Introduction to Finance

mortgage-backed security
is a 
debt security created by pooling together a group of mortgage loans whose periodic payments 
belong to the holders of the security. The value of these mortgage-backed securities depended 
on the value of the homes against which the underlying mortgages were issued.
As previously noted, housing prices peaked in 2006 and home values then began a sharp 
decline leading to the 2007–2008 fi nancial crisis. Housing-related jobs were lost and unem-
ployment increased, resulting in increasing mortgage loan defaults by homeowners. Falling 
house prices and rising mortgage loan defaults, in turn, caused the value of mortgage loans, 
and associated mortgage-backed securities, on those houses to also drop. In many instances, 
mortgage 
loan backed by real 
property in the form of buildings 
and houses
mortgage-backed security 
debt 
security created by pooling together 
a group of mortgage loans

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3.2 Types and Roles of Financial Institutions
47
the value of houses declined to levels below the amounts of the underlying mortgages, wiping 
out all equity the homeowners had in the houses. When mortgage loans exceed the value of 
the underlying houses, the mortgage loans are said to be “underwater.”
Many banks and other fi nancial institutions that held mortgage loans and mortgage-backed 
securities as assets suff ered liquidity and solvency problems when the values of these loans 
and securities fell to such low levels that there was concern whether the fi nancial institutions 
could meet their liability obligations when they came due. This situation was made worse by 
increasing unemployment throughout the United States, resulting in a contraction in economic 
activity that culminated in the Great Recession of 2008–2009.
In March 2008, Bear Sterns, a major fi nancial institution, was on the verge of failing 
due to the collapse of the values of mortgage-backed securities and had to be acquired by 
the JPMorgan Chase & Co. with the help of the Federal Reserve and the U.S. Treasury. By 
September 2008, the fi nancial crisis was at its peak. Lehman Brothers, a major investment 
bank, was allowed to fail, and Merrill Lynch was sold to Bank of America. 
Shortly after the Lehman bankruptcy and the Merrill sale, American International Group 
(AIG), the largest insurance fi rm in the United States, was “bailed out” by the Federal Reserve 
with the U.S. government receiving an ownership interest in AIG. Like Merrill, the Federal 
National Mortgage Association (Fannie Mae), and the Federal Home Mortgage Association 
(Freddie Mac), AIG was considered “too large to fail” due to its potential impact on the global 
fi nancial markets.
In late September 2008, Washington Mutual, the largest S&L in the United States, 
failed with most of its assets being purchased by JPMorgan Chase. Wachovia Bank, then 
the fourth largest commercial bank in the United States, was also on the brink of bank-
ruptcy before fi nally agreeing to be purchased by Wells Fargo Bank. Citigroup and Bank of 
America, the fi rst and second largest U.S. banks, respectively, also were suff ering fi nancial 
diffi
culties.
The U.S. government responded with the passage of the Economic Stabilization Act of 
2008 in early October 2008. A primary focus of the legislation was to allow the U.S. Treasury 
to purchase up to $700 billion of “troubled” or “toxic” assets held by fi nancial institutions. 
This became known as the Troubled Asset Relief Program (TARP). However, much of the 
TARP funds were actually used to invest capital in banks with little equity on their balance 
sheets, as well as to rescue large nonfi nancial business fi rms, specifi cally General Motors and 
Chrysler, who were on the verge of failing. In an eff ort to stimulate economic activity, the U.S. 
government also passed the $787 billion American Recovery and Reinvestment Act of 2009 in 
February 2009. Funds were to be used to provide tax relief, appropriations, and direct spend-
ing. In Chapter 5, we will discuss the legislative and other actions by the U.S. government and 
the Federal Reserve to counter the perfect fi nancial storm.
3.2
Types and Roles of Financial Institutions
The current system of fi nancial institutions or intermediaries in the United States, like the 
monetary system, evolved to meet the needs of the country’s citizens and to facilitate the 
savings-investment process. Individuals may save and grow their savings with the assist-
ance of fi nancial institutions. While individuals can invest directly in the securities of 
business fi rms and government units, most individuals invest indirectly through fi nancial 
institutions that do the lending and investing for them.