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Figure 3. Th e MBS market reacts to the bubble’s defl ation

Source: Th ompson Reuters Debt Capital Markets Review, Fourth Quarter 2008, available at http://
thomsonreuters.com/products_services/fi nancial/league_tables/debt_equity/ (accessed July 30, 2009).
Th e decline in housing values had a profound adverse eff ect on the liquidity
of all fi nancial institutions that were exposed to PMBS. As noted above, one of the
benefi ts of holding PMBS, especially those with AAA ratings, was that they were
readily marketable. As such, they were considered sound and secure investments,
carried on balance sheets at par and suitable to serve as collateral for short term
fi nancing through repurchase agreements, or “repos.” In a repo transaction,
a borrower sells a security to a lender with an option to repurchase it at a price
that provides the lender with a return appropriate for a secured loan. Th e lender
assumes that if its counterparty defaults the collateral can be sold. Accordingly, if
the collateral asset loses its reputation for high quality and liquidity, it loses much
of its value for both capital and liquidity purposes, even if the collateral itself has
not actually suff ered losses. Th is is what happened to AAA-rated PMBS as housing
prices fi rst leveled off and then began to fall in 2007, and as mortgage delinquencies
rolled in at rates no one had expected. As discussed more fully below, when AAA-
rated PMBS became unmarketable they lost their value for liquidity purposes,
making it diffi cult or impossible for many fi nancial institutions to fund themselves
using these assets as collateral for repos. Th is was the liquidity challenge to which
Chairman Bair referred in her testimony.
Th e near-failure of Bear Stearns in March 2008 was an excellent example of
how the unexpected collapse of the PMBS market could cause a substantial loss of
liquidity by a fi nancial institution, and ultimately its inability to survive the resulting
loss in market confi dence. Th e FCIC staff ’s review of the liquidity problems of
Bear Stearns showed that the loss of the PMBS market was the single event that
was crippling for Bear, because it eliminated a major portion of the fi rm’s liquidity