Investments, tenth edition

  Mortgages and Mortgage-Backed Securities 

 Because of the explosion in mortgage-backed securities, almost anyone can invest in a 

portfolio of mortgage loans, and these securities have become a major component of the 

fixed-income market. As described in Chapter 1, a  mortgage-backed security  is either 

an ownership claim in a pool of mortgages or an obligation that is secured by such a 

pool. Most pass-throughs have traditionally been comprised of  conforming mortgages,  

which means that the loans must satisfy certain underwriting guidelines (standards for 

the credit-worthiness of the borrower) before they may be purchased by Fannie Mae 

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P A R T   I

 Introduction

or Freddie Mac. In the years leading up to the financial crisis, however, a large amount 

of  subprime mortgages,  that is, riskier loans made to financially weaker borrowers, 

were bundled and sold by “private-label” issuers.  Figure  2.6  illustrates the explosive 

growth of both agency and private-label mortgage-backed securities, at least until 

the crisis.  

 In an effort to make housing more affordable to low-income households, Fannie and 

Freddie had been encouraged to buy subprime mortgage securities. As we saw in Chapter 1, 

these loans turned out to be disastrous, with trillion-dollar losses spread among banks, 

hedge funds and other investors, and Freddie and Fannie, which lost billions of dollars on 

the subprime mortgage pools they had purchased. You can see from  Figure 2.6  that start-

ing in 2007, the market in private-label mortgage pass-throughs began to shrink rapidly. 

Agency pass-throughs shrank even more precipitously following an agreement for Freddie 

and Fannie to wind down purchases of mortgages for new pass-throughs. At the same time, 

existing pass-throughs shrank as healthy loans were paid off and delinquent loans were 

removed from outstanding pools. 

 Despite these troubles, few believe that securitization itself will cease, although prac-

tices in this market are highly likely to become far more conservative than in previous 

years, particularly with respect to the credit standards that must be met by the ultimate 

borrower. Indeed, securitization has become an increasingly common staple of many 

credit markets. For example, car loans, student loans, home equity loans, credit card 

loans, and even debt of private firms now are commonly bundled into pass-through secu-

rities that can be traded in the capital market.  Figure 2.7  documents the rapid growth of 

nonmortgage asset-backed securities.    The market expanded more than five-fold in the 

decade ending 2007. After the financial crisis, it contracted considerably as the perceived 

risks of credit card and home equity loans skyrocketed, but the asset-backed market is 

still  substantial.