help the capitalist people of the country get access to easy home financing options? To make money! These mortgages are first rated, ranging from AAA to CCC, based on the creditworthiness or Probability of Default, then bundled based on similarities and sold as a derivative (in secondary markets) to an investor. For an investor, they are similar to fixed-income bonds that generate coupon payments. Likewise, the coupon payments are proportional to the risk associated with the mortgages underlying the MBS along with several other factors. One of the jobs of a Quantitative Researcher is to price these MBS. MBS come under the category of Collateralized Debt Obligation (CDOs), which have similar features, but encapsulate a more diversified set of debt-based instruments. They are collateralized as a recovery process exists in place to pay back the CDO investors if the loans default, with higher priority for higher-rated MBSs.

Credit Default Swaps (CDS):

The idea of a Credit Default Swap is similar to how insurance works; however, for a completely different purpose. As a lender, you can buy a CDS from a financial institution for a premium (credit spread) and shift the risk of default to the issuer of the CDS (swap the risk of credit default). In the event that the underlying borrower defaults, the lender is reimbursed the borrowed amount. The premium depends on the risk associated with the underlying debt instrument, along with several other factors. They are Over the Counter (OTC) Derivatives, i.e., traded on a one-on-one basis.

Synthetic CDOs:

Synthetic Collateralized Debt Obligations are structured derivatives based on assets such as CDS, Options, etc., which are non-cashable. Their value is thus derived from the cash flows generated by their premiums, unlike a traditional CDO that derives value from the loan repayments. For an investor, the returns from a synthetic CDO can be much higher compared to other market products, thus making it lucrative. One party is essentially taking a short position (purchasing the CDS) by paying (interest payments) premiums to the other party, that is long on the CDO and bears the loss if the underlying security fails. It is similar to betting on whether the underlying security in the CDS will default or not.

How everything eventually played out

The first event in this series was the lowered borrowing rates. Following the terrorist attacks in September 2001, the US government lowered the fed rates to 1% in order to boost business lending and replenish the economy. This led to many middle-lower income bracket people to purchase mortgages and realize their dream of owning a house. Since the housing prices were continuously increasing (as one would expect in a booming economy), the probability of default was assumed to be very low and even low creditworthy individuals were approved for these mortgages. These mortgages were then packaged into MBSs, attracting many investors. Even Subprime mortgages (low credit score) were given a AAA rating as the valuation models were based on the assumption that the housing prices would continue to rise (no default). These investors would get interest payments generated from the loan cash flows. Firms such as American International Group (AIG), Bear Sterns, and Lehman Brothers would then issue CDS on these MBS so investors (hedge funds) that were short on these MBSs could buy these. These firms would then use the CDS to create Synthetic CDOs. These synthetic CDOs were good arbitrage opportunities for these firms until the loans did not default and the housing prices rose.

However, in 2006, the supply became too high compared to the demand and the housing prices began to fall. This led to many people eventually defaulting since selling the houses could no longer generate sufficient mortgage payments, especially for Adjustable Rate mortgages, which had a higher rise in mortgage payments due to Fed increasing the market rates. Banks and other institutions failed to realize the intensity of the situation and continued issuing CDS, CDO and MBS, even though they did not have sufficient funds to pay back the investors if the loans were to default. Following mass defaults, many institutions filed for Bankruptcy or had to be supported by the government until repayment.

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PS: I write these posts for my own reference and not as a reference for people trying to learn more about the topic.