Mortgage-backed securities

Mortgage-backed securitiesq

What are mortgage-backed securities (MBS)?

Mortgage-backed security (MBS) is a bond-like investment that consists of a bundle of home loans purchased from the issuing bank. Investors in MBS receive periodic payments similar to bond coupon payments.

MBS is asset-backed security. As was evident in the subprime mortgage crisis of 2007-2008, mortgage-backed security is only as sound as the mortgage backing it.

How mortgage-backed securities work

Essentially, mortgage-backed securities make banks a middleman between home buyers and the investment industry. Banks can issue mortgages to customers and then sell them at a discount to be included in residential mortgage-backed securities. The bank recorded the transaction on its balance sheet and had nothing to lose if the buyer defaulted at some point in the future.

Investors who buy mortgage-backed securities are essentially lending money to homebuyers. MBS can be bought and sold through brokers. The minimum investment amount varies by issuer.

Along with subprime lending, mortgage-backed securities played a central role in the financial crisis that began in 2007, which wiped out trillions of dollars in wealth.

This process applies to all involved because everyone does what they are supposed to do. That said, banks follow reasonable standards when issuing mortgages; homeowners keep payments on time, and credit-rating agencies that review mortgage securities conduct due diligence.

To be sold in today’s market, mortgage-backed securities must be issued by a government-sponsored enterprise (GSE) or private finance company by a bank. Collateral must come from a regulated and authorized financial institution. And mortgage securities must have one of the top two ratings issued by an accredited credit rating agency.

Understanding Mortgage-Backed Securities

Types of mortgage securities

There are two common types of residential mortgage-backed securities: pass-through and mortgage-backed debt (CMO).

Pass-through

A pass-through trust is a form of trust in which mortgage payments are collected and passed on to the investor. They usually specify a maturity date of 5, 15, or 30 years. The closing period may be less than the stated maturity date, depending on the principal payment of the mortgage that constitutes the closing.

Mortgage secured debt

A CMO consists of multiple pools of securities called slices, or installments. These tranches are given a credit rating that determines the rate of return to investors.

The Role of Mortgage Loan Securitization in Financial Crisis

Mortgage-backed securities played a central role in the financial crisis that began in 2007 and roiled world financial markets by draining trillions of dollars of wealth to Lehman Brothers.

In retrospect, it seems inevitable that the rapid rise in home prices and the growing demand for residential mortgage-backed securities will encourage banks to lower lending standards and push consumers to jump into the market at all costs.

That was the start of the war for subprime MBS companies. With Freddie Mac and Fannie Mae actively supporting the mortgage market, the quality of all mortgage-backed securities declines, and ratings become meaningless. Then, in 2006, house prices peaked.

Subprime borrowers began to default, and the housing market began to collapse for a long time. More and more people are starting to forgo their mortgages because their homes are worth more than their debts. Even the traditional mortgages that underpin the MBS market have fallen sharply in value. The high number of delinquencies means that many mortgage securities and mortgage pool-based collateralized debt obligations (CDOs) are overvalued.

Losses piled up as institutional investors and banks tried to dump bad investments in MBS. The credit crunch has brought many banks and financial institutions to the brink of bankruptcy. Lending is disrupted to the point that the entire economy is in danger of collapsing.

Ultimately, the US Treasury stepped in with a $700 billion rescue program for the financial system, intended to ease the crisis credit crunch. This Fed has purchased $4.5 trillion in Troubled Mortgage Securities over the past few years in the Troubled Asset Relief Program (TARP) directly to Bank injection.

The financial crisis is finally over, but the government’s total commitment far exceeds the oft-cited figure of $700 billion.

KEY TAKEAWAYS

  • Mortgage securitization has turned banks into middlemen between home buyers and the investment industry.
  • The bank processes the loans, which are then packaged into mortgage-backed securities at a discount to sell to investors as a type of mortgage bond.
  • For investors, residential mortgage-backed securities are as safe as mortgages.

Mortgage-Backed Securities Today

MBS is still bought and sold to this day. They have a market again, simply because people usually pay off their mortgages as long as they can.

The Fed still has a huge market share of residential mortgage-backed securities (MBs), but it is gradually selling off its holdings. Even CDOs are making a comeback after falling out of favor in the years following the crisis.

Suppose it was Wall Street who learned his lesson and would question the value of residential mortgage-backed securities instead of buying them blindly. Time will tell.

By Master James

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