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Chrisman's Corner: A Primer on Mortgage-Backed Securities

There are some who blame the housing crisis on securities backed by mortgages (MBS). This is not the case, however, and it is important for JMAC’s staff, and its broker clients, to understand how MBS are formed and why MBS did not cause many of the problems we have seen in the last five years.

When JMAC’s broker provides a borrower with a home loan using JMAC’s funds, and the borrower agrees to pay the money back by signing a note, JMAC has two options. It can either collect the money that the borrower is paying every month, or sell the loan to Fannie, Freddie, or a large aggregator, thereby providing the lender with more cash to make more loans.

Most independent mortgage banks chose the latter option (carried out by the Capital Markets Department). Meanwhile, the aggregator is purchasing thousands of other loans from different lenders that have similar interest rates and terms in order to create a large pool of loans, called a mortgage-backed security. The aggregator then sells parts of the pool to investors, so the aggregator has new funds to purchase more mortgages, create more MBSs and sell parts of them off to investors.

This mechanism was created in the 1970s, and worked very well. In fact, it still works well – if the investors know the types of loans that make up the MBS and are comfortable with the risk. In the early 2000s, however, to increase profits lenders lowered their standards and granted loans to subprime borrowers who had low credit ratings and a high risk of defaulting on their loan. Unfortunately for many lenders this didn’t matter because the lender passed the risk of default on to the MBS investors.

JMAC has always focused on producing loans of a high quality. And at this point, other lenders are once again focused on originating quality loans with solid documentation and appraisals, and once again investors are fully aware of the collateral making up the MBS. This not only helps the flow of funds, but also helps to keep rates low for JMAC’s broker’s borrowers.