What are mortgage-backed securities?

Mortgage-backed securities (MBS) fall into a unique category of securities. 

An MBS is a particular type of debt security that is secured by a mortgage or a bundle of mortgages. A bank that issues similar mortgage loans can pool them together and sell these to a government agency or an investment bank that securitizes (packages) the loans together into a security that investors can buy.

Typically, there are agencies owned by the government like Ginnie Mae. Other agencies, such as Fannie Mae or Freddie Mac, are sponsored by the government, therefore they are called government sponsored-enterprises (GSEs).

MBS holders typically receive monthly interest payments, because homeowners (whose mortgages make up the underlying collateral for the MBS) pay monthly installments on their mortgages.

MBS and the GFC

The global financial crisis (GFC) of 2007/2008 was partly blamed on the proliferation of subprime mortgages that borrowers weren’t able to repay. Subprime (low quality) mortgages are especially risky since borrowers often have a poor credit history, no assets, or in some cases even no income. 

Banks essentially gave out loans to people who were unlikely to pay them back. The reasoning behind this was that they could sell their exposure to these loans via MBS, so they didn’t need to worry whether borrowers defaulted (was unable to pay back the loan). Credit rating agencies exacerbated the problem by giving these packaged MBS a solid rating thereby making investors believe these were financially secure assets. 

This shortsighted policy was directly responsible for the crisis. A lot of people who had home loans also held MBS. The market crash triggered by mass loan defaults led to an insane ripple effect through the whole economy. Despite the disaster that nearly toppled the world economy, the MBS market is still functioning. Due to their checkered past, complexity and high minimum investment amount (generally $10,000), MBS are typically shunned by retail investors.

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