10. Historically, Fannie Mae and Freddie Mac went to banks andother mortgage originators, firms that loaned money to homebuyers,and buy their mortgages. This allowed the banks and otheroriginators to make still more mortgage loans. Fannie and Freddieand investment banks would combine mortgages and sell them toindividuals and businesses in the form of mortgage-backedsecurities (MBS).
In financial investing, there is generally a tradeoff betweenrisk and reward. Greater returns usually come with greater risks.Financial investors interested in investing in the U.S. housingmarket while prices were still rising, sometimes at double-digitannual rates (“Flip This House”), became interested in U.S.mortgage-backed securities issued by Fannie and Freddie and majorinvestment banks
a. How did private markets evaluate the default risk of MBS andwhy were risks so underpriced prior to the 2007-09 recession?
b. Conservative investors in MBS could buy a form of“insurance,” from other firms including traditional insurancecompanies (AIG) called credit default swaps, against potentialmortgage defaults. When MBS became toxic assets, what happened inthe market for these insurance-like contracts?
