QUESTION TWO

The $2007-2009$ Global Financial Crisis $($GFC$)$ was one of the most severe economic downturns since the Great Depression. It originated in the housing market, but its impact was global, affecting financial institutions, markets, and economies worldwide. A key factor in the crisis was the securitization of subprime mortgages into financial products such as mortgage$-$backed securities $($MBS$)$ and collateralized debt obligations $($CDOs$),$ which were widely distributed across financial institutions globally.

Required:

A$)$

Explain the structure of Mortgage$-$Backed Securities $($MBS$)$ and how they are created. In your answer, define what is meant by tranching in the context of MBS$,$ and describe the role of these tranches in distributing risk. $[4$ Marks$]$

B$)$

Discuss the role of credit rating agencies in the mispricing of risk during the lead$-$up to the Global Financial Crisis. How did rating agencies contribute to the widespread misjudgment of risk in MBS and CDOs? $[4$ Marks$]$

C$)$

Describe the role of Credit Default Swaps $($CDS$)$ in the financial system during the $2007-2009$ crisis. How did the widespread use of CDS on MBS and CDOs contribute to the magnification of losses and systemic risk? $[4$ Marks$]$

D$)$

What is the "originate$-$to$-$distribute" model, and how did it contribute to moral hazard in the housing and securitization markets? Discuss the incentives for mortgage originators and financial institutions under this model. $[4$ Marks$]$

E$)$

After the Global Financial Crisis, various regulatory reforms were introduced to address issues in the securitization market and improve financial stability. Discuss two key reforms related to securitization$,$ including changes in transparency, capital requirements, and credit rating agencies. $[4$ Marks$]$

$[$Total: $20$ Marks