46. Mortgage-backed securities: mechanism of issuance, the role in the international financial crisis of 2007-2009.

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

While a residential mortgage-backed security (RMBS) is secured by single-family or two to four family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured as a different type of security than an RMBS

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.)^[15]

• 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.

Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.

Mechanism of issuance of mortgage-back securities (on example of Fannie Mae). Fannie Mae buys loans from approved mortgage sellers, either for cash or in exchange for a mortgage-backed security that comprises those loans and that, for a fee, carries Fannie Mae's guarantee of timely payment of interest and principal. The mortgage seller may hold that security or sell it. Fannie Mae may also securitize mortgages from its own loan portfolio and sell the resultant mortgage-backed security to investors in the secondary mortgage market, again with a guarantee that the stated principal and interest payments will be timely passed through to the investor. By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial institutions with fresh money to make new loans. This gives the United States housing and credit markets flexibility and liquidity.

In order for Fannie Mae to provide its guarantee to mortgage-backed securities it issues, it sets the guidelines for the loans that it will accept for purchase, called "conforming" loans. Mortgages that don't meet the guidelines are called "nonconforming". Fannie Mae produced an automated underwriting system (AUS) tool called Desktop Underwriter (DU) which lenders can use to automatically determine if a loan is conforming; Fannie Mae followed this program up in 2004 with Custom DU, which allows lenders to set custom underwriting rules to handle nonconforming loans as well.^[35] The secondary market for nonconforming loans includes jumbo loans, which are mortgages larger than the maximum mortgage that Fannie Mae and Freddie Mac will purchase. In early 2008, the decision was made to allow TBA (To-be-announced)-eligible mortgage-backed securities to include up to 10% "jumbo" mortgages.

The role in the international financial crisis of 2007-2009. The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing finance that led, in 2006, to an increasing number of borrowers, often with poor credit, who were unable to pay their mortgages - particularly with adjustable rate mortgages (ARM), caused a precipitous increase in home foreclosures. As a result, home prices declined as increasing foreclosures added to the already large inventory of homes and stricter lending standards made it more and more difficult for borrowers to get mortgages. This depreciation in home prices led to growing losses for the government-sponsored enterprise (such as Fannie Mae and Freddie Mac), which back the majority of US mortgages. In July 2008, the government attempted to ease market fears by reiterating their view that "Fannie Mae and Freddie Mac play a central role in the US housing finance system". The Treasury Department and the Federal Reserve took steps to bolster confidence in the corporations, including granting both corporations access to Federal Reserve low-interest loans (at similar rates as commercial banks) and removing the prohibition on the Treasury Department to purchase the GSEs' stock. Despite these efforts, by August 2008, shares of both Fannie Mae and Freddie Mac had tumbled more than 90% from their one-year prior levels.

On Oct 21, 2010 Federal Housing Finance Agency estimates revealed that the bailout of Fredie Mac and Fannie Mae will likely cost taxpayers $224–360 billion in total, with over $150 billion already provided.