huh? mortgage-backed securities explained

image courtesy of here

okay, this gets a little more complicated, so hang on.

when housing prices were rising in the late 90’s, many people purchased homes with sub-prime loans due to a confluence of factors: 1. they believed housing prices would continue to rise and they would be able to re-finance at a more favorable rate in the future 2. banks realized they could charge much higher origination fees for sub-prime loans and so encouraged people without adequate education to apply for a sub-prime loan 3. everyone got a little greedy.

the goal of homeownership is basically the bedrock of the american dream, so it’s hard to really blame anyone for allowing more americans that experience. regardless, when the percent of sub-prime loans skyrocketed, financial institutions realized they could spread the risk of defaulting around by packaging the sub-prime loans into mortgage backed securities.

let's break it up to explain. a security is an instrument of financial value; stocks and bonds are securities. a mortgage backed security is where a bunch of mortgage loans are grouped together to create a large pool of debt. this debt is then sold to investors the same way a bond is; you buy it at a discount and rely on the mortgage payments for the payout. it was supposed to be a relatively safe investment, partly thought so because of these odd rating rules for bond insurers (i’m sure you’ve heard about this), and because some of these mortgages were structured so that people ended up paying MORE than they were borrowing, it sounded like a great deal.

the primary holders of these mortgage-backed securities (and there are also these other very complicated things called collateralized debt obligations , or CDO’s, which are made up of various types of mortgage related securities) were corporate and institutional investors and investment banks like Bear Stearns, who bought them in droves during the height of the real estate boom, often touting them as “undiscovered gems”.

tomorrow we'll look at the fallout and how the government is getting involved.
Anonymous said...

I wish I were born 20 years earlier! this housing market was far more stable, and thus were less likely to end up with negative equity. I the nowadays you would be foolish not to get a Mortgage Bond!

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