How Does a Mortgage-Backed Security Work?First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment bank or a quasi-governmental agency like Fannie Mae, Freddie Mac or Ginnie Mae. They bundle a lot of loans with similar interest rates. They then sell a security that delivers the same payments that the bundle of loans do. That's the MBS, which is a security backed by the mortgage. The MBS is sold to institutional, corporate or individual investors on the secondary market.
The MBSs sold by the governmental agencies were particularly attractive, because the returns were guaranteed by these agencies, who were themselves backed by the Federal government. Therefore, those who bought a Fannie Mae or Freddie Mac MBS knew they would get something in return for their investment. Ginnie Mae absolutely guaranteed that investors would receive their payments. (Source: SEC, Mortgage-backed Securities)
Types of Mortgage-backed SecuritiesThese investments can be very complicated. The most basic are called pass-through participation certificates. They simply pay the holder their fair share of both principal and interest payments made on the mortgage bundle.
As banks tried to create more investment products, they came up with the more complicated collaterized mortgage obligations or mortgage derivatives. These sliced up the bundles into similar risk categories, known as tranches. The least risky tranche would only contain the first 1-3 years of payments, since borrowers are most likely to pay the first three years. However, for adjustable-rate mortgages, these years also have the lowest interest rates. Therefore, some investors may prefer a tranche that contains the next 5-7 years of payments. They're willing to take the higher risk of non-payment for the higher interest rate reward.
The greatest risk with MBSs is that the borrowers may not pay. If the borrower prepays the mortgage because they refinance, then the investor gets the initial investment back. However, people usually refinance when interest rates are low, so the investor doesn't have many attractive alternatives. The worse risk is when the borrower defaults altogether. Then the investor takes a loss.
Mortgage-Backed Securities Changed the Housing IndustryThe invention of mortgage-backed securities completely revolutionized the housing, banking and mortgage business. At first, mortgage-backed securities allowed more people to buy homes. During the real estate boom, many less careful banks and mortgage companies made loans with no money down, thus allowing people to get into mortgages they really couldn't afford. The lenders didn't care as much, because they knew they could sell the loans, and not pay the consequences when and if the borrowers defaulted. This created an asset bubble, which then burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds and financial institutions owned mortgage-backed securities, everyone took losses, creating the 2008 financial crisis.
How Mortgage-Backed Securities Went WrongThe ability to create mortgage-backed securities was authorized by the 1968 Charter Act which created Fannie Mae. The intent was to allow banks to sell off mortgages, thus freeing up funds to lend to more homeowners. The founders didn't anticipate that this would also remove an important discipline for good lending practices. Banks soon realized that they wouldn't be around to take the loss if the borrower didn't pay off the loan. The banks got paid for making the loan, but didn't get hurt if the loan went bad. Therefore, they weren't as careful about the credit-worthiness of the borrower.
Second, mortgage-backed securities allowed financial institutions other than banks to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. They had the deep pockets to wait patiently until these loans were repaid 15 or 30 years later. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. Mortgage lenders sprang up everywhere, and they also weren't too careful about who they lent to. This created additional competition for traditional banks, who had to lower their standards to keep the loan volume up.
Third, MBSs were not regulated. Traditionally, banks had been highly regulated by governmental agencies to make sure their borrowers were protected. MBSs, and mortgage brokers, were not.