Question

What is a mortgage backed security (MBS)? Why is it difficult for ratings agencies to determine the risk of mortgage backed securities? How can the MBS help homebuyers in the United States? How did the MBS spread financial troubles around the world in 2008?

Answer 1

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What is a mortgage backed security (MBS)?

A mortgage based security (MBS) is a security traded in secondary financial markets and are backed by mortgages. It's a synthetic security created by pooling together a large number of individual loans backed by individual mortgages. Since home loans are typically backed by mortgage of homes to lenders, you will see mortgage based securities created out of home loans. A bank lends to an individual as home loan. Hundreds of such loans are then packaged together to create one mortgage backed security. An investor need not buy the entire package but can buy a pie in the MBS called a tranche. We have usually seen two types of MBS in markets: Pass through securities and Collateralized debt obligations. The buyer of MBS receives periodic payments which in turn are nothing but payments emanating from individual home loan owners towards interest and repayments.

Why is it difficult for ratings agencies to determine the risk of mortgage backed securities?

Rating agencies find it difficult to rate MBS because of following reasons:

1. Complexity in structure of the MBS
2. Complexity in assessing the credit worthiness of large numbers of loan owners whose loans have been pooled together to create a particular MBS
3. Complexity in valuation of the MBS
4. Agency problems: high pressure from the issuers on the rating agencies to give a good rating

How can the MBS help homebuyers in the United States?

1. MBS allowed more buyers in USA to buy homes and properties. Their normal creditworthiness on a stand alone basis might have prevented them from owning that home or property.
2. MBS allowed homeowners to borrow more than what might have been permissible under a normal home loan.
3. Banks didn't care much about the creditworthiness of the home owners because they knew the default by a home loan owner can be compensated for the bank.

How did the MBS spread financial troubles around the world in 2008?

MBS actually led the banks forget good lending practices. They were no longer concerned about the credit worthiness of the home owners. They were also not influenced by the probability of default by the home loanswer because they were paid for making the loans.

Rating agencies were paid handsomely to assign good ratings to MBS pushing their trades in the market. Lots of non banking finance companies entered into the markets. In good times, when valuation went up, banks went ahead and lent more money to the homeowner. There were breach of prudent lending practices all across. When the bubble burst, the financial troubles were seen across all the components of banking sector.