MBS, Moral hazard and the Financial crisis

The primary reason, i believe, for the recent financial crisis was more to do with "Moral hazard" because of the ecosystem that was created out of the so called innovative financial instruments.

Before i go a little deep into this, let me briefly describe what MBS(Mortgage backed securities) mean...

A loan secured by real property is referred to as a mortgage or mortgage loan. Typically, in these kind of  transactions, bank grants the loan to the borrower and the property is kept as collateral with the bank in case the borrower defaults. Based on the type and the value of the collateral, the loan can be characterized into prime or subprime loan or Alt A loan (will discuss this some other day). In the case of US, most of them were sub prime loans meaning "Not so good with respect to loan recovery prospects" loans.

In the typical transaction described above, the bank is earning nothing on the collateral present with the bank and thereby losing a chance to earn more. So, what they do is create a security, issue them to new investors and raise money.

since the bank is raising money from the investors, bank will also have to pay interest to these investors. This is where mortgage comes into picture. The securities issued to these investors are mortgage backed i.e. the interest which the borrowers(mortgage loan takers) pay to the bank is directly passed on to these investors and hence these securities are mortgage backed. (There is a lot to MBS than what has been described above like tranches etc which is not required as of now... will describe them later)

So, essentially, banks do not assume the risk of non payment of mortgage loan takers. since they have linked loan takers with the investors and have made them risk free.(or rather appears to be risk free) and since they were risk free now, the issue of "Moral hazard" comes in.

Banks, now, kept on issuing mortgage loans, without much worry about the borrower, as they have got no risk and the investors(MBS buyers) are the ones bearing the risk. And when this reached a sizeable proportion and when the housing bubble busted then mortgage borrowers failed to pay loans, investors lost their money, there were many bank runs and the whole economy collapsed.

MBS were only one of the instruments that led to these behavior among banks. There were many other instruments in use !!!

Funding Gap in case of banks

Typically, banks accept deposits, make loans and earn the "interest spread" between the deposits and the loans.

At any point of time, banks always need to estimate the expected credit offtake and the deposits expected. Funding gap is calculated as the difference between current and projected credit and deposit flows. If the difference shows the projected need for credit exceeding the expected deposit flows, bank will have to raise additional resources. If the difference shows the projected credit requirement falling short of resources, banks will have to find profitable investment avenues for the surplus resources.