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Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis

Bruce I. Jacobs
Financial Analysts Journal
Vol. 65, No. 2 (Mar. - Apr., 2009), pp. 17-30
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/40390349
Page Count: 14
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Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis
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Abstract

The credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. These instruments—RMBSs, CDOs, SIVs, and CDSs—shifted the risk of mortgage lending, especially the default risk, from one party to another, until many lost sight of the real risks of the underlying loans. But when housing-price appreciation reversed, many subprime borrowers, having made only negligible down payments, owed more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders, and losses, magnified by vast leverage, spread up the tower of structured instruments to CDO investors and CDS sellers. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.

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