Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by pooling together a collection of mortgages and then selling shares of that pool to investors. They allow investors to earn income from the mortgage payments made by homeowners, while providing banks with liquidity to issue more loans. MBS play a crucial role in the financial services sector by facilitating capital flow and supporting housing finance.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities can be categorized into two main types: pass-through securities, where payments are directly passed to investors, and collateralized mortgage obligations (CMOs), which offer different tranches of risk and return.
2. The creation of MBS allows banks to reduce their risk exposure by transferring the credit risk of mortgages to investors, which also helps in freeing up capital for additional lending.
3. The secondary mortgage market is where mortgage-backed securities are bought and sold, playing a vital role in determining interest rates for new loans based on MBS performance.
4. MBS were at the center of the 2008 financial crisis, as many were backed by subprime mortgages that defaulted at high rates, leading to significant losses for investors and institutions.
5. Government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac significantly influence the MBS market by guaranteeing a portion of these securities, providing stability and attracting investor confidence.

Review Questions

• How do mortgage-backed securities contribute to the liquidity of financial institutions?
  • Mortgage-backed securities enhance liquidity for financial institutions by allowing them to bundle mortgages into tradable securities. When banks sell these MBS, they receive immediate cash, which can be used to issue more loans or meet other obligations. This process not only reduces the risk associated with holding long-term mortgage debt but also enables continuous lending in the housing market.
• Discuss the risks associated with investing in mortgage-backed securities and how they were highlighted during the 2008 financial crisis.
  • Investing in mortgage-backed securities carries risks such as credit risk, interest rate risk, and prepayment risk. During the 2008 financial crisis, these risks became apparent as many MBS were composed of subprime mortgages that defaulted at alarming rates. The widespread failure of these underlying mortgages led to massive losses for investors and prompted a reevaluation of how MBS were rated and traded in the financial markets.
• Evaluate the impact of government-sponsored enterprises on the mortgage-backed securities market and how they influence economic stability.
  • Government-sponsored enterprises like Fannie Mae and Freddie Mac play a critical role in stabilizing the mortgage-backed securities market by providing guarantees on a portion of these securities. This backing reassures investors about potential losses, making MBS more attractive and lowering borrowing costs for homeowners. However, reliance on these GSEs can also lead to systemic risks if their practices encourage excessive lending without adequate risk assessment, highlighting the delicate balance between market stability and potential economic vulnerabilities.

Related terms

Asset-backed securities: Financial securities backed by a pool of assets, such as loans, leases, or receivables, allowing investors to receive income from the underlying cash flows.

Securitization:

The process of converting illiquid assets, like mortgages, into securities that can be sold to investors, enhancing liquidity and diversifying risk.

Subprime mortgages: Loans offered to borrowers with poor credit histories or limited creditworthiness, often associated with higher default risks and higher interest rates.