Discuss how securitization, mortgage-backed securities, credit-rating agencies, and credit default swaps contributed to the financial meltdown of 2008

Question

What will be an ideal response?

Answer 1

Answer: The secondary mortgage market is a vital source of funds for lenders, because they can sell their loans to investors and use the proceeds to make even more loans. In the secondary market, individual loans are often pooled and transformed into investment products through the process of securitization, which allows investors to buy shares of a given pool.
Mortgage-backed securities (MBSs) are specifically based on home mortgages, and they became spectacularly popular during the housing boom. MBSs can be good investments, but during the boom years, the securitization process was so convoluted that many investors had no idea what was in the securities they were buying. In addition, credit rating agencies sometimes assigned investment-quality grades to MBSs that were full of time-bomb ARMs and other toxic mortgages—investments that should've been treated like junk bonds. This proved to be one of the most fundamental mistakes in the entire mess.
However, that wasn't the end of it. To protect themselves against the risk of borrower defaults, investors who bought MBSs could buy credit default swaps to transfer default risk to somebody else. Like most every other financial tools available in the years leading up to the crisis, credit default swaps can be put to good use or misused in destructive ways. Swaps became so popular with speculators that by the peak of the bubble, $45 trillion was invested in swaps, an amount approaching the output of the entire global economy.