Mortgage-Backed Securities and the Financial Crisis Kelly Finn FNCE 4302 Mortgage-Backed Securities (MBS) are “pass-through” bundles of housing debt sold as investment vehicles A mortgage-backed security, MBS, is a type of asset-backed security that pays investors regular payments, similar to a bond. It gets the title as a “pass-through” because the security involves several entities in the origination and securitization process (where the asset is identified, and where it is used as a base to create a new investment instrument people can profit off of). Key Players involved in the MBS Process [Mortgage] Lenders: banks who sell mortgages to GSE’s GSE: Government Sponsored Entities created by the US Government to make owning property more accessible to Americans 1938: Fannie Mae (FNMA): Federal National Mortgage Assoc. 1970: Freddie Mac (FHLMC): Federal Home Loan Mortgage Corp. Increase mortgage borrowing Introduce competitor to Fannie Mae 1970: Ginnie Mae (GNMA): Government National Mortgage Assoc. US Government: Treasury: implicit commitment of providing support in case of trouble The several entities involved in the process make MBS a “pass-through”. Here we have 3 main entities that we’ll call “Key Players” for the purpose of this presentation which aims to provide you with a basic and simple explanation of MBS and their role in the financial crisis. GSE’s created by the US Government in 1938 Part of FDR’s New Plan during Great Depression Purpose: make owning property more accessible to more Americans GSE (ex. Fannie Mae) buys mortgages (debt) from banks, & then pools mortgages into little bundles investors can buy (securitization) Bank’s mortgage is exchanged with GSE’s cash Created liquid secondary market for mortgages Result: 1) Bank has more cash to lend out to people 2) Now all who want to a house (expensive) can get the money needed to buy one! Where MBS came from & when Yay for combatting homelessness and increasing quality of life for the common American! Thanks Uncle Sam! MBS have been around for a long time. Officially in the US, they have their origins in government. During the Great Depression in the 1930s, President Franklin Delano Roosevelt signed into creation Fannie Mae that was brought about to help ease American citizen’s difficulty in becoming homeowners. The sole purpose of a GSE thus was to not make profit, but to promote citizen welfare in regards to housing. Seeing that it was created by regulatory government powers, it earned the title of Government Sponsored Entity, which we will abbreviate as GSE. 2 other GSE’s in housing were created in later decades like Freddie Mae, to further stimulate the mortgage market alongside Fannie, and Ginnie which did a similar thing but only for certain groups of people (Veterans, etc) and to a much smaller scale. How MBS works: Kelly is a homeowner looking to borrow a lot of money *The Lender, who issued Kelly the mor ...

1. Mortgage-Backed Securities and the Financial Crisis
Kelly Finn
FNCE 4302

2. Mortgage-Backed Securities (MBS) are “pass-through” bundles
of housing debt sold as investment vehicles
A mortgage-backed security, MBS, is a type of asset-backed
security that pays investors regular payments, similar to a bond.
It gets the title as a “pass-through” because the security
involves several entities in the origination and securitization
process (where the asset is identified, and where it is used as a
base to create a new investment instrument people can profit off
of).
Key Players involved in the MBS Process
[Mortgage] Lenders: banks who sell mortgages to GSE’s
GSE: Government Sponsored Entities created by the US
Government to make owning property more accessible to
Americans
1938: Fannie Mae (FNMA): Federal National Mortgage Assoc.
1970: Freddie Mac (FHLMC): Federal Home Loan Mortgage
Corp.
Increase mortgage borrowing
Introduce competitor to Fannie Mae
1970: Ginnie Mae (GNMA): Government National Mortgage
Assoc.
US Government: Treasury: implicit commitment of providing
support in case of trouble

3. The several entities involved in the process make MBS a “pass-
through”. Here we have 3 main entities that we’ll call “Key
Players” for the purpose of this presentation which aims to
provide you with a basic and simple explanation of MBS and
their role in the financial crisis.
GSE’s created by the US Government in 1938
Part of FDR’s New Plan during Great Depression
Purpose: make owning property more accessible to more
Americans
GSE (ex. Fannie Mae) buys mortgages (debt) from banks, &
then pools mortgages into little bundles investors can buy
(securitization)
Bank’s mortgage is exchanged with GSE’s cash
Created liquid secondary market for mortgages
Result:
1) Bank has more cash to lend out to people
2) Now all who want to a house (expensive) can get the money
needed to buy one!
Where MBS came from & when
Yay for combatting homelessness and increasing quality of life
for the common American!
Thanks Uncle Sam!
MBS have been around for a long time. Officially in the US,
they have their origins in government. During the Great
Depression in the 1930s, President Franklin Delano Roosevelt

