Before we talk about what a Mortgage Backed Security is one should understand what a security is in the financial world.  In finance, a security is a fungible, negotiable instrument that represents some value.  The notion of being fungible means that individual units of the underlying good or commodity are substitutable.  So, in the financial world, stocks, bonds, mutual funds, and you guessed it, mortgage backed securities are fungible.  So there, you learned a new word today.

So back to the question.  A mortgage backed security (MBS) is an asset-backed security, in this case residential and commercial real estate, whose cash flows are backed by the principal and interest payments of a set of mortgage loans that make up the security.

Where the MBS gets interesting is the fact that since homeowners can make prepayment on many different types of mortgages, the investor does not know the true remaining principal balance, and monthly cash flow, on the underlying mortgages in the MBS.

Why is this important?  Well, due to the real estate slowdown that has gripped the US, the value of these MBS have been dropping.  As you may have heard, many individuals have simply stopped paying their mortgages, which begins to erode the quality of the underlying assets in the MBS portfolio, and therefore, lowers the value of the MBS.

Banks and Mortgage Brokers sold their mortgages to invest banks so that they could in turn make more mortgages.  If the banks and brokers do not do this, then they hold onto these loans for the life of the loan, in most cases 30 years, collecting principal and interest payments every month.  If they sell the mortgages they underwrite, then they have new capital in which to lend money.  This is one of the major reasons MBS exist and why some banks and investment banks are having such a time right now.

These MBS are on the books of a lot of financial institutions and hedge funds that invested in them, and therefore they are forced to write down the value of these MBS to reflect true market prices.  The only issue with this is; what is the “true” market price of these securities?  It is open to interpretation for sure.

To further complicate the matter, many of these MBS are wrapped into another type of security called a collateralized debt obligation, or CDO.  CDOs are a form of structured credit product that combine fixed income assets such as MBS, corporate debt in the form of bonds, and other forms of debt.  CDOs are an unregulated asset backed security, which has made them very attractive in the past.

I will talk more about CDOs in a future post, since they are a complex security with many moving parts.  It goes without saying that by even scratching the surface of these various financial securities, one can see how the financial markets have gotten to where they are.  We have a bunch of debt, that is collateralized by an asset, in this case a house, a condo, a large multi-family dwelling, or a huge office tower.  The value of those assets has been falling, more than 20% in some cases.  So, these MBS are then worth less, so they need to be revalued, but to what value?  Since these securities have been bundled within a CDO, the CDOs quality begin to deteriorate.  And the vicious cycle goes on.

Stay tuned; I will attempt to demystify what the CDO really is in a future post.