One of the reasons for the mortgages to become more liquid and hence providing easy access to mortgages all parts of the society is an innovative approach to handling mortgages called 'Mortgage Backed Securities'. This innovation was made possible by some bond traders who wanted to make mortgages look like 'Bonds', and some believe that it is these financial geniuses on Wall Street that you should be thankful for or blame for the Global Financial Crisis of 2008
Who invented Mortgage Mortgage Backed Securities?
The past quarter-century has seen a revolution in finance. It's felt every time a homeowner refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this revolution -- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for converting home loans into bonds that could be sold anywhere in the world.
A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans through a process known as securitization.
After the Great Depression, the federal government of the United States created the Federal Housing Administration (FHA) with the National Housing Act of 1934 to assist in the construction, acquirement, and/or rehabilitation of residential properties. The FHA helped develop and standardize the fixed rate mortgage as an alternative to the balloon payment mortgage by insuring them, and helped the mortgage design garner usage.
In 1938, the government also created the government-sponsored corporation Federal National Mortgage Association (FNMA), colloquially known as Fannie Mae, to create a liquid secondary market in these mortgages and thereby free the loan originators to originate more loans, primarily by buying FHA-insured mortgages. In 1968 Fannie Mae was split into the current Fannie Mae and the Government National Mortgage Association (GNMA), colloquially known as Ginnie Mae, to support the FHA-insured mortgages, as well as Veterans Administration (VA) and Farmers Home Administration (FmHA) insured mortgages, with the full faith and credit of the United States government. In 1970, the federal government authorized Fannie Mae to purchase private mortgages, i.e. those not insured by the FHA, VA, or FmHA, and created the Federal Home Loan Mortgage Corporation (FHLMC), colloquially known as Freddie Mac, to do much the same thing as Fannie Mae. Ginnie Mae does not invest in private mortgages.
What are different types of Mortgage Backed Securities (MBS)? How do Mortgage Backed Securities (MBS) work?
A pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, it is a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
A residential mortgage-backed security (RMBS) is a pass-through MBS backed by mortgages on residential property.
A commercial mortgage-backed security (CMBS) is a pass-through MBS backed by mortgages on commercial property.
A collateralized mortgage obligation (CMO) is a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.
A net interest margin security (NIMS) is resecuritized residual interest of a mortgage-backed security
A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
There are a variety of underlying mortgage classifications in the pool:
Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)
Subprime mortgages have weaker credit scores, no verification of income or assets, etc.
Jumbo mortgages when the size of the loan is bigger than the "conforming loan amount" as set by Fannie Mae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are not MBS can also have these subtypes.