What are securities in economics? (loans, union, agent, real estate)

[celticseas]

I'm trying to learn about economics and trying to understand what economists mean when they say "mortgage backed securities". Are they financial assets like stocks, bonds, etc...?

[mathjak107]

They are an instrument like a bond

[bale002]

Originally Posted by celticseas

I'm trying to learn about economics and trying to understand what economists mean when they say "mortgage backed securities". Are they financial assets like stocks, bonds, etc...?

They are loans packaged into one or more legal instruments (securities) whose collateral is mortgages on property such that if the borrower defaults the lender takes title to the underlying property.

So some diversification and legal claim to the mortgages and underlying properties reduce credit risk. But there is still a lot of risk in terms of market, credit, legal, legal costs, and management/administrative and related costs.

Anyway, this is more a finance question rather than an economics question. In terms of economics, one economic agent transfers cash assets to another in return for promise to repay plus interest, indeed like a bond as mathjak107 says.

You could have probably found these and better definitions on the web.



All the best!

[Mircea]

Originally Posted by celticseas

I'm trying to learn about economics and trying to understand what economists mean when they say "mortgage backed securities". Are they financial assets like stocks, bonds, etc...?

You got good answers.

If you want to know why, it has to do with the way real estate is financed.

You have two types of real estate, commercial and residential. For a very long time in the US, residential mortgages were issued by credit unions, savings and loans and mutual savings banks and not by the banks you know and love.

Credit unions, savings and loans and mutual savings banks (aka community banks) operate differently than banks.

Because they do operate differently, they were more likely to suffer from liquidity issues.

To fix the problem of liquidity issues, the federal government stepped in and created a few entities: Fannie Mae (Federal National Mortgage Association), Ginny Mae (Government National Mortgage Association), and Freddie Mac (Federal Home Loan Mortgage Corporation).

How's that work?

When a credit union, savings and loan or mutual savings bank has liquidity issues, it has a dire need for urgent cash.

This is where the government comes in. Those entities sell the mortgages they hold to Fannie Mae, or Ginny Mae or Freddie Mac for cash.

So, you work for Fannie and you just bought a bunch of mortgages. Your first task is to group them by value, length of loan, type of loan, remaining balance or payments, and risk factor.

We ain't talkin' about 4 or 5 mortgages, or even a few dozen mortgages, we're talking a thousand or more. If the average value of the mortgages is $250,000 then you have $250 Million (for 1,000 mortgages).

Let's say you created --packaged -- 10 different groups with each group having a total value of $25 Million.

Now you sell $250 Million worth of bonds. Note that you're selling 10 different bonds, each with a different term and interest rate.

So, Group 1 is $25 Million and that's high-value mortgages that are more than 50% paid and the household has a high credit score. You might sell that as a 10-year bond at 2.15% interest.

Group 2 is $25 Million and that's high-value mortgages that are less than 50% paid, with the household having an high credit score, so you sell those for 30-years at 2.25% interest.

Let's say Groups 8, 9 and 10 are "sub-prime" so you might sell them 10-, 20- and 30-years respectively with significantly higher interest rates, maybe 3.0%-5.0% or even higher.

Why?

It's win-win-win.

The credit union has an infusion of cold hard cash, so liquidity issues are solved; the government now holds the mortgages and is receiving payments from households, and the interest on the mortgage is greater than the interest on the bonds, so the government profits; and then the bond holders are holding an interest-bearing security that is backed by collateral -- real property.

See?