Mortgage-Backed Security
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What Is Mortgage-Backed Security?
A mortgage-backed security (MBS) is a financial instrument created by pooling many home loans together and selling investors the right to a share of the mortgage payments that flow in. Related products called collateralized debt obligations (CDOs) repackage such pools into layered slices carrying different levels of risk. The process, known as securitization, lets lenders convert illiquid loans into tradable securities and pass credit risk on to investors. In the mid-2000s, mortgage-backed securities were central to spreading subprime mortgage risk throughout the financial system, as loans made in one place ended up on the balance sheets of banks and funds around the world.
Why It Matters
These securities matter because they linked ordinary home loans to the global financial system, turning a U.S. housing downturn into a worldwide crisis. When subprime borrowers defaulted, the securities built on their loans lost value, inflicting losses far beyond the original lenders. Insurer AIG had sold vast amounts of credit default swaps insuring such securities and required an emergency federal rescue that ultimately reached about $182 billion. Complex, hard-to-value mortgage securities also made it difficult for institutions to know who was exposed, freezing lending as trust evaporated. The crisis spurred reforms such as the Basel III bank capital standards, aimed at making these risks more transparent and better cushioned.