4. signed into creation Fannie Mae that was brought about to help
ease American citizen’s difficulty in becoming homeowners.
The sole purpose of a GSE thus was to not make profit, but to
promote citizen welfare in regards to housing. Seeing that it was
created by regulatory government powers, it earned the title of
Government Sponsored Entity, which we will abbreviate as
GSE. 2 other GSE’s in housing were created in later decades
like Freddie Mae, to further stimulate the mortgage market
alongside Fannie, and Ginnie which did a similar thing but only
for certain groups of people (Veterans, etc) and to a much
smaller scale.
How MBS works: Kelly is a homeowner looking to borrow a lot
of money
*The Lender, who issued Kelly the mortgage, collects and hands
off the payments to the GSE who bought Kelly’s mortgage off
of the Lender
* The GSE pools together Kelly’s and other mortgage holder’s
payments into an MBS and sells *Creators of the secondary
market of mortgages
*Kelly now makes regular payments to the Lender to pay off the
mortgage
*Buys the MBS from the GSE because is promised a constant
stream of cash flows derived from the regular mortgage
payments!
Homeowner
Mortgage Cash Flow
Lender
GSE
Investor
*Kelly applies to a bank (Lender) for a loan

5. *After Lender vets Kelly, she is granted a mortgage
Note: *lendor=bank, mortgage=loan
This is a simple representation of how a basic MBS works. In
this example a person named Kelly gets a loan from a bank, the
Lender. Because it’s a big loan, Kelly had to put up collateral
so the bank would be incentivized to lend Kelly the money
knowing if anything goes wrong, the bank has rights to Kelly’s
collateral to sell and recover the loan amount.
At this point, Kelly and the Lender are happy. Kelly gets her
big lump of money, and the bank is happy to give it to her
because the bank earns interest, and can sleep happy at night
knowing that there’s a back-up plan given the collateral if Kelly
isn’t good for the money.
Over time, Kelly is required to periodically pay the bank the
interest she owes on the loan. These payments are the cash
flows from the mortgage. While she pays these to the bank, the
bank doesn’t actually hold onto these cash flows. At some point
prior, the bank sold Kelly’s mortgage for cash to a GSE so that
the bank could have more cash to lend out for more business.
The GSE is happy to buy the mortgages from the bank because
it means fulfilling its mission of promoting homeownership
among Americans, and is lucrative.
“How is an MBS lucrative for a GSE?” you might ask. Well you
see the GSE gets pretty jiggy with the mortgages it now holds.
The GSE has a ton of these mortgages and finds a way to add a

6. second layer of financial instruments (where the mortgage, the
loan, is the first).
By promising an investor a portion of the expected payment
from a mortgage, the GSE can offer investor’s a valuable
investment. Investors see the return and think it’s a pretty safe
investment since the MBS is just a portion of a bunch of
people’s promise to pay their mortgages regularly. So, they buy
it.
What could go wrong?
It’s important to note that the main “pass-through” occurs at the
hand off to an MBS investor from a mortgage payer’s payment.
Yes the investor gets the payments passed on to her, but she
also gets the risk of any payment irregularities associated with
the mortgage passed on to her as well.
GSE operates as usual, buying mortgages from
originators/lenders (banks who sell mortgages to people)
To do so, GSE must get the cash to buy the mortgages from
originators/lenders
Because market perceives GSE’s as implicitly backed by the
government, GSE’s borrow cheaply
+35 bps on long-term treasuries vs +70 for AAA corps. also
securitizing mortgages
Result from GSE being able to borrow cheaply: monopoly on
MBS market
1) can buy high volume of mortgages & operate on a large scale
2) pass on savings to investors, making GSE’ MBS’ attractive
MBS evolution pre-financial crisis (1/3)

