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MORTGAGE-BACKED SECURITIES

Definition

A mortgage-backed security is a security backed by a collection of mortgages held by an organization.

Why It's Important
Mortgage-backed securities are a pretty complex topic to understand, so let me give an analogy.  Let's pretend one of the organizations (Ginnie Mae) goes grocery shopping.  In the grocery store are hundreds of thousands of mortgages on the shelf.  My mortgage is somewhere on those shelves, as is yours.  Ginnie Mae goes down the aisles and groups the mortgages in their cart based on creditworthiness and chances of getting their money back.  The ones with the highest rate of default are called sub-prime mortgages.  When they check out at the register, they put hundreds if not thousands in each bag and then resell the bags to investors.  The best mortgages have a lower return because they are not as risky.  The subprime mortgage bags have a higher return because they are the riskiest.  As I pay on my mortgage, the principal and interest gets paid back to the investors who bought a portion of the bag my mortgage is in.

Here is where it gets interesting.  Remember the 2008-2009 financial crisis?  Of course, you do!  One of the reasons it happened was due in part to the subprime mortgage-backed securities.  Investors were making a lot of money from them, so they kept investing more and more.  Mortgage lenders were giving loans to people that really couldn't afford them so that they can keep up with demand.  Well, once individuals started defaulting on their mortgages, the whole structure collapsed.  People were losing their homes, and investors were losing money.  This is why mortgage-backed securities are so important to understand!  

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