Back in 2008, the housing market was in free fall. Markets that were based on securities created from baskets of residential mortgages were described as having "gaping wounds" that required government intervention just to keep them afloat. As with current quantitative easing in which the Federal Reserve is buying bonds to keep the money supply propped up, the Fed bought hundreds of billions in mortgage-backed securities (MBS) at the height of the credit crisis because the private market essentially dried up. Recent estimates put the Fed's total MBS purchases at over $1 trillion over the past several years. (Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing. Check out Profit From Mortgage Debt With MBS.)
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Today, the market for residential MBS is in a transition as the Fed has largely relinquished its role as a major purchaser of the securities. Below is a brief overview how the MBS market changed and where it stands right now as private investors start to return to the market again.
MBS Basics and a Brief Background
A mortgage-backed security is a specific type of asset-backed security - in this case the underlying asset is a mortgage. An MBS represents a grouping of mortgages that are "pooled" together to create the security. The security is then sold to investors. Investors receive payments as the homeowners make principal and interest payments on the underlying mortgages. The entire process is referred to as securitization. Another appropriate term for these securities is a "mortgage pass-through," which describes how mortgage payments are passed through to whoever ends up holding the security.
These days, the creators of the MBS are the entities that currently hold them. Government agencies, including Fannie Mae and Freddie Mac, are the ones that handle the securitization process and package the mortgages into MBSs. Their traditional role as creators changed fundamentally as the housing market reached a fever pitch and burst. As homeowners stopped making payments on their mortgages, a deluge of unwanted MBS bonds hit the market and left the government as a buyer of last resort. Fannie and Freddie were effectively nationalized because of the mountain of bad MBSs on their balance sheets.
In effect, the housing bust caused the MBS market to collapse because many supposedly "safe" securities had become extremely risky or even became worthless. This affected the banks and financial institutions that held them. In fact, MBSs based on sub-prime mortgages were cited for helping cause a number of firms, including Lehman and Bear Stearns, to go bust. These toxic assets nearly brought down other large institutions such as Merrill Lynch and UBS (NYSE:UBS). (Find out how weighted average life guards against prepayment risk. Read The Risks Of Mortgage-Backed Securities.)
The Market Environment Today
The collapse of the MBS market is well-documented and there are a number of sources that can provide a more detailed account of how it occurred. For investors, what matters is whether they can return to the market for safe, bond-like returns or find other ways to garner substantial profits from the still-recent market collapse.
It is important to understand that there are very safe parts of the MBS market. The Fed and government housing agencies remain huge investors in MBSs, especially those from the particularly toxic years between 2005 and 2008. But since then, financial institutions have implemented more stringent underwriting standards. This means that recent MBS issues have returned to being safer investments for the vast majority of investors.
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Private Buyers Returning
The fact is that private buyers are only now just starting to return as investors in MBSs. The Fed has largely stopped its role as the primary buyer, though it continues to hold the securities it already purchased, letting them decline naturally over time. Given the massive MBS holdings it has, the Fed would be hard pressed to find enough private buyers as the market stands right now.
The primary buyers of MBS in the past were fixed income money managers and institutions, including pension funds, banks, and insurance companies. They are trickling back into the market because other alternatives for fixed income investments yield very low rates these days. MBS yields are still pretty low given the volume support the Fed has provided. However, they have appeal when compared to other types of bonds, such as U.S. Treasuries. (Four major players slice and dice your mortgage in the secondary market. To learn more, see Behind The Scenes Of Your Mortgage.)
The Bottom Line
The securitization of many mortgages into MBSs will continue to be an important part of the market, but it has gone through historically uneven times. Overall, the Fed has to be credited with saving the market. For starters, it provided liquidity when there wasn't any. Its actions also kept mortgage rates relatively low and likely saved even more foreclosures from hitting the market. The market will slowly return to normal as private buyers step back up to the plate.
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