What are mortgage-backed securities, anyway?

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March 17 2008 7:09 PM

What Is a Mortgage-Backed Security?

The financial instrument that destroyed Bear Stearns.

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The implosion of securities firm Bear Stearns over the weekend was a painful blow to an already turbulent market. Bear Stearns, which was founded in 1923 and had survived the Depression and weathered a dozen recessions, was undone in large part by its investments in a financial commodity known as "mortgage-backed securities." What are those, exactly?

Mortgage-backed securities resemble bonds, instruments issued by governments and corporations that promise to pay a fixed amount of interest for a defined period of time. Mortgage-backed securities are created when a company such as Bear Stearns buys a bunch of mortgages from a primary lender—that is, from the company you actually got your mortgage from—and then uses your monthly payments, and those of thousands of others, as the revenue stream to pay investors who have bought chunks of the offering. They allow lenders to sell the mortgages they make, thus replenishing their coffers and allowing them to lend again. For their part, buyers of mortgage-backed securities take security in the knowledge that the value of the bond doesn't just rest on the creditworthiness of one borrower, but on the collective creditworthiness of a group of borrowers.

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In addition to creating mortgage-backed securities, Wall Street firms such as Bear Stearns also traded them.

When the housing market is doing well and interest rates are low, investing in a mortgage-backed security is a fairly safe bet. So long as homeowners stay current with their payments, holders of mortgage-backed securities receive a stream of payments. Even those investors who buy lower-quality mortgage-backed securities, in the hopes of receiving higher interest payments, generally fare well in a bull market. But when the housing market goes south, or if interest rates rise, even the safest of these investments are in serious jeopardy. Rising interest rates reduce the value of securities that pay a fixed rate of interest. When borrowers default on mortgages, the stream of payments available to holders of mortgage-backed securities declines. And when a firm has borrowed heavily to finance the purchase and trading of such securities, it doesn't take much of a fall in value to trigger serious problems.

The nationwide mortgage-default crisis has harshly punished many of the participants in the mortgage-backed-securities market. As subprime lenders failed, Wall Street firms such as Bear Stearns, which underwrote the issuance of such securities, saw their revenues fall. Hedge funds that traded mortgage-backed securities using lots of borrowed money suffered heavy losses as the value of the bonds fell. Last summer, two Bear Stearns hedge funds that specialized in mortgage-backed securities melted down, giving the firm a black eye. In recent months, as the market for mortgage-backed securities—and for financial instruments based on them—has seized up, large investment banks and hedge funds have been forced to write down the value of the mortgage-backed securities on their books, taking huge charges against earnings and scaring off other market participants from trading with them. Bad bets on mortgage-backed securities have contributed to a crisis in confidence at many of Wall Street's largest players, including Bear Stearns. Last week, Bear fell victim to a run on the bank, which had its origins in the firm's concentration in the mortgage-backed securities market. Rather than file for bankruptcy, Bear Stearns accepted a takeover bid from JPMorgan Chase for $2 a share. (A year ago, it traded at $150.) Analysts warn that other firms that invested so heavily in mortgage-backed securities may not be far behind.

Got a question about today's news? Ask the Explainer.

Chris Wilson is a Slate contributor.

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