Mortgage-backed securities (MBS) explained, The Big Short
The primary reason for the 2008 crisis was the failure of mortgage-backed securities. These securities, shown in the movie The Big Short, were invented by Lewis Ranieri, known as the “father of mortgage-backed securities.” His contributions revolutionized the way mortgages were financed and traded.
But were these mortgage-backed securities so bad, or did they have some good purpose? Let’s understand all the details of these mortgage-backed securities. If you understand how these mortgage-backed securities are made and how they work, you will understand exactly how the 2008 crisis happened. So make sure you read this article with full attention.
Contents
Initial phase of MBS
In the early 1970s, Ranieri worked at an investment bank and quickly moved up due to his analytical skills. At that time, the U.S. housing market relied on traditional mortgage lending, where banks held mortgages until repayment, limiting their capacity to issue new loans.
In 1970, the Government National Mortgage Association introduced the first pass-through security, allowing investors to buy mortgages. This was the beginning of mortgage-backed securities.
Because of this, the system mixed good loans and bad loans together, leaving investors uncertain about their safety. Lewis Ranieri saw an opportunity to take this concept further by developing a more sophisticated and scalable approach.
This process of bundling lots of loans together is known as securitization. If you come across this word in the news, keep in mind that they are talking about mortgage-backed securities or asset-backed securities.
Ranieri also pooled the loans together, but he gave structure to his method. The key advantage of his approach was that it spread the risk associated with individual mortgages across a broader base, which made these MBS attractive to investors.
Lewis worked on structuring them in ways that a MBS catered to different types of investors. He introduced the concept of tranches, or layers, within these mortgage pools. Tranches such as Triple-A, Triple-B, and Triple-C. Each tranche had different levels of risk and returns, giving investors the choice to choose securities that matched their risk tolerance and investment objectives. This innovation significantly increased the marketability of MBS and attracted a wide range of institutional investors, including pension funds and insurance companies.
Standardisation of MBS
One of the critical challenges in the early days of the MBS market was the lack of standardization. Without a consistent framework, it was difficult for investors to assess the quality and risk of different mortgage-backed securities. Ranieri recognized the importance of standardization and pushed for the creation of industry-wide standards for MBS issuance and trading.
To achieve this, Ranieri played a pivotal role in the development of the Secondary Mortgage Market Enhancement Act (SMMEA) of 1984. The act allowed the creation of standardised MBS structures. Because of this act, investors’ trust in these MBS products increased.
These innovations, introduced by Ranieri, had a huge impact on the housing market. It created a secondary market for mortgages. Banks could now sell their mortgage loans to investors. This freed up the bank’s capital and allowed them to give more loans. Because of this, homeownership was more accessible to millions of Americans.
After this, the housing market experienced substantial growth, leading to increased construction activities and job creation. Homeownership rates in the United States rose significantly, contributing to the economic well-being of many households.
By the late 1980s and early 1990s, MBS had become a significant component of the global financial system. Financial institutions around the world began to embrace this MBS model and started applying it to other types of assets beyond residential mortgages, such as commercial mortgages, auto loans, and credit card receivables. These were known as asset-backed securities.
Till this point, all was well and good, and it was working. And all the problems faced by the banks for liquidity and risk were solved by these MBS.
How Mortgage backed securities work?
Let’s see a step-by-step process for creating MBS.
Step 1
The first step is to acquire a large number of individual home loans from various banks and mortgage lenders. For example, a bank bought 1,000 mortgages with different interest rates, terms, and geographic locations. They just pooled these mortgages together.
Step 2
Then they would create a separate trust, also known as a special-purpose vehicle. The investors pooled mortgages into a trust specifically created to hold the mortgage assets and issue securities backed by these assets. Creating a separate trust allowed banks to isolate the risk.
Step 3
After this, the issued loans were arranged in different tranches to create a MBS product.
For example,
Senior Tranche:- This tranche had the first claim on the mortgage payments and was considered the safest, typically receiving a lower interest rate.
Mezzanine Tranche:- This tranche was riskier than the senior tranche and offered a higher interest rate to compensate for the increased risk.
Equity Tranche:- The riskiest tranche, which absorbed any initial losses from defaults but offered the highest potential returns
Step 4
After this, each tranche was rated by credit rating agencies like Moody’s and S&P. The senior tranche often received a high triple-A rating due to its lower risk. While the mezzanine and equity tranches received lower ratings of triple-B and triple-C, reflecting their higher risk,.
Then these MBS were marketed to a wide range of institutional investors, including pension funds, insurance companies, and mutual funds. The different tranches appealed to various investor risk profiles, from conservative to aggressive.
For example, pension funds and insurance companies bought safe triple-A-rated tranches. Where some mutual funds bought triple-C-rated tranches for more returns.
Step 5
When the borrowers paid the premiums, the cash flows from the mortgage payments distributed to investors in the MBS tranches. The senior tranche received payments first, followed by the mezzanine tranche, and finally the equity tranche. This waterfall structure ensured that the riskiest tranches absorbed losses first, protecting the senior tranches.
Mortgage backed securities example
Let’s walk through a simplified example of how a bank creates Mortgage-Backed Securities (MBS) and how payments are distributed among different tranches of investors.
Step 1: Creating the Mortgage Pool
- Bank buys 1,000 mortgages from various lenders.
- Each mortgage is worth $200,000.
- Total value of the mortgage pool = $200,000 * 1,000 = $200 million.
