{"id":833,"date":"2023-08-16T12:09:00","date_gmt":"2023-08-16T16:09:00","guid":{"rendered":"http:\/\/aky.pbv.mybluehost.me\/?p=833"},"modified":"2023-09-28T15:37:10","modified_gmt":"2023-09-28T19:37:10","slug":"subprime-mortgage-bonds-and-cds","status":"publish","type":"post","link":"https:\/\/aky.pbv.mybluehost.me\/subprime-mortgage-bonds-and-cds\/","title":{"rendered":"The Resurgence of Subprime Mortgage Bonds & Credit Default Swaps"},"content":{"rendered":"\n

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. <\/p>\n\n\n\n

While this resurgence is now accompanied by better risk management and regulations, concerns about potential systemic risks persist.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

Financial markets tend to periodically undergo economic crises, triggering recessions. These are then replaced by periods of economic booms, and so the cycle continues.<\/p>\n\n\n\n

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. <\/p>\n\n\n\n\n\n

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The 2008 Subprime Mortgage Crisis<\/h2>\n\n\n\n

Over a decade ago, the infamous mortgage crisis<\/a> 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 \u201cGreat Recession,\u201d as it is also referred to nowadays, caused numerous corporate and individual defaults worldwide.  <\/p>\n\n\n\n

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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

The problem\u2019s 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.<\/p>\n\n\n\n

The repossessed properties often lost 60-70% of their original value by the time they ended up with the banks.<\/p>\n\n\n\n

Many factors contributed to the escalation of the 2008 crisis. However, the one that received the most scrutiny was subprime lending.  <\/p>\n\n\n\n

Engineering a Crisis<\/h3>\n\n\n\n

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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

Insurer companies dealing with default-facing institutions were unprepared for the sheer volume of payments they\u2019d have to make, causing them also to go down.<\/p>\n\n\n\n

The list of affected financial institutions includes Fannie Mae, Freddie Mac, AIG, Lehman Brothers, and Bear Stearns, to name a few.<\/p>\n\n\n\n

The Re-Emergence of Subprime Mortgages<\/h2>\n\n\n\n

Common sense suggests anyone who\u2019s seen the events of 2008 play out would go out of their way to avoid such a risky investment construct. <\/p>\n\n\n\n

In reality, that doesn\u2019t seem to be the case. The same subprime mortgages that were at the core of the financial crisis are experiencing a vigorous resurgence. <\/p>\n\n\n\n

It may come in a different form, but the underlying concept is the same. However, the US isn\u2019t ground zero this time; it\u2019s actually happening in the world\u2019s 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. <\/p>\n\n\n\n

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)<\/a>. Among them are:<\/p>\n\n\n\n