key term - Mortgage-Backed Securities

Definition

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, including residential and commercial mortgages. They are a type of asset-backed security that is created by securitizing a group of mortgages into a tradable financial instrument.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities were a key component of the Great Deregulation Experiment, as they allowed for the securitization and trading of mortgage debt, which expanded access to credit and fueled the housing bubble.
2. The growth of the MBS market was facilitated by the deregulation of the financial industry, which removed barriers to the creation and trading of these complex financial instruments.
3. The rise of subprime mortgages and the packaging of these high-risk loans into MBS contributed to the financial crisis of 2007-2008, as the underlying mortgages began to default at high rates.
4. The collapse of the MBS market and the broader financial crisis led to a severe economic recession and the implementation of new regulations aimed at increasing transparency and reducing systemic risk in the financial system.
5. The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac played a significant role in the MBS market, as they purchased and securitized mortgages, providing liquidity and fueling the growth of the housing market.

Review Questions

• Explain how the growth of the mortgage-backed securities market was facilitated by the deregulation of the financial industry.
  • The deregulation of the financial industry, which occurred as part of the Great Deregulation Experiment, removed barriers to the creation and trading of mortgage-backed securities. This allowed for the rapid expansion of the MBS market, as financial institutions could more easily securitize mortgage loans and package them into tradable financial instruments. The increased availability of credit and the ability to offload mortgage risk through the MBS market fueled the growth of the housing bubble leading up to the financial crisis.
• Describe the role of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac in the mortgage-backed securities market.
  • Fannie Mae and Freddie Mac, as government-sponsored enterprises, played a significant role in the growth of the mortgage-backed securities market. These GSEs purchased and securitized mortgages, providing liquidity and fueling the expansion of the housing market. By purchasing mortgages and packaging them into MBS, Fannie and Freddie helped create a robust secondary market for mortgage debt, which in turn increased the availability of credit and contributed to the housing bubble leading up to the financial crisis.
• Analyze how the collapse of the mortgage-backed securities market and the broader financial crisis led to a severe economic recession and the implementation of new regulations.
  • The collapse of the MBS market, driven by the high default rates of subprime mortgages that had been packaged into these securities, was a key trigger of the broader financial crisis. This crisis caused a severe economic recession, as the collapse of the housing market and the broader financial system led to a contraction in credit, a decline in consumer spending, and widespread job losses. In response to the crisis, policymakers implemented new regulations, such as the Dodd-Frank Act, aimed at increasing transparency, reducing systemic risk, and preventing similar crises from occurring in the future. These regulations sought to address the vulnerabilities exposed by the MBS market and the broader deregulation of the financial industry.

Related terms

Securitization:

The process of transforming illiquid assets, such as mortgages, into tradable securities that can be bought and sold on financial markets.

Collateralized Debt Obligation (CDO): A type of structured finance product that is backed by a pool of debt assets, such as mortgages, bonds, and loans, and divided into tranches with varying levels of risk and return.

Subprime Mortgage: A mortgage loan granted to borrowers with poor or limited credit history, often with higher interest rates and less favorable terms compared to prime mortgages.