Mortgage-backed securities (MBS) are a type of financial instrument that allow investors to invest in a pool of mortgages, rather than investing in individual mortgages directly. MBS are created by bundling together a large number of individual mortgage loans, which are then sold as a single security to investors.
Here’s how the process works:
1. A bank or other financial institution originates a large number of individual mortgage loans to home buyers.
2. The bank then sells these mortgages to a government-sponsored enterprise (GSE), such as Fannie Mae or Freddie Mac, or to a private issuer of MBS.
3. The issuer of the MBS then pools these individual mortgages together and creates a single security, which is divided into shares or bonds that can be sold to investors.
4. The MBS is then sold to investors, who receive a share of the interest and principal payments made by the homeowners whose mortgages are part of the security.
5. As homeowners make their mortgage payments, the payments are passed through to the investors who hold shares in the MBS.
6. The issuer of the MBS charges a fee for managing the pool of mortgages and distributing the cash flows to investors.
Why are these kinds of investments attractive? Subprime mortgage backed securities were backed by subprime mortgage debt, which offered a higher rate of return. This is because the interest rates were higher to so-called subprime borrowers.
However, many people who could have qualified for a traditional 30 year fixed rate mortgage were sold subprime loans. This is because they were more profitable for the bank bundling the loans. Think about it: they could sell the security for more money because the rate of return was higher.
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