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09 05 2015 | by Victor Xing | Capital Markets
How did the subprime mortgage crisis onset a global recession?
The mortgage market underwent a transformation during late 1970s and 1980s. With the invention of mortgage-backed security, millions of mortgage loans were packaged into securities (functions as bonds) and sold to investors – hedge funds, mutual funds, pension funds, as well as held on banks’ balance sheet.
Under the MBS structure, each home owner’s monthly mortgage payment would pass directly (“pass-through”) investors’ portfolio as income. To portfolio managers managing fixed income portfolios and looking for yield, having MBS in the portfolio was (and still is) a popular way to achieve higher yield.
On the other hand, the “pass-through” nature of the security directly coupled the housing market with the financial market. When the housing boom turned to a bust and home-owners faced risk of default, these securities quickly lost value because each default negatively impacts cashflow or increase their investor’s prepayment risk. Since many of these securities were re-bundled into more complex securities, and higher quality MBS were used as collateral to secure financial transactions, risk contagion quickly spread to the entire financial system. All the sudden everyone were scrambling to review their balance sheet and to see how many transactions were conducted with MBS as collateral. Banks deemed most at risk suddenly found themselves isolated in the capital markets as counter-party risk mount. Soon, the very fabric of the financial system began to unravel.
That kick started the Great Recession
Next article09 05 2015 | by Victor Xing | Economics