Mortgage-backed securities, also known as mortgage bonds, are debt instruments collateralized by pools of mortgages. Lenders originate mortgages by lending to prospective homeowners. After closing, the lenders often sell their mortgages to governmental or private agencies that create pools of similar mortgages. The agencies then issue MBS through a process called “securitization.” MBS are purchased by investors looking for a relatively high yield on a fixed-income security.
Liquidity is the ability to easily sell an asset at the market price. Liquidity is a good thing because it allows entities to reallocate their resources to earn the highest returns. Agencies that purchase mortgages provide fresh cash to lenders that can be lent out again to generate additional profits. Investors who buy MBS provide liquidity to mortgage-pooling agencies, facilitating the entire securitization cycle. Government agencies use part of the proceeds from the sale of MBS to partially subsidize mortgages for low-income homeowners.
The MBS debt developed through the securitization cycle is frequently cheaper to own than forms of financing such as bank loans and credit lines. The lower interest rates available through MBS make these instruments an efficient source of funding when compared to the rates on private non-secured bonds, which are considered riskier, since they are not collateralized.
When a bank sells a mortgage to a pooling agency, it relieves itself of the risk of a borrower default. The asset is moved off the bank’s books and is replaced with cash. This lowers the bank’s risk profile and allows stronger hands — in this case, mostly huge governmental agencies — to assume the risks associated with mortgages.
The securitization of mortgages encourages lenders not to under- or overcharge for mortgages. Mortgage rates that are too low relative to prevailing rates aren't attractive to pooling agencies, since they offer below-market returns. Overpriced mortgages are also problematic because agencies assume that the high rates indicate higher default risk. Agencies may shy away from purchasing mortgages that appear to be overly risky. Thus banks are tied fairly closely to the prevailing mortgage rates in their geographic areas.
Problems with the Mortgage-Backed Security Market
One prominent criticism of the MBS market is that banks, knowing they can quickly sell off mortgages to pooling agencies, can abandon lending standards and honest dealings, causing defaults and foreclosures will rise, exposing investors to huge losses. This was one of the causes of the U.S. subprime mortgage crisis that began in August 2007, according to a November 2008 report by the Brookings Institute. The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 contains provisions to reform the regulation of asset-backed bonds, including mortgage-backed securities.
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