Mortgage Securities Market Essay Sample

Published: 2022-11-23
Mortgage Securities Market Essay Sample
Type of paper:  Research paper
Categories:  Finance Financial management
Pages: 7
Wordcount: 1861 words
16 min read
143 views

A mortgage-backed security is a kind of asset-back security which is secured by one or several securities. A security is any investment traded on a security market and which enables an investor to profit from the mortgage without actually having to purchase or sell a real home loan. These securities are usually bought by individual, institutional, or corporate investors. When someone invests in a mortgage-backed security, he or she is purchasing the rights to own the value of a package of mortgages. This is inclusive of repayment of the mortgage's principal as well as the monthly payments. Given that it is a security, an investor has the option of purchasing just a part of the mortgage and getting an equivalent portion of its payments. A mortgage-backed security is considered a derivative because it gets its value from the original assets.

Trust banner

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

How the Mortgage Securities Market Works

The first step involves a mortgage company or a bank making a home loan and then selling it to an investment bank. The money gotten from the investment bank is used to make new loans. The investment bank combines the loan with several mortgages having the same interest rates. It then places the bundle in a special investment vehicle, which is a unique company specifically designed for that purpose. The company separates the mortgage-backed securities from the other services offered by the bank. It then markets the securities while the mortgages remain. Most MBS are also traded by government agencies, with the federal government guaranteeing payments. Investors who purchase an MBS are almost assured that they will not lose their investment.

There are two main types of MBS: pass-throughs and CMOs (collateralized mortgage obligations). Pass-through participation certificates are the simplest ones as they pay investors their fair share of interest and principal interests for the entire mortgage bundle. The mortgage securities marker became quite competitive during the early 2000s, spurring banks to come up with a wide range of investment products in a bid to attract customers. For instance, they came up with collateralized debt obligations for other loans apart from mortgages, and then applied this deliberative technique to MBS. The banks divided the mortgage bundles into several equal risk categories referred to as tranches. The tranche with the least amount of risk consisted of payments stretching from the first to the third year since borrowers were more likely to repay in the course of the first three years. This time period also had the least interest rates in the case of adjustable-rate mortgages.

Some investors went for the riskier tranches containing between the fourth and the seventh payment years as they had higher interest rates. The risks would remain predictable provided the interest rates did not rise too high. If borrowers paid the mortgage earlier because they had refinanced, then investors would get back their initial investment. Risk increased whenever rates of interests rose. People who had borrowed adjustable-rate mortgages were somehow caught off guard when they found out that their payments had increased. They were unable to finance as the interest rates were much. Such a situation meant there was a high probability that they would default, causing investors to lose everything.

Driving Forces behind the Subprime Mortgage Crisis beginning 2006

The subprime mortgage crisis was a sharp rise in high-risk mortgages that began at around 2006, and which led to the most devastating recession experienced in decades. There was a housing booming during the mid-2000s that went hand in hand with the low interest rates being offered at the time. the situation spurred many lenders to offer home loans to with a poor credit score. Once the real estate burst, most of these borrowers found themselves unable to make monthly payments on their subprime mortgages.

In light of the Tech Bubble and the economic trauma that resulted from the 9/11 terrorist attacks, the Federal Reserve sought to stimulate the struggling economy. It reduced interest rates to very low levels, causing the house market to soar for a number of years. This in turn triggered a house-buying frenzy that lenders decided to capitalize on. These lenders decided to offer mortgages to people who otherwise were not qualified for traditional loans due to certain disqualifying measures like a weak credit history. Investment firm were very enthusiastic about buying these loans and then repackaging them as MBS and various other credit products.

Most subprime mortgages happened to be adjustable-rate loans characterized by reasonable interest rates. However, they could reset to a much higher interest rate after a specific period of time. This is exactly what happened when liquidity and credit dried up in the onset of the Great Recession. The abrupt rise in mortgage rates significantly contributed to the increasing number of defaults that began in 2007 and peaked in 2009. The situation was made worse by significant layoffs of workers throughout the economy. As many people who had borrowed the subprime mortgages lost their jobs, their payments went up at the same time. It was virtually impossible for an unemployed borrower to refinance the mortgage even at a lower fixed rate. The resultant meltdown drove dozens of investment banks into bankruptcy and caused huge losses on hedge funds and Wall Street that made heavy investment in or marketed risky MBS. The fall greatly contributed to the long-running economic downturn that ensued.

As home prices fell, investment bankers stopped trusting each other. They were not eager to lend each other because, if they did, they would receive the unfavorable MBS as collateral. As soon as home prices began falling, the bankers couldn't determine the value of real estate assets. If banks decline to lend to each other, the entire financial system gradually begins to collapse. In the wake of the subprime mortgage meltdown, the blame was directed at these banks and several other parties. Others included investment firms and mortgage brokers that gave loans to people with poor credit scores. Credit agencies that put too much faith in non-traditional loans were also to blame. Perhaps the biggest blame could be directed at Fannie Mae and Freddie Mac, the mortgage giants who encouraged irresponsible lending standards by guaranteeing or buying billions of risky loans.