7. GSEs were privatized in the later 1900s but still had a strong
perceived association with the government. This association
made GSE investment products appear less risky, causing the
return:risk ratio to appear to be very attractive even against
other investment options from regular corporations.
GSE was thus able to retain their stronghold in the MBS market
even as other private competitors entered. They became more
aggressive, especially because of high housing demand at the
turn of the century, and were established monopolizers on the
mortgage and MBS markets.
MBS evolution pre-financial crisis (2/3)
MBS attractiveness makes it popular among investors, who buy
lots of it
More GSE MBS’ sold = higher profits for GSE = large reach of
MBS
The cheap borrowing GSE’ enjoyed as a result to their
association with the government and thus potential government
protection, made their MBS’ very attractive. Because a lot of
investors invested, and because the GSEs continued to issue
MBS’ in the growth of the housing market, MBS turned out to
be very profitable for both GSEs and investors alike.
Private firms on Wall Street encouraged to enter MBS
securitization incentivized by
Low interest-rate environment
High profits produced by MBS monopolizers: the GSEs
Although had higher borrowing rates> GSE, found other ways to
increase profit margins on MBS, securitizing mortgages with:
Adjustable-rates (uncertain cash flows)

8. Negative amortizing (pay low payments now, higher later)
To keep up, GSEs combat new MBS market entrants by
purchasing and securitizing more, higher margins loans:
subprime mortgages
MBS evolution pre-financial crisis (3/3)
Corporations on Wall Street could not pass up the opportunity
for profit potential in the MBS market. They observed the
profits of GSE’s and wanted in. Even though they could not
compete on a cheap borrowing basis, they could compensate in
other areas through financial engineering innovation.
These firms found many creative ways to squeeze out additional
offered return from an MBS to investors. By far the most
employed and popular, was selling MBS collateralized by not
just any plain ol’ mortgage, but a subprime mortgage.
Subprime MBS explained by Margot Robbie in a bubble bath
Subprime mortgages are significant because as Margot Robbie
explains, they mean “s***”.
For a person to get a subprime mortgage, they typically have to
pay high rates for the loans because they are risky investments
the bank makes.

9. There could be several reasons for this, but the major one is
because the person is expected to be very unreliable in paying
off their loans. In terms of a mortgage, this would mean, the
person is expected to have a degree of difficulty paying their
regular mortgage payments to the bank.
So you can imagine when an MBS is securitized (attached,
based on) to a mortgage with an unreliable mortgage-payment-
payer, the MBS is riskkkky. Yet, finance 101 tells us the more
risk yields higher return. And in a low rate environment like the
early 2000s saw, investors were hungry for return and willing to
“turn a blind eye”.
2 Major, Fatal Assumptions with Subprime Mortgages
Key Players’ believed they had sufficient protection, and a plan
to address any hiccups in the MBS pass-through process on the
basis of 2 assumptions
1) People won’t default on their mortgages
Mortgage contract terms laid out & transparent
Homeowners know how much and when need to pay, there are
no surprises
2) If people do default on their mortgages, the money lost on
the mortgage will be recovered from seizing & selling the
house/property
As an asset-backed security (ABS), a mortgage is money lent
out collateralized against property, like a house
But investors aren’t stupid. They had enough rationale to justify
their investments in MBS securitized by subprime mortgages.
Heck, the GSE and MBS sellers had enough to justify even
creating them and selling them.
Mortgages were typically a priority for the common man: it was
a debt necessary to be paid off. History of the MBS showed that
typically mortgage holders kept their promise to pay back

10. (despite the refinancing risk). Not only that, but if a mortgage
holder couldn’t make a payment, or finish paying off their
mortgage, the bank had every right to this person’s
home/property to sell it and recuperate the costs of the loan.
For these reasons, MBS creators/vendors and MBS investors
had grounding to proceed with strong MBS market activity.
The Mortgage Market Meltdown
The Caveats to the 2 Assumptions: Mortgage Defaults & Loss
Recovery
Housing Market Bubble Burst
Scale of subprime “NINJA” mortgages and MBS’
Unfortunately, not everything is as it seems. The MBS
landscape and housing market began to change in the years
leading up to the financial crisis.
Amidst the buying and selling frenzy of MBS, the housing

