Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by pooling together a collection of mortgage loans and then selling shares of that pool to investors. They are essentially a way for banks to turn illiquid mortgages into liquid assets, which can then be traded in the financial markets. This process helped to fuel the housing bubble, as it allowed for the widespread distribution of risk and increased the availability of credit.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities became popular in the 1980s and 1990s as a way for banks to manage risk and increase liquidity in the housing market.
2. During the housing bubble, MBS were often backed by subprime mortgages, which increased their risk and contributed to the financial crisis when defaults rose.
3. Investors in MBS receive periodic payments derived from the mortgage payments made by homeowners, but these payments can vary based on default rates.
4. The collapse of the MBS market played a significant role in the 2008 financial crisis, as many investors were left holding worthless securities when mortgage defaults skyrocketed.
5. Regulatory changes in the early 2000s allowed for more aggressive lending practices, leading to a significant increase in MBS issuance and contributing to the housing bubble.

Review Questions

• How did mortgage-backed securities contribute to the housing bubble prior to the financial crisis?
  • Mortgage-backed securities contributed to the housing bubble by enabling lenders to extend more credit than they typically would have. By pooling together risky subprime mortgages and selling them as MBS, banks spread out the risk among many investors. This practice incentivized lenders to issue more loans, often without proper scrutiny of borrowers' ability to repay, thus inflating housing prices and creating a bubble that eventually burst when defaults increased.
• Evaluate the impact of regulatory changes on the issuance of mortgage-backed securities leading up to the financial crisis.
  • Regulatory changes in the early 2000s encouraged riskier lending practices that resulted in a surge in mortgage-backed securities issuance. With less oversight on loan origination and underwriting standards, banks began approving subprime loans at alarming rates. This lack of regulation created an environment where MBS could be filled with high-risk mortgages, setting the stage for massive defaults when housing prices began to decline, ultimately triggering a broader financial meltdown.
• Analyze how the failure of mortgage-backed securities affected global financial markets during the 2008 crisis.
  • The failure of mortgage-backed securities had devastating effects on global financial markets during the 2008 crisis. As defaults surged, the value of MBS plummeted, leading to enormous losses for investors around the world. Financial institutions heavily invested in these securities faced severe liquidity issues and systemic risks, resulting in bank failures and government bailouts. The interconnectedness of global finance meant that the fallout from MBS failures rippled across economies, contributing to a worldwide recession that highlighted vulnerabilities in the financial system.

Related terms

subprime mortgage: A type of mortgage that is offered to borrowers with poor credit histories, often leading to higher interest rates and greater risk of default.

collateralized debt obligation (CDO): A financial product that pools together various types of debt, including mortgages, and sells them as securities to investors, often with different risk levels.

foreclosure: The legal process by which a lender takes possession of a property from a borrower who has failed to make mortgage payments.