Mortgage originators issued mortgages to home buyers and sold these mortgages to securitizing firms. These firms bundled these mortgages into pools and created securities that were backed by the mortgage payments. A portion of these pools were called tranches. Groups of tranches were further combined and then divided again into more complex securities called collateralized debt obligations (CDOs). These securities were redivided and recombined to create even more complex securities called CDOs-squared. This process had important implications: (1) The total risk embedded in the mortgages did not change; (2) since the risk was spread amongst several CDOs, it was difficult to assess the risk in each CDO; and (3) during the process of securitization and resecuritization, financial institutions earned fees and were thus encouraged to continue this process.
These securities were sold to investors across the world. If all went well, home buyers would make their payments and investors would earn their returns. However, a series of mortgage defaults led to the meltdown. Investors who were the indirect lenders to the home buyers didn't receive the expected cash flows, and on top of that, financial institutions skimmed fees during the process.
A. Mortgages were accessible for borrowers who did not meet income and minimum down payment requirements. Moreover, the Fed kept interest rates really low to prevent a recession. This led to a decrease in the demand for homes and a further decline in housing prices.
B. The total amount of risk embedded in the securities created by bundling mortgages did not change. The securitization and resecuritization processes led to a distribution of total risk among different types of collateralized securities.
C. Mortgage payments based on short-term interest rates-called adjustable-rate mortgages (ARMs)—were preferred by subprime borrowers.
D. Rating agencies, such as Moody's and Standard & Poor's, earned fees from securitizing agencies for providing ratings for CDOs. The securitizing agencies were looking for higher ratings for their CDOs, and the rating agencies were earning fees. This led to a conflict of interest; thus, ratings did not reflect the true risk involved in the CDOs, which were backed by mortgages.
Factors that caused the financial crisis
Analysts and theorists have debated over the different factors that caused the subprime mortgage meltdown. According to your understanding of the crisis, which of the following factors led to the financial crisis?
A. Real estate appraisers and rating agencies were lax.
B. Regulations were relaxed, leading to non-qualifying mortgages getting approved for loans.
C. Investors were fully aware of the risks involved, yet still settled with low returns.
D. Home buyers opted for traditional fixed-rate mortgages to avoid any payment delinquency.