Despite their role in the 2008 crisis, subprime mortgage bonds (also known as mortgage-backed securities – MBSs) and credit default swaps (CDSs) are resurging. Financial institutions are reviving these instruments to seek higher profits in a low-interest-rate environment.
While this resurgence is now accompanied by better risk management and regulations, concerns about potential systemic risks persist.
The cyclical nature of financial markets resembles the story of the mythological Phoenix, which lives, dies, and then rises from its ashes again and again.
Financial markets tend to periodically undergo economic crises, triggering recessions. These are then replaced by periods of economic booms, and so the cycle continues.
Also, the market will often completely lose faith in a specific asset, only to re-discover it with renewed enthusiasm later. So is the case regarding subprime mortgage bonds and credit default swaps.
The 2008 Subprime Mortgage Crisis
Over a decade ago, the infamous mortgage crisis threw the world economy into a downward spiral causing the biggest crash since the Great Depression. As one of the most significant financial collapses in history, the “Great Recession,” as it is also referred to nowadays, caused numerous corporate and individual defaults worldwide.
Global financial markets were shaken to their core after investment banks filled their portfolios with financial products like subprime mortgage bonds and credit default swaps.
Behind those assets was what proved to be worthless real estate, which generated excessive default risks. Many financial institutions had to be bailed out by the government, while others were bought by their more stable competitors.
The problem’s implications were felt by real estate owners worldwide, especially those who financed their purchases through loans. Prices dropped so low that borrowers’ best course of action was to cut their losses and default.
The repossessed properties often lost 60-70% of their original value by the time they ended up with the banks.
Many factors contributed to the escalation of the 2008 crisis. However, the one that received the most scrutiny was subprime lending.
Engineering a Crisis
The idea was to re-package subprime mortgage bonds into regulated over-the-counter securities and then cover the risk of default by purchasing Credit Default Swaps.
At the time, it seemed like a perfect risk-free construct. Unfortunately, the process of transforming these mortgages into tradable securities has made them far too detached from the real estate market.
As the rate of defaults on these mortgages swelled to a sizable percentage, the securities they were bundled into started losing value. This made the institutions issuing these securities unstable.
Insurer companies dealing with default-facing institutions were unprepared for the sheer volume of payments they’d have to make, causing them also to go down.
The list of affected financial institutions includes Fannie Mae, Freddie Mac, AIG, Lehman Brothers, and Bear Stearns, to name a few.
The Re-Emergence of Subprime Mortgages
Common sense suggests anyone who’s seen the events of 2008 play out would go out of their way to avoid such a risky investment construct.
In reality, that doesn’t seem to be the case. The same subprime mortgages that were at the core of the financial crisis are experiencing a vigorous resurgence.
It may come in a different form, but the underlying concept is the same. However, the US isn’t ground zero this time; it’s actually happening in the world’s second-largest economy – China, where subprime mortgages are not only making a comeback, they are doing so at way higher interest rates and down payments.
At the same time, in the US, the risk controls are stricter due to the subprime mortgage restrictions imposed by the Consumer Financial Protection Bureau (CFPB). Among them are:
- Potential homebuyers must be given homebuyer counseling by a representative approved by the U.S. Department of Housing and Urban Development.
- The restriction also placed a limit on the increase of interest rates and other loan terms.
- All loans must be properly evaluated before approval.
The Spillover of Subprime Mortgages to Other Industries
The phenomenon isn’t limited to the real estate market; it also extends to corporate loans. However, subprime mortgages aren’t exclusively financed by the regulated banking industry but also by China’s so-called shadow banking system.
Alternatively, the financing comes in the form of loans from private companies or individuals rather than China’s commercial banking system or state-run banks.
The situation is further complicated by the lack of information on the amount of capital circulating in the shadow banking system.
What we do know for a fact is that these unregulated loans are packed into special financial assets with the help of financial institutions, who then resell them as tradable securities.
There is no clarity about the exact number and size of these loans. Some estimates say they make up as much as two-thirds of all lending in China.
On the other hand, we can’t even begin to estimate the number or ratio of defaults. In spite of that, the number of subprime mortgages continues to increase.
Potential Risks of the Resurgence of Subprime Mortgages
The resurgence of CDS and subprime mortgage bonds have potential risks that require careful consideration.
Today the instruments of this kind that are in circulation exceed USD 1 trillion in value.
Experts argue that their widespread global exposure resurfaces the risk for potential instabilities for the financial system.
Another potentially worrying moment would be if these subprime loans eventually reach critical mass just like they did in 2008. Considering China’s systemic importance for the global economy, the implications might again be felt worldwide.
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To Wrap Up
The rise of the mortgage-backed security Phoenix shows us that investors are more than willing to give shunned old assets a second chance as long as they come with a new coat of paint.
Despite the previous financial crisis brought by these instruments, they are making a comeback. However, the resurgence of subprime mortgage bonds and CDSs poses significant risks that demand attention. Stricter regulations are required to mitigate the potential chain-like instabilities that threaten to disrupt the financial system.
