key term - Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by bundling together a pool of mortgage loans and selling them to investors. These securities represent a claim on the cash flows generated by the underlying mortgages, allowing investors to earn returns based on the mortgage payments made by borrowers. MBS played a significant role in the global financial crisis as they were often linked to subprime mortgages and were a key factor in the housing bubble and subsequent market collapse.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities gained popularity in the 1980s and were seen as a way to provide liquidity to the housing market by allowing banks to offload mortgage risks.
2. The 2008 financial crisis was largely attributed to the collapse of MBS linked to high-risk subprime mortgages, leading to massive losses for investors and financial institutions.
3. As housing prices declined, many homeowners defaulted on their mortgages, causing the value of MBS to plummet and triggering widespread financial instability.
4. Government-sponsored enterprises like Fannie Mae and Freddie Mac played a crucial role in the MBS market by guaranteeing many of these securities, which added a layer of risk when they failed during the crisis.
5. The aftermath of the crisis led to increased regulatory scrutiny of MBS and related financial products, prompting reforms aimed at improving transparency and reducing systemic risk.

Review Questions

• How did mortgage-backed securities contribute to the housing bubble prior to the global financial crisis?
  • Mortgage-backed securities contributed to the housing bubble by encouraging lenders to offer more subprime mortgages, which often came with risky terms. As MBS became popular, banks were able to package these high-risk loans and sell them to investors, creating a cycle of demand that inflated housing prices. This led to an unsustainable boom in the housing market, where many borrowers took on loans they couldn't afford, setting the stage for widespread defaults when the market collapsed.
• Evaluate the role of government-sponsored enterprises like Fannie Mae and Freddie Mac in the mortgage-backed securities market and their impact during the financial crisis.
  • Fannie Mae and Freddie Mac played a pivotal role in the mortgage-backed securities market by providing guarantees on a large volume of MBS, which encouraged banks to issue more mortgages. During the financial crisis, their guarantees became liabilities as housing prices fell and defaults surged. The failure of these enterprises not only led to significant losses for taxpayers but also intensified the financial instability that gripped the entire banking sector.
• Assess how the global financial crisis reshaped perceptions and regulations surrounding mortgage-backed securities after 2008.
  • The global financial crisis drastically reshaped perceptions of mortgage-backed securities, exposing their inherent risks and leading to a loss of trust among investors. As a result, regulatory bodies implemented new rules aimed at enhancing transparency in MBS transactions and improving risk assessment practices. These changes included stricter capital requirements for banks dealing with MBS and efforts to regulate credit rating agencies that had previously given overly optimistic ratings on these complex financial products, aiming to prevent another crisis fueled by similar risky investments.

Related terms

Subprime Mortgages: Loans offered to borrowers with poor credit histories, typically associated with higher interest rates and increased risk of default.

Collateralized Debt Obligation (CDO): A type of structured financial product that pools together various types of debt, including mortgage-backed securities, and sells them as tranches to investors.

Credit Default Swap (CDS): A financial derivative that allows an investor to 'swap' or offset their credit risk with another party, often used to protect against defaults on mortgage-backed securities.