Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments that are created by pooling together a large number of individual mortgage loans and selling shares in that pool to investors. These securities allow investors to earn returns based on the mortgage payments made by homeowners, providing liquidity to the mortgage market while transferring some risk from lenders to investors. MBS played a pivotal role in the financial system, especially during times of economic stress.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities were popularized in the 1980s and became a significant part of the financial markets as they provided a way to finance home loans while spreading risk among investors.
2. During the 2008 financial crisis, MBS were heavily impacted by rising default rates on subprime mortgages, leading to massive losses for investors and contributing to a widespread financial meltdown.
3. The value of MBS is influenced by interest rates; when rates rise, the value of existing MBS can decline as new mortgages with higher rates become more attractive.
4. Government-sponsored entities like Fannie Mae and Freddie Mac played a crucial role in the MBS market by guaranteeing these securities, which contributed to their growth but also to systemic risks.
5. The complexities associated with MBS, including how they were structured and rated, led to a lack of transparency in the financial system, exacerbating the crisis when defaults increased.

Review Questions

• How do mortgage-backed securities provide liquidity to the mortgage market and what role do they play in risk management?
  • Mortgage-backed securities enhance liquidity in the mortgage market by allowing lenders to bundle mortgages and sell them as securities to investors. This process frees up capital for lenders, enabling them to issue more loans. Additionally, MBS help in risk management by distributing the risks associated with mortgage defaults from individual lenders to a broader base of investors who hold these securities.
• Discuss how the collapse of the mortgage-backed securities market contributed to the Global Financial Crisis of 2008.
  • The collapse of the mortgage-backed securities market was a major factor in the Global Financial Crisis of 2008. As subprime mortgages began defaulting at alarming rates, the value of MBS plummeted, causing significant losses for investors and financial institutions. This loss of confidence led to a credit crunch, where banks became hesitant to lend money, resulting in widespread economic instability and recession.
• Evaluate the impact of government-sponsored entities like Fannie Mae and Freddie Mac on the mortgage-backed securities market and systemic risks within the financial system.
  • Government-sponsored entities like Fannie Mae and Freddie Mac had a substantial impact on the mortgage-backed securities market by providing guarantees that boosted investor confidence. However, this backing also created systemic risks; as these entities grew in size and complexity, their exposure to risky mortgages increased. When defaults rose during the financial crisis, it became evident that their failure could threaten the entire financial system, leading to government bailouts and long-term reforms in housing finance.

Related terms

Collateralized Debt Obligation: A type of structured asset-backed security that is backed by a pool of loans or other debt obligations, allowing different levels of risk and return for investors.

Subprime Mortgages: Loans granted to borrowers with poor credit histories, characterized by higher interest rates and risk of default, often contributing to the creation of MBS.

Securitization:

The process of converting an illiquid asset or group of assets into a security, allowing for easier trading and investment in those assets.