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2008 Financial Crisis:
How did the world collapse?

17/03/24

Leela Tarang Krishna

Consumer Insights

Giving loans is the primary purpose of a bank. Its income is the interest paid upon the loans provided. To ensure the repayment of the loan, including the interest thereon, the bank undertakes an extensive background check of the person's credibility. Nevertheless, there is always a degree of risk associated with giving bank loans, as the borrower may default on the payment of a loan.

What if that risk is transferred to someone else? What if the one taking the risk becomes the collector of the principal and the interest instead of the Bank? What if the Bank, by letting that person be the collector, gets all the principal it has given and the interest it would receive over the next few years from the person willing to assume the risk? What if this happens on every loan that the Bank has given?

Essentially, a person would get to fulfil their dream of a house. Because it is a bit risky, the bank sells that mortgage loan to someone who wants to assume that risk for a price calculated by adding the principal loan and the interest expected to be received. It would gain the money it has lent in exchange for the rights to collect the loan’s principal and interest.

I know what you are wondering - it is the Bank's duty to collect the money and to get the principal and the interest; ergo, it is the Bank's risk. Why would anyone assume the risk of nonpayment of a loan on behalf of the bank? Why would anyone step in as a collector instead of the Bank? What is their incentive?

You are right. No one would.

Unless they think that if they purchase all or some of the mortgages that the Bank has, they can get significant money periodically (as collectors) over the next few years, which can be used for investment purposes.

Suddenly, substituting oneself as the principal and interest collector becomes a very lucrative option. Suddenly, planning for the future becomes extremely easy, for assured cash flow exists. Suddenly, the Banks and investors are rich - they can invest in many products and improve many services, and people can fulfil their lifelong dream of owning a home.

A seemingly perfect world is created if the risk for the Bank is transferred, and Lewis Ranieri, a former New York bond trader, was the first to develop an instrument that embodies this idea.

He created a Mortgage-backed security (MBS).

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