11. market bubble began to deflate. Housing prices fluctuated
downward and all of a sudden the value of mortgage holder’s
collateral decreased. This means that the mortgage holder no
longer had the sufficient capital (the house/property) to cover
the mortgage’s collateral requirements, used to recover loan
costs in the case of default.
So when mortgage holders began to default, not only was the
bank no longer receiving payments, but the bank couldn’t even
recover enough money to pay off the cost of the loan. The pass-
through concept becomes very important here. If the bank isn’t
getting the money promised and actually loses money from it,
then all other involved entities lose too. Because MBS is a
direct link between mortgage holders and banks, GSE’s, and
MBS investors, everyone loses.
The second caveat is the prevalence of subprime mortgages. We
briefly talked about how the MBS market grew and more MBS
suppliers entered with innovative versions of the MBS, many of
which were more risky. The poster child of such a version was
the subprime mortgage.
The attractive returns offered to investors on subprime MBS
created a lot of demand. That coupled with the fierce
competition between MBS issuers (GSE and others), there was
high demand for subprime mortgages. This high demand for
subprime mortgages incentivized GSEs and others to be less
stringent with assessment processes on potential mortgage
holders of the subprime category. The assessment levels to
determine how risky or not a potential mortgage holder was had
already been bare especially compared to that for a non-
subprime candidate.
The significance of this was that a low to non-existent audit of
candidates meant any one, including the financially-ill, could
manage to get a mortgage. Besides, if they could buy a house
that was inflated by the housing market bubble, the candidate
could claim enough collateral to get a mortgage, no questions

12. asked. But here they are, truly unable to service the payments
they owe on the mortgage, and undercollateralized with the
housing market deflation.
1+1 = 2 = A recipe for disaster in the MBS market.
The financial crisis (1/2)
Massive, widespread mortgage defaults impacting all Key
Players
GSE’s
Banks who
a) originated the mortgages, and
b) issued MBS’ themselves,
Investors
who invested trillions of dollars in the security, and
US Government
who was ultimately responsible of cleaning up the mess.
The huge MBS market, infected by many subprime mortgages,
fell apart one defaults began to occur. It became a vicious cycle
where each entity involved in the MBS origination,
securitization, and investment areas of the process got screwed
over.
But wait...
NOT

13. The MBS meltdown has large systemic impacts
Systemic risk: effects of one market failure into others
The meltdown spilled over quickly and broadly from Wall
Street (Key Players) to Main Street (everyone else)
Exacerbating already tumultuous conditions in the American,
and Global economy
An example: dried up liquidity for Small Businesses because of
Wall Street
The housing market bubble pop and the subsequent subprime
mortgage market breakdown seized up channels of liquidity
Everyone seemed to be short on actual money
Banks/GSEs had been promised and expected cash from
mortgage payments
Mortgage holder’s who were never able to pay their payments in
the first place (subprime) still don’t have money and can’t
service the payments
If the banks, the GSEs don’t have money, they can’t pay
investors
Investors who are insurance companies, commercial banks, and
retail investors all lose the money invested in MBS
Banks can no longer afford to lend out money including those
who need it to operate like small businesses
The financial crisis (2/2)
The systemic impact of the MBS meltdown could have it’s own
course. For now, we will explore just one aspect of how it
impacted stakeholders.
The example used here is the liquidity problem for both
institutional and retail investors.

14. Since 2008:
Prevalence of subprime mortgages being issued by banks/loaned
out have significantly decreased
Assessment on candidate’s credit has been restored and
increased
The housing market has been restored from the crash it
experienced after it’s bubble popped
inflated house prices adjusted to realistically reflect their value
determined by supply and demand measures
The GSE’s Fannie Mae and Freddie Mac, who were privatized
prior to the financial crisis, have become officially government-
owned
With this “privilege”, they now guarantee their marketed MBSs.
3 Major Changes to MBS market post-financial crisis
Overall, the changes that have occurred in the MBS market
correspond to stronger infrastructure of controls and default
protection on behalf of the Key Players: the banks/lenders, the
GSEs/firms securitizing MBS’.
Sources
https://www.investopedia.com/articles/economics/08/fannie-
mae-freddie-mac-credit-crisis.asp
https://www.internationalinvestment.net/internationalinvestment
/news/3504116/mortgage-backed-securities-naughty-step
https://www.investopedia.com/terms/m/mbs.asp
https://krannert.purdue.edu/faculty/mcconnell/publications/The-
Origins-and-Evolution-of-the-Market.pdf