Mortgage Backed Securities 101

Mortgage_backed_securityAs always, let's start with the basic definition. What is a mortgage?

A mortgage is a loan secured against the collateral of your home or property. Other common variants of a mortgage are home loans, housing loans and property loans.

A mortgage occurs when the mortgagor (owner) pledges his / her ownership of the property as collateral for the loan. A property mortgaged to the bank is an encumbered property. The title deed is then withheld by the bank/financial institution. When the borrower defaults on his mortgage, it gives the bank the right to foreclose the house/property to recover the monies that they have lend out to the mortgagor or borrower. A property that is fully paid up is called an unencumbered property.

What is a Mortgage backed security (MBS)?

Mortgage backed securities (MBS) are securities certificates secured against the debt obligations of property mortgages. In 2008, the mortgage backed securities (MBS) brought upon the subprime crisis that crippled the US economy. Four years on, the US economy is still recovering from the subprime crisis.

Commonly used by the smaller US banks to acquire cash for home / commercial lending in the US. When home owners want to buy a house, they would go to a bank to borrow money. To have money for lending, Banks acquire cash by selling securities paper to investors paying them coupon interest on their investments, quite similar to bonds.

With the monies acquired from selling the mortgage paper securities (MBS), the banks then lends out the money to home owners and charge them interest on their mortgages. The lending bank receives the mortgage interest payments from the home owners and pays out a portion of the interest received to Mortgage backed securities (MBS) investors.

The bank earns a spread between the coupon yield of the Mortgage backed securities and the interest payment on the borrower’s mortgages. The lending risk is also effectively transferred from the bank to the mortgage backed securities (MBS) investor.

Let’s use an example for illustration. Bank A sells Mortgage backed security to Investors XYZ and pays the investors a coupon yield of $30,000. The bank acquired a cash fund of 10 million. The bank lends out the $10 million to borrowers / home owners and earns $50,000 in interest income. The bank pays out $30,000 to investors XYZ of the Mortgage backed securities (MBS) and earns the spread of $20,000. The bank also effectively transfers the lending risk to the Mortgage backed securities investors while earning a spread between the interest payment and the coupon yield.

This sounds like an excellent formula, so what went wrong?

When the pool of good quality borrowers dried up and with lending risk effectively being transferred upon to investors of the Mortgage backed securities (MBS), US banks started lending to customers with low credit ratings. Subsequently, when the interest rates on their homes were adjusted upwards, many of these low credit borrowers turn into problems paying for their mortgage loans.

Foreclosure rose and the supply of properties exceeded the demand. Property prices started falling and many home owners started owning debts more than the worth of their house. Many home owners disappeared and foreclosure rose twin fold.

As the property market turned sour, so did the Mortgage backed securities. As the Mortgage backed securities (MBS) were sold to everyone, including banks, corporations, companies and individual, the souring of the property market and Mortgage Backed Security(MBS) have major domino knock on effect. What came next in news not too long after was the collapse of Fannie Mae and Freddie Mac.