Mortgage Backed Securities

Description:

Part of the secondary mortgage market, mortgage backed securites are created by pooling together a large amount of similar loans, and using them as collateral for issuing marketable securities.

For example, a pool of 30 year fixed rate loans at 6% would be packaged together, and serve as collateral for a security such as a bond paying a specific interest rate. These securities are then sold and traded in the financial markets.

The benefits to this arrangement are that loan originators can resell their loans quickly, and replenish their funds to make more loans. Plus, they usually keep a fee to continue servicing the loan, which adds additional income. Banks aren't stuck holding on to loans for several years, tying up their funds.

Unfortunately, the downsides to this arrangement recently became clear with the economic crisis. Because banks were no longer holding on to the loans they made, there was much less quality control, and few repercussions for loan originators that made bad loans. Basically, the more loans they made, the more money they made. This fed the cycle of easy money, which much like a Ponzi Scheme eventually collapsed.