How Mortgage Backed Securities Work

A: Getting way too many emails and questions from clients asking me to explain why we are having these liquidity problems. In a nutshell, the secondary mortgage markets are not functioning properly; there is no liquidity and a lack of buyers for mortgage backed securities. Here is a quick 4-step guide that hopefully will break it down for you.

The problem we are currently seeing is in the secondary mortgage markets, which was created in the first place to provide more liquidity in the mortgage markets and allow banks and lenders to provide more financing and more loan options to YOU, the consumer. Now that liquidity has completely dried up in these secondary markets, banks and lenders are left holding assets that are virtually worthless and that no one wants to buy. We still don't know WHO HOLDS WHAT or what the market value of these holdings are! This is what we are working through right now.

Let me try to explain by first defining for you what the secondary mortgage markets are.

Secondary Mortgage Markets - The secondary mortgage market allows banks to sell mortgages, giving them new funds to offer more mortgages to new borrowers. If banks had to keep these mortgages the full 15 or 30 years, they would soon use up all their funds, and potential homebuyers would have a more difficult time to find mortgage lenders. Many of the mortgages on the secondary market are bought by Fannie Mae. Other are packaged into mortgage-backed securities, and sold to investors.

Lets talk about that last part, where mortgages are packaged up into mortgage backed securities and then resold to investors. That is where we got into trouble and is what led to a re-pricing of risk on the street!

STEP 1 - A pool of mortgages are owned by a bank or lender. They are grouped into categories by credit risk including subprime, alt-a (between subprime and prime), and prime.

STEP 2 - The pool of mortgages are packaged into a mortgage backed security.

STEP 3 - The mortgage backed security is then sliced and diced into different classes with varying maturities (called tranches). Each tranche offers varying degrees of risk to the investor. The first loan to default will be placed into the Junk tranche while the strongest loans receive the highest credit rating of 'AAA' and are placed at the top of the tranche division. As with any asset associated with risk, the highest risk tranche receives the highest rate of return or yield while the lowest risk (AAA rated) will receive the lowest yield.

STEP 4 - The tranches are then resold to investors who are willing to take on the varying degrees of risk and maturities.

*refer to the following chart for a visual of the above defined steps

There are many fees embedded in this process for the lender, brokerage, hedge fund or investor that I did not go into. This is not an in depth analysis of how MBS work but the easiest way for me to explain the basics of how mortgages are packaged into mortgage backed securities, sliced and diced up, and then resold to investors. It's interesting because if you take a pool of subprime mortgages and go through this process, in the end you can come out with AAA rated paper. Turning subprime into AAA; hmm, I wonder why we are in trouble.

Right now, holders of these securities are having trouble finding investors to buy them as the secondary mortgage markets basically freezed up. There is no liquidity. As a result, those that hold these assets and who took out financing to do so, may have margin calls due that force them to liquidate assets at market value which is not desired. The market value of these assets fell substantially as subprime loans started to default leading us to where we are today.

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