Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage businesses. At first, mortgage-backed securities created more demand to lend out money, which allowed more people to buy homes. While all mortgage-backed securities are essentially the same product—a bond—there are some variations on the product that investors can choose from.

How did the 2008 financial crisis impact the market for mortgage-backed securities?

By selling loans for MBS, banks and finance companies can free up capital that will allow mortgage backed securities meaning them to lend more money to borrowers. Meanwhile, since agency MBS come with certain guarantees, there’s relatively little risk to investors, although that isn’t to say there is no risk. Not only does securitization of mortgages provide increased liquidity for investors, lenders and borrowers, it also offers a way to support the housing market, which is one of the largest engines of economic growth in the U.S. A strong housing market often bolsters a strong economy and helps employ many workers. Think of a mortgage-backed security like a giant pie with thousands of mortgages thrown into it. The creators of the MBS may cut this pie into potentially millions of slices — each perhaps with a little piece of each mortgage — to give investors the kind of return and risk they demand.

Investing: What Is Your Risk Tolerance?

1. Stripped mortgage-backed securities are created by dividing the cash flows from a pool of mortgages into two or more parts, each of which has its own risk and return characteristics.
2. CMBS are backed by large commercial loans, referred to as CMBS or conduit loans.
3. Refinancing is the most significant source of prepayment, as borrowers can pay off their remaining balance at par without penalty when market interest rates decline.

Prepayment risk is highly likely in the case of an MBS and consequently cash flows can be estimated but are subject to change. Investors should understand the following three types of MBS to ensure they’re making a purchase that fits with their risk tolerance and cash flow needs. This bust resulted in enormous losses in MBSs, many of which contained these subprime loans. As mortgage holders began to default, the price of MBSs plummeted, leading to an eventual government bailout. These structures allow investors to invest in mortgage-backed securities with certain risks and rewards.

For instance, mortgage-backed securities typically pay out to investors on a monthly basis, like the mortgages behind the securities. The 2008 financial crisis was caused in part by the collapse of the subprime mortgage market, which significantly impacted the market for mortgage-backed securities. Many investors suffered significant losses, leading to increased regulatory scrutiny and changes in the market. Next, the investment bank takes the original loan and adds it to a bundle of mortgages based on the credit quality attached to the underlying security and markets them to investors.

How do mortgage-backed securities affect mortgage rates?

This, in turn, made it possible for institutional funds to buy up and package many loans into an MBS. Mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth. Residential Mortgage-backed securities (RMBS) are backed by residential mortgages, generally for single-family homes. Commercial mortgage-backed securities (CMBS) are backed by commercial loans. Your loan terms should stay the same whether the lender keeps your mortgage or it gets sold and bundled as part of a mortgage-backed security.

The purchase of these MBS helped keep mortgage rates low, which provided an economic boost because housing accounts for a significant share of the money pumped into the economy. However, cheaper financing meant higher home prices – something that is, at this point, actually detrimental. MBS also increase the liquidity in the marketplace, allowing for more mortgages to be issued.

Just as this article describes a bond as a 30-year bond with 6% coupon rate, this article describes a pass-through MBS as a $3 billion pass-through with 6% pass-through rate, a 6.5% WAC, and 340-month WAM. The pass-through rate is different from the WAC; it is the rate that the investor would receive if he/she held this pass-through MBS, and the pass-through rate is almost always less than the WAC. The difference goes to servicing costs (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors).

And if so, it’s a cog in the machinery that keeps the financial system running and helps borrowers access capital more cheaply. It can be useful to understand that the MBS market ultimately has a powerful influence over qualifications for mortgages, resulting in who gets a loan — and for how much. The first modern-day mortgage-backed security was issued in 1970 by the Government National Mortgage Association, better known as Ginnie Mae. Its  MBSs were — and still are — actually backed by the U.S. government, with a guaranteed income stream. A mortgage-backed security is a type of financial asset, somewhat like a bond (or a bond fund).