Mortgage-Backed Securities Fraud

To outline all the steps involved in how a mortgage becomes a mortgage-backed security and then becomes a source of fraud would take pages of complex legal and financial jargon. Here is a basic outline of one of the most common series of steps that led to the latest financial crisis:

First, a bank or mortgage-lender gives a borrower a loan at a certain interest rate.

Second, many of the nation's largest financial institutions (such as the now-defunct Bear Sterns or Lehman Brothers) purchased and pooled these loans together into large pools called mortgage-backed securities (MBSs), which represented a claim on the cash flows coming from the mortgages (i.e., the amount that individual must pay the lender each month, year, etc., for the amount borrowed). By buying these loans from lenders, they allowed that lender to loan even more out to new home-buyers, often to increasingly riskier customers.

Third, the nation's largest financial institutions repackaged thousands of loans into one investment called a collateralized debt obligation (CDO), a structured asset-backed security (in this case, back by mortgages) where the different levels, called tranches, represent the varying levels of risk, with the highest tranches representing the safest loans and the lowest tranches representing the riskiest. What essentially occurred prior to the 2008 credit crunch was that financial institutions were able to take the lowest levels of certain CDOs and repackage them into entirely new CDOs (that were relatively diverse). Because credit rating agencies like Moody's tend to look at the level of diversification in order to determine the value of the investment, they gave these other "diverse" CDOs good ratings, thus securing consumer confidence.

Fourth, while mortgage-backed securities are a relatively safe investment in normal economic times, they can quickly turn sour if homeowners start defaulting on their loans. If loan payments aren't being met, money owed to investors disappears and, in the blink of an eye, a CDO "worth" billions and relatively well-rated can become absolute junk.

What regulators are discovering with increasing frequency was that many of the nation's largest financial institutions began to realize in 2007 that these asset-backed securities (ABSs) were essentially worthless. All that these complex financial tools had done was spread the risk around and make it more complicated and expensive. When the companies realized that they could potentially be carrying billions of dollars in risk on their books, they quickly thought of ways to sell off these ABSs to potential victims without disclosing their true risk.

Source: cheatingculture