Step 2: Creating the Tranches
The bank transfers these 1,000 mortgages into a trust, ensuring mortgage payments go directly to investors. The $200 million pool is then divided into three tranches:
- Senior Tranche (AAA rating)
- Value: $120 million
- Annual Interest Rate: 3%
- Annual Interest: $120 million * 3% = $3.6 million
- Monthly Interest: $3.6 million / 12 = $300,000
- Mezzanine Tranche (BBB rating)
- Value: $50 million
- Annual Interest Rate: 5%
- Annual Interest: $50 million * 5% = $2.5 million
- Monthly Interest: $2.5 million / 12 = $208,333
- Equity Tranche (CCC rating)
- Value: $30 million
- Annual Interest Rate: 7%
- Annual Interest: $30 million * 7% = $2.1 million
- Monthly Interest: $2.1 million / 12 = $175,000
Step 3: Distributing Mortgage Payments
Let’s assume the total monthly premium payment from all 1,000 mortgage owners is $700,000. This amount is distributed among the tranches as follows:
- Senior Tranche (AAA)
- Monthly Interest: $300,000
- Mezzanine Tranche (BBB)
- Monthly Interest: $208,333
- Equity Tranche (CCC)
- Monthly Interest: $175,000
Total payments required: $300,000 (AAA) + $208,333 (BBB) + $175,000 (CCC) = $683,333
- Surplus: $700,000 – $683,333 = $16,667
The Equity Tranche (CCC) investors receive the surplus of $16,667 because they take on the highest risk.
Step 4: Handling Shortfalls
If the total premiums collected are less than required, for example, if only $600,000 collected, we would prioritize the distribution as follows:
- Senior Tranche (AAA)
- Paid first: $300,000
- Mezzanine Tranche (BBB)
- Paid next: $208,333
- Equity Tranche (CCC)
- Paid last: remaining $600,000 – $300,000 – $208,333 = $91,667
In this scenario, the Equity Tranche (CCC) investors absorb the loss first, followed by the Mezzanine Tranche (BBB), and lastly the Senior Tranche (AAA).
Conclusion
Now imagine, if all the borrowers in the MBS start to default on their loans and the total monthly premium collected is only $100,000. Only a few people in triple-A tranches would get paid.
This is exactly what happened in the 2008 crisis. Banks gave bad loans to people who couldn’t pay; those loans ended up in MBS. When those people defaulted, investors all around the world who had invested in MBS lost huge amounts of money causing the global crisis.
This was the main reason for the 2008 crisis. Check out this playlist to learn more about Big Short and 2008 crisis.
FAQs
What is a mortgage-backed security example?
Here is the detailed Example of Mortgage-Backed Securities.
How do mortgage-backed securities work?
Mortgage-backed securities (MBS) are created by pooling multiple home loans into a trust. This trust issues securities divided into tranches with varying risk levels. Mortgage holders make payments to investors, prioritizing senior tranches first, followed by mezzanine and equity tranches. This structure spreads risk and caters to different investor profiles.
Who created mortgage-backed securities?
Lewis Ranieri, known as the “father of mortgage-backed securities,” revolutionised mortgage financing. In the 1970s he did it by structuring MBS into tranches, spreading risk, and making them more attractive to investors.
What is the cash flow of MBS?
In an MBS, cash flow comes from mortgage payments made by borrowers. Investors receive these payments in different tranches, starting with the senior tranche, followed by the mezzanine and equity tranches. If payments fall short, the riskiest tranches absorb the losses first.
What was the first mortgage-backed security?
The Government National Mortgage Association introduced the first mortgage-backed security in 1970, enabling the sale of mortgages to investors and creating a new financial product that pooled mortgages together.
What are the components of mortgage-backed securities?
Mortgage-backed securities (MBS) consist of pools of mortgages divided into tranches: senior, mezzanine, and equity. Each tranche has different risk levels and returns, with payments prioritized from senior to equity tranches, spreading risk among investors.
What is the difference between mortgage and mortgage-backed securities?
Individuals take out mortgages to buy property, while financial institutions create mortgage-backed securities (MBS) by pooling multiple mortgages. Investors in MBS receive payments from the underlying mortgage holders.
What is MBS in simple words?
An MBS is a financial product that allows investors to buy shares in a large pool of home loans, receiving a portion of the payments made by the borrowers.
Who issues mortgage-backed securities?
Banks, mortgage lenders, and government-sponsored entities like Fannie Mae, Freddie Mac, and Ginnie Mae typically issue mortgage-backed securities.
What is the difference between ABS and MBS?
Asset-backed securities (ABS) back various types of loans (e.g., car loans, credit card debt), while mortgage-backed securities (MBS) specifically back mortgage loans.
What is the most common type of mortgage-backed security?
Pass-through securities, the most common type of MBS, collect mortgage payments and pass them through to investors.
What is the biggest risk of mortgage-backed securities?
The biggest risk of MBS is borrower default, which can lead to significant losses for investors, particularly those holding riskier tranches.
Who sells mortgage-backed securities?
Financial institutions, including investment banks and mortgage lenders, often sell mortgage-backed securities through brokers or directly to institutional investors.
What is the difference between MBS and CDO?
MBS are securities that mortgages back, while collateralised debt obligations (CDO) are complex financial products that can include various types of debt, including MBS. We have explained CDO’s in this article in detail.
Are MBS fixed-income?
Yes, MBS consider fixed-income securities because they pay regular interest to investors based on the mortgage payments from borrowers.
Who is the largest holder of mortgage-backed securities?
Large institutional investors, such as pension funds, insurance companies, and government-sponsored entities, are typically the largest holders of MBS.
Does India have mortgage-backed securities?
Yes, India has mortgage-backed securities, though the market is not as developed as in the United States.
What happens to MBS when interest rates rise?
When interest rates rise, the value of existing MBS typically falls because issuers issue new securities at higher rates, making older ones less attractive.
What is the minimum investment for MBS?
The minimum investment for MBS can vary widely depending on the issuer and the specific security, often starting from a few thousand dollars to higher amounts for institutional investments.