Why Many Subprime Mortgages were created between 2000 and 2006

The Tax Reform Act that was passed in 1986 introduced interest reductions on home mortgages. The legislation made the debt accrued from mortgages to be much cheaper for many homeowners when compared to consumer debt. There was also some spirited effort in economic police to increase the number of people who owned homes in the United States. Consequently, the housing market had been experiencing continued price increases since 1986. The housing boom was accompanied by more growth for the mortgage lending industry. Legislations like the Depository Institutions Deregulation and Monetary Control Act enacted in 1980 as well as the Alternative Mortgage Transaction Parity Act passed in 1982 made subprime lending possible. These laws enabled lenders to charge high fees and interest rates together with balloon payments and variable interest rates.

In 1994, an increase in interest rates resulted in a reduction in prime mortgages. Mortgage companies and brokers resorted to the subprime market in order to maintain the volume. At the time, subprime mortgages were a relatively new phenomenon and how they performed in the long-term was not well known. For instance, the subprime loan market in 1995 was valued at about $65 billion. By 2007, subprime mortgages accounted for $1.3 billion, with the total amount of outstanding mortgages being $10 trillion.

If perceived as consumer goods, it is actually possible for mortgages to be bundled and then sold. Following the loans and savings crisis experienced in the 1980s, which was characterized by the issue of lenders funding long-term mortgages with short-term deposits, it became much tougher to acquire mortgages. The government thus gave agencies such as Ginnie Mae and Fannie Mae the go-ahead to purchase bank mortgages in the secondary market. This arrangement provided lenders with a means to replenish their and originate more mortgages. These agencies together with some private firms then resorted to issuing securities whereby the mortgage debts acted as collaterals. Such types of securities were bought in huge numbers by foreign investors from all over the world who wished to join the US housing market. Since 1980, the value of government-sponsored MBS has increased from $200 billion to more than $4 trillion. Additionally, private mortgage pools that include non-conforming loans as well as mortgage insurers account for $2 trillion.

It is evident that the secondary market acted as an incentive for investment banks to issue more loans. When securitization of loans became possible, mortgage lenders and banks effectively became a business that involved the origination and servicing of mortgages. Such a situation meant that the amount of profits for lenders depended on the number of mortgage originations. There was an enormous and rapidly expanding secondary market for repackaged products based on the mortgages. Consequently, the effective size of the mortgage market ended up being much bigger than that of the originations. Starting the mid-1990s, the rise in securitization resulted in a dramatic growth in subprime lending. By 2007, the volume of securitized stood at 75%, all the way up from 60% in 1980.

Subprime loans could only be repackaged and then sold in the secondary markets because of the presence of credit rating agencies like Standard & Poors and Moody's . Although they do not offer any guarantees, it is apparent that investors rely on them too much for accurate rates. these agencies estimate the credit /default risks. Risk managers spend a lot of time coming up with credit risk models based on two major concepts: recovery rate and default probability. Together, these two concepts give an acceptable measurement of the quality of a debt. When these factors are combined with a measure of the amount a creditor would lose if a borrower defaults, agencies can calculate to loss to expect in any given obligation. Once a credit company gives a positive assessment and stamp of approval, investors tend to ignore the quality of the mortgages in question.

Changes instituted after the subprime mortgage crisis

In March 2007, it dawned on the Fed that losses incurred in hedge fund housing posed a danger to the economy. Banks were unwilling to lend to each other due to fears of receiving toxic MBS in return. By August of that year, the situation became so bad that the Fed had to loan bank $75 billion. The idea was to restore liquidity for long enough to enable banks cut down their losses and resume lending money. The central bank also reduced interest rates to 2.0% all the way from 5.75%. A superfund was created that used the money in private sector dollars to purchase bad mortgages, with the Treasury even guaranteeing them.

The business structural change after the subprime mortgage crisis has been the Federal Reserve's dominant presence. It has amassed about $1.78 trillion of MBS on its balance sheet using its quantitative-easing programs. This is a signal to investors that the Fed is prepared to offer support should it be needed again. The strategy has managed to minimize volatility for the MBS market that is valued at more than $7 trillion. However, some investors are worried that the market is not prepared for what would happen if the Fed withdrew.

Cite this page

Mortgage Securities Market Essay Sample. (2022, Nov 23). Retrieved from https://speedypaper.net/essays/mortgage-securities-market

Request Removal

If you are the original author of this essay and no longer wish to have it published on the SpeedyPaper website, please click below to request its removal:

Liked this essay sample but need an original one?

Hire a professional with VAST experience!

24/7 online support

NO plagiarism