Question

What is a mortgage-backed security, how it functions, and how it contributed to the financial crisis of 2007 & 2009. (1000 words)

Answer 1

a. What is Mortgage based Security:

Ans: A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a group of home loans bought from the banks that issued them. It is a type of Asset Based Security. Basically it is traded on Secondary market which enables the Investors to Make profits from mortgages business without need to directly buy or Sell home loans.

Investors in MBS receive periodic payments similar to bond coupon payments.

Under this Investor purchase the Mortagage -Based Security from bank who has issued the home loan to home buyers. Indirectly Investor are giving lending money to Home buyers. Investor also have right value of Mortgage, interest and principal payment

Accordingly Bank come the middleman between MBS investor and Home buyers.

Generally there are two type of MBS

a. Pass-Through MBS : Pass Through MBS structured as Trust in which payments of interest and principal collected and passed through to Customer. The life of Pass Through may be less than stated Maturity age.

b. Collateralized mortgage obligation (CMO): Collateralized mortgage obligations comprise multiple pools of securities, also known as tranches. Each tranche comes with different maturities and priorities in the receipt of the principal and the interest.The tranches are also given separate credit ratings. The least risky tranches offer the lowest interest rates while the riskier tranches come with higher interest rates and, thus, are generally more preferred by investors.

2. How MBS Functions:

When Someone want to buy a home, that person approach a bank to give him a mortgage. If the bank confirms that that person are creditworthy based on their parameter defined , it will deposit the money into his account as loan. That person will then be required to make periodic payments to the bank according to the mortgage agreement. The bank may choose to collect the principal and interest payments, or it may opt to sell the mortgage to another financial institution.

If the bank decides to sell the mortgage to another bank, government institution, , private entity or individual, it will use the proceeds from the sale to make new loans. The institution that buys the mortgage loan pools the mortgage with other mortgages having similar features such as interest rates and maturities.

It then sells these mortgage-backed securities to interested investors. It uses the funds from the sale to buy more securities and float more MBS in the open market.

3. how it contributed to the financial crisis of 2007 & 2009.

Ans: Mortgage-backed securities played a vital role in financial Crises that come up in 2007 and 2009 and wipe out trillions of dollars in wealth, bring down the banks and roil the world financial markets.

Before that there were increase in home prices which increased the demand of MBS and to meet the requirement bank has reduced their landing standards and drive consumers to jump to market at any cost.

That was the beginning of the Subprimce MBS. the quality of all mortgage-backed securities declined and their ratings became meaningless. Then in 2006, housing prices peaked.

Subprime borrowers started to default and the housing market began its long collapse. More people began walking away and stop paying for their mortgages because their homes were worth less than their debts. The avalanche of non-payments meant that many MBSs and collateralized debt obligations (CDO) based off of pools of mortgages were vastly overvalued.

The losses piled up as institutional investors and banks tried and failed to unload bad MBS investments. Credit tightened, causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of collapse so major reason was of Financial crisis is giving Subprime MBS.