Mortgage Backed Securities

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Mortgage-backed securities may sound complicated, but they really aren’t.

When you take out a mortgage with a local bank, that bank typically sells the mortgage to another entity—usually a big financial institution, such as an investment bank or one of the two U.S. mortgage giants, Fannie Mae and Freddie Mac.

Those financial institutions take your mortgage, packages it with hundreds of other mortgages, and sell shares of the package. These shares are called mortgage-backed securities.

Simple, right?

If you’re familiar with the term, it’s probably because mortgage-backed securities became controversial during the housing boom of 2004 and 2005.

Around that time, lower interest rates increased consumer demand for loans, and banks responded by creating a new type of mortgage. It was called the subprime mortgage, and it was made to individuals with questionable credit histories.

Banks then sold these subprime mortgages, which were packaged together with regular mortgages in mortgage-backed securities.

With this kind of structure, investment-grade ratings were awarded to billions of dollars of mortgage-backed securities that had subprime mortgages as underlying collateral. Then, in 2007 and 2008, when the subprime mortgages defaulted, so did the mortgage-backed securities.

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