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In the wake of the Great Recession, many people began to wonder how such a devastating financial crisis could have happened. A consensus emerged that regulatory failures were at the heart of it all. Specifically, it was believed that regulations on mortgage-backed securities had been insufficient to prevent a recurrence of the 2008 housing crisis. As a result, there has been an uptick in discussions about what exactly mortgage-backed securities are and why they should be concerning to investors. After all, if there’s something nefarious about them, we need to know before we invest! But what exactly are they? What makes them so risky? And why are they important? If you’re like most people, you’re probably already somewhat familiar with the workings of mortgage-backed securities — whether you realize it or not! But with so much misinformation floating around out there, rest assured that we’ve got you covered. Keep reading to learn more about these complex financial instruments and their implications for your portfolio
What are Mortgage-Backed Securities?
Mortgage-backed securities (MBS) — also known as collateralized debt obligations (CDOs) — are essentially a kind of “package deal” for financing residential or commercial mortgages. They are financial securities backed by a group of mortgages that investors purchase in order to earn a return. In short, MBS are like a “slice of pie” that represents a proportionate share of a pool of mortgages. They allow for a wider distribution of investment in real estate lending. And the best part? MBS are generally easier to obtain than a regular mortgage! Let’s say you’re looking to buy a house. To finance the purchase, you’ll probably need to secure a mortgage loan. With a mortgage loan, you’ll be required to put up a sizeable chunk of your own money — what’s called a down payment.
What Is a Mortgage-Backed Security?
When you invest in MBS, you’re essentially loaning money to the people who have been given mortgages. And just like when you get a mortgage, they will pay off the loan over time by making monthly payments via a process called amortization. That said, it’s important to remember that MBS investors are not guaranteed their money back! In fact, it’s very possible that some or all of your investment will be lost due to defaulting borrowers. Mortgage-backed securities are bundles of mortgage loans that are repackaged into securities for resale to investors. Mortgage-backed securities are generally split into two types: Residential mortgage-backed securities (RMBS) — or residential mortgage pass-through securities (RMPS) — represent loans backed by real estate properties like homes. Commercial mortgage-backed securities (CMBS) — or commercial mortgage pass-through securities (CMPS) — represent loans backed by commercial properties like office buildings and shopping malls.
The Importance of MBS to Investors
As mentioned above, MBS are often used by investors looking to purchase homes or commercial real estate. They can also be helpful for people who otherwise may not be able to obtain a mortgage loan to purchase a home. If a bank or mortgage lender feels that a prospective borrower’s financial situation is too risky, they might deny the application. But with MBS, investors can essentially “take a gamble” on the borrower’s ability to pay back the loan. Thus, they can help to offset some of the risk for banks, lenders, and mortgage brokers. Likewise, MBS can also help to lower the down payment requirements for borrowers who might not otherwise be able to come up with the required money.
What Caused the 2008 Housing Crisis?
The 2008 housing crisis was primarily caused by reckless and irresponsible lending practices. It was a time when mortgage brokers were handing out loans to people who had no business obtaining them! They were issuing mortgages to individuals who didn’t make enough money to pay them back, who didn’t have stable employment, or who had bad credit. As a result, the individuals who were ultimately granted the mortgages were likely to default on the loan — and do so rather quickly! This ultimately caused a huge drop in the housing market and a resulting financial crisis that had a ripple effect throughout the economy. Since the root cause of the crisis was irresponsible lending, regulations were subsequently implemented to prevent future abuses. Among these, researchers and policymakers identified a need to strengthen regulation of mortgage-backed securities — which, at the time, were largely unregulated! As such, more stringent guidelines were put in place to ensure that these financial instruments would be held to a higher standard.
The Bottom Line
The bottom line is that mortgage-backed securities — while they have their place in the financial industry — have a history of being problematic. This makes them a somewhat risky investment for most investors. That said, there are ways to mitigate the risk. And given how far-reaching the effects of a downturn in the real estate industry could be, it’s important for investors to understand the ins and outs of these complex financial instruments. If you’re concerned about what happened in the past, and want to know what to look out for in the future, make sure to keep an eye on mortgage-backed securities!
Mortgage-backed securities are complex financial instruments that are often associated with the Great Recession. They are bundles of mortgages that are repackaged into securities for resale to investors. While they were initially intended to be helpful, their unregulated nature and subsequent repackaging led to a fall in the housing market and the beginning of the recession. Nowadays, the regulation toward MBS has been strengthened, making them less risky for investors.