 Personal Finance Powerpoint Presentation, Mortgage-backed Securities, MBS. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Mortgage-backed Security MBS, which you can find online. Take a look at the references, resources, continue your research from there. This by Julia Kagan, updated October 28, 2021. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a mortgage-backed security in MBS? A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issue them. So as individual investors, we might be trying to get a diversified portfolio pointing some of our investments in stocks or equities, some possibly in fixed-income areas, which might include bonds and other instruments of that nature. When we're thinking about a bond, we can compare to some of these fixed-income instruments. We can compare to government bonds oftentimes because the government bonds typically have very low risk with regards to default risk because generally the government can tax for talking about the U.S. government and basically print money. A bond, then, we can think of as, in essence, we're loaning money to the issuer of the bond, typically the government or a corporation. We expect to receive the money back at the end or maturity of the bond, and then we also want the rent on the purchasing power, in essence, the interest, which oftentimes is paid on a similar annual basis, oftentimes with the bonds. So the government bonds are quite secure because, again, it's not likely the government is going to default. If you go to, say, like corporate bonds, then there's more risk that they're going to go bankrupt or something and not be able to pay off the bonds, especially if you go into other kinds of bonds or smaller corporations, but there could be potential also for higher returns. So then if you go into other kinds of investments, you would be looking possibly for other ways that they can back or support the bond. And you would think that the mortgage-backed security would be good because if you're talking about the loans, the loans are actually supported from a classical sense. If you take out a loan, then, and you don't pay back the loan, it's supported by the bank can then basically foreclose in order to basically pay off the loan. However, the mortgage-backed securities have gotten kind of a bad rap, bad reputation due to the great recession that took place in part for multiple different reasons. It's an interesting topic. We'll talk a little bit about it here, but the complexity and the types of instruments being used for investment instruments are part of the complexity that are involved in it. So in theory, you would think it makes sense, but you got to make sure that you got to take it into consideration with everything else, all the players that are going along within the process. So let's go through it. Investors in MBS receive periodic payments similar to bond coupon payments. So you've got that kind of income stream situation similar to the bonds. Understanding mortgage-backed securities, MBS. So mortgage-backed securities, MBS are variations of asset-backed securities that are formed by pooling together mortgages exclusively. So the investor who buys a mortgage-backed security is essentially lending money to home buyers. And MBS can be bought and sold through a broker. The minimum investment varies between issuers. So as became glaringly obvious in the subprime market meltdown of 2007-2008, it's like the great recession that we saw, a mortgage-backed security is only as sound as the mortgage that back it up. And MBS may also be called a mortgage-related security or a mortgage pass through. Essentially, the mortgage-backed security turns the bank into an intermediary between the home buyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on its balance sheet and loses nothing if the home buyer defaults sometime down the road. So notice, if the bank is able to basically remove their liability here, notice what happens now. Now the bank might end up making loans, for example, that are more risky loans, that there's a higher risk of basically default, and then if they can basically pass that risk on to somewhere else on the secondary market or using other complex investment tools, now they've shifted the risk. And that's part of the problem that took place here with this whole system because then you can imagine they start giving loans out that are more likely to default, possibly not taking as big a down payment on it so that you can end up with loans that are higher than the actual home value. So those are the things that need to be looked out for. Those will clearly result in problems in the market at some point over time. So this process works for all concerned as everyone does what they're supposed to do. That is the bank keeps the reasonable standards for granting mortgages. So don't go crazy bank and just start, you know, you got to have some safeguards so that the bank who's in the loans has risk involved with the loans they're issuing as opposed to just shifting that risk. So the home buyer keeps paying on time and the credit rating agencies that review MBS perform due diligence. So that's the other one that was a big issue and that these securities then were rated quite high even though it should you would think have been easy to see over time or someone should have been able to see the fact that the banks were now issuing loans that were way more risky that are creating these securities. So you would think then that the rating score would be decreased and that's where the rating scores lost a bit of faith as well which is another concern. You can't depend completely upon them although they're a great guide and tool. So in order to be sold on the market today the MBS must be issued by a government sponsored enterprise GSE or a private financial company. The mortgage must be organized from a regulated and authorized financial institution and the MBS must have received one of the top two ratings issued by the accredited credit rating agency. And again that they're going to have to earn their their trust back on those credit ratings. So there are two common types of MBS pass through and collateralized mortgage obligations CMO one pass through pass throughs are structured as trusts in which mortgage payments are collected and pass through to investors. They typically have stated maturities of five fifteen or thirty years. The life of a pass through may be less than the stated maturity depending on the principal payment on the mortgages that make up the pass through. Number two we got the collateralized mortgage obligation the CMO. CMOs consist of multiple pools of securities which are known as slices or trenches. The trenches are given credit ratings which determine the rates that are returned to investors. MBS and the financial crisis. So mortgage backed securities played a central role in the financial crisis between that began in 2007 and went on to wipe out trillions of dollars in wealth bring down Lehman Brothers and royal the world financial markets. So in retrospect it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards. Again it's hard when you look back on this it's hard to you know you have hindsight. So it seems kind of glaring looking back at it like how could we not know that there's an issue here because there's been a shift of the banks from having the risk that they had to other places and so you would think that that would incentivize them to take on