Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by bundling together a collection of mortgage loans and selling shares in this pool to investors. This process allows financial institutions to manage risk while providing capital to homeowners, ultimately facilitating the housing market. MBS can be issued by government-sponsored enterprises or private entities, and they generate returns for investors through the interest payments made by homeowners on their mortgages.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities became popular in the 1980s as a way to provide liquidity to the housing market, allowing lenders to free up capital for new loans.
2. MBS can carry different levels of risk depending on the quality of the underlying mortgages; those backed by prime loans are generally seen as safer investments compared to those backed by subprime loans.
3. The 2008 financial crisis was significantly influenced by the collapse of mortgage-backed securities, which led to widespread defaults and a severe downturn in the housing market.
4. MBS can be categorized into agency-backed securities (issued by government entities) and non-agency securities (issued by private companies), impacting their perceived risk and return.
5. Investors in mortgage-backed securities receive monthly payments that consist of both principal and interest from homeowners, making them an attractive option for income-seeking investors.

Review Questions

• How do mortgage-backed securities function within the financial system, and what role do they play for both lenders and investors?
  • Mortgage-backed securities function by pooling multiple mortgage loans together and allowing investors to purchase shares in this pool. For lenders, MBS provides a way to manage risk by transferring some of it to investors while also freeing up capital for new mortgages. For investors, MBS offers a relatively stable income stream through interest payments from homeowners, making it an appealing investment option within the financial system.
• Evaluate the impact of the 2008 financial crisis on the market for mortgage-backed securities and how it reshaped regulations in the financial sector.
  • The 2008 financial crisis severely impacted the market for mortgage-backed securities, leading to significant losses for investors as defaults on subprime mortgages surged. This collapse highlighted the risks associated with MBS and resulted in widespread calls for regulatory reform within the financial sector. Consequently, new regulations were implemented to increase transparency and oversight in the securitization process, aiming to prevent a similar crisis in the future.
• Assess how changes in housing policy and interest rates influence the demand for mortgage-backed securities and their overall market performance.
  • Changes in housing policy, such as adjustments to lending standards or government intervention in the housing market, directly influence the demand for mortgage-backed securities. Lower interest rates generally make borrowing cheaper, encouraging more homeowners to refinance or take out new mortgages, thus increasing the supply of MBS. Conversely, higher interest rates may lead to decreased demand for mortgages, resulting in a lower volume of new MBS issuance and potentially impacting investor returns. The interaction between these factors can significantly shape overall market performance and investor confidence in MBS.

Related terms

Collateralized Mortgage Obligation (CMO): A type of mortgage-backed security that organizes mortgage loans into different tranches with varying levels of risk and return for investors.

Subprime Mortgage: A type of mortgage offered to borrowers with poor credit histories, often carrying higher interest rates due to increased risk.

Securitization: The process of converting illiquid assets, like mortgages, into liquid securities that can be traded on the market.