A mortgage-backed security or MBS is an asset that is secured by a group of mortgages. This process is made possible through securitization. Mortgage-backed securities are split into tranches, all with different interest rates and risk.
Mortgage-backed securities allow investors from all over the world to get exposure to a specific home mortgage market, with the largest being the US.
Investors effectively loan money to homeowners and get repaid through the mortgage payments of the homeowners. The risk to investors is that the homeowner does not meet the mortgage payments, defaults and therefore the asset the investor owns is worthless.
The other key feature of a mortgage-backed security is that it is a pool of mortgages which theoretically reduces risk. Rather than take on the risk of one homeowner's mortgage payments, MBS's pool hundreds and thousands of mortgages together so even when some default, the majority which do not default will more than make up the difference.
Unfortunately, this theoretical reduction in risk, and fees for creating mortgage-backed securities led mortgage originators and investors to start issuing / buying worse quality loans.
The problem with mortgage-backed securities is that they are highly dependent on the price of houses. As long as house prices keep going up in value, people will continue to pay mortgages and refinance their homes. However, as soon as the value of a house starts to drop, owners will default (as there is no real penalty for doing so) and the MBS will lose value.
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- Collateralized Debt Obligation (CDO)
- Interest Rate (IR)
- Junior Tranche
- Ratings Agency
- Senior Tranche