Title Topics: What are Mortgage Backed Securities?

Posted by Amrock

The housing crisis left many families facing great financial losses and financial institutions facing extreme losses. It can be accredited in large part to mortgage backed securities (MBS), which are shares of a home loan that are sold to investors. But to really understand an MBS, you need to know how they originate.

How a mortgage backed security is created

Jim wants to buy a home and is approved for a mortgage from the bank. The bank will give Jim the money to purchase his home if he agrees to pay them back on a regular basis.

Now the bank has two options. They can either:

  1. Collect the money that Jim’s repaying on his loan, plus interest over the next several years
  2. Or sell the loan to Company X, providing the bank with more cash to make more loans, and they can collect a fee before they pass the rest of Jim’s monthly payment to Company X

The bank chose the latter option. Conveniently, Company X purchased 999 other loans from different banks that have similar interest rates and terms to Jim’s loan, so they add his to the pool. The pool is now called a mortgage backed security. Company X then sells parts of the pool to investors, so they have new funds to purchase more mortgages, create more MBSs and sell parts of them off to investors.

To recap, when Jim makes his monthly mortgage payment to the bank, they keep a fee and send the rest of the money to Company X. Company X then collects a fee and passes what’s left of the mortgage to the investors who purchased the MBS. By the time the housing crisis of 2008 hit, home loans became so divided and spread around that it was possible a homeowner could unknowingly own shares in their own mortgage.

Where it failed

MBSs used to yield a high return, because they were based on quality mortgages made to a limited amount of dependable borrowers. To increase profits, banks lowered their standards and granted loans to subprime borrowers who had low credit ratings and a high risk of defaulting on their loan. That didn’t matter, because the bank no longer takes on the risk of a loan default with a MBS, they simply issue it to the borrower and quickly sell it to another company that will have to take on the risks. Standards were lowered so much that people who may have been unemployed as far as the lender knew received loans for hundreds of thousands of dollars.

When subprime borrowers stopped making payments on their mortgages, because they couldn’t afford the monthly payments, the nation saw a significant increase in home loan defaults. The ceased payments left MBS investments completely worthless or at best performing badly, exacerbating the financial devastation faced during the housing crisis.

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