more risk than they otherwise would. But again when these things are actually happening we don't see them so you don't know what the next bubble is. So banks to lower their lending standards and drive consumers to jump into the market at any cost. So the crisis. So that that was the beginning of the subprime MBS with Freddie Mac and Fannie Mae aggressively supporting the mortgage market. The quality of all mortgage backed securities declined and their ratings became meaningless. Then in 2006 housing prices peaked. So subprime borrowers started to default which is the failure to repay on a loan. So clearly the bank now issued a bunch of loans and possibly taking things like zero down or doing very risky things to lenders that they don't think they're going to be able to pay it back possibly or wouldn't take on the risk if they were able to keep the risk because they were able to shift the risk. So as a result the housing market began its long collapse. More people began walking away from their mortgages because their homes were worth less than their loans. So you can imagine if the bank starts making loans and they don't even collect a down payment and there's a crash in the housing market that starts to spiral out of control then you're going to end up with homes that have higher or lower values fair market values than the loan. And so that so then that incentivizes people to just walk away from the home and the bank is stuck with them because they can't sell it in order to recap on their loan and plus they're not in the business of really selling homes. They're hoping they don't have to sell the home or foreclose on it. So and plus now who actually is the one that owns the home once you've basically bundled the security and it's not the bank you know the one that issued the loan. So in any case even the conventional mortgages underpainting the MBS market saw steep declines in value. The avalanche of nonpayments meant that many MBSs and collateralized debt obligations CDO based on pools of mortgages were vastly overvalued at that point in time. And again you know you would think they wouldn't be overvalued given the ratings on them and the fact that they were backed by the mortgages which are backed by the homes but you can see how this whole thing cascaded and caused this problem. So the losses piled up as institutional investors and banks tried and failed to unload the MBS investment. So then they had to dump these investments that were no longer they could see where the road was going. Credit tightened causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of collapse. The bailout the U.S. Treasury stepped in with Congress to authorize a $700 billion financial system bailout intended to ease the credit crunch. Also the Federal Reserve bought $4.5 trillion in MBS over a period of years while the troubled asset relief program TARP injected capital directly into banks. So this was a whole kind of controversy thing because this is where the bailing out too big to fail thing kind of went into play and it seems like once once again we started from a situation where these banks were not taking on kind of the risk and then when everything fell apart it seems like now if the Federal Reserve bails people out these big institutions out then they're not taking out the same risk as other people and if they don't have the risk related to them because they can be bailed out then you would think that they would make more risky decisions because they're now again shifting the risk elsewhere. So this is a whole thing that we're still we're still feeling now in terms of our policies and what not. So some of the measures of the bailout include the following. So nearly $250 billion to stabilize the banking industry, 27 billion stabilized the credit markets $80 billion to support the U.S. auto industry almost $70 billion to bail out insurance giant AIG of the American International Group and $46 billion was allocated to help struggling families avoid home foreclosures which is when a mortgage lender or bank seizes borrowers homes due to non-payment of the loan. So on October 3, 2010 the authority to initiate new financial commitments ceased essentially ending any new bailouts under the TARP program. So also in 2010 Congress authorized the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act reduced the initial amount of the $700 billion authorized for the TARP program to $475 billion. Mortgage backed securities today. Mortgage backed securities are still bought and sold today. There is a market for them again simply because people generally pay their mortgages if they can. So hopefully you know once we get things back under control you would think that the mortgages would be secure because they're traditionally supported by the home. So you would think if they put the 20% down for example and all that kind of stuff that it could be a good support. So the Fed still owns a huge chunk of the market for MBSs but is gradually selling off its holding. So even CDOs have returned after falling out of favor for a few years post-crisis. The assumption is that Wall Street has learned its lesson and will question the value of MBSs rather than heedlessly buying them. Time will tell. What are the types of mortgage backed securities MBS? Two common types of mortgage backed MBS pass-through and collateralized mortgage obligations. CMO pass-throughs are structured as trusts in which mortgage payments are collected and pass-through to investors. They typically have stated maturities of 5, 15 or 30 years. CMOs consist of multiple pools of securities which are known as slices or trenches. The trenches are given credit ratings which determine the rates that are returned to investors. So what's the relationship between an MBS and a bank? Essentially the mortgage backed security turns the bank into an intermediary between the home buyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on its balance sheet and loses nothing if the home buyer defaults sometime down the road. So this process works for all concerned as long as everyone does what they're supposed to do. That is the bank keeps the reasonable standards for granting mortgages. To some degree you're trying to say everybody should do what they should do, but people should do what is in line with the market to do. So obviously if you take the risk away from the bank, they're going to behave in a way that's different than if they were incurring the risk. Sometimes it feels like when they make the policy they come up with these ideas and just say, well people should just act this way even though the incentives don't line up for them to act that way. It's like well that's not how people act. They're going to act in a self-interested way. But anyway the home buyer keeps paying on time and the credit rating agencies that review MBS perform due diligence. So what is an asset backed security ABS? An asset backed security ABS is a type of financial investment that is collateralized by an underlying pool of assets, usually ones that generate a cash flow from debt such as loans, leases, credit card balances or receivables. It takes the form of a bond or note paying income at a fixed rate for a set amount of time until maturity. So for income oriented investors ABS's can be an alternative to other debt instruments like corporate bonds or bond funds. For issuers ABS's allow them to raise cash which can be used for lending or other investment purposes.