Mortgage-Backed Security (MBS)

See: Mortgage.

You know that time you went out for Indian food, ate way too much, and then caught a stomach bug the next day, causing you to throw up chucks of curried chicken and naan for about three hours straight? How tempted are you you to go back to that Indian place again?

That's kind of the position of mortgage-backed securities after the financial crisis of 2007-2008. A relatively simple type of investment, one that isn't inherently risky or dangerous, has become a symbol of violent illness after one really bad stretch of indulgence and subsequent regret.

Basically, the whole economy spent an unpleasant period of time hugging a toilet after taking in too much mortgage-backed securities. And even years later, it's hard for the MBSs to get away from that reputation.

MBSs work like this: a bank (or some other financial institution) acquires a bunch of mortgages. The loans will all have similar qualities (credit scores of borrowers, size of mortgage, etc.). All these mortgages are put together into what is known as a pool. Then the bank will issue securities backed by this pool.

If you buy one, you receive a portion of the income generated from the underlying mortgages. Because the securities are based on a pool of mortgages (rather than a single mortgage, like a mortgage-backed note), you don't have to worry about losing everything if a single person defaults on the mortgage. They are diversified across a number of individual loans.

In the mortgage crisis that precipitated the overall financial maelstrom of 2007-2008, investors had vastly overestimated how safe mortgage-backed securities were. This optimism was demonstrated by rating agencies, who gave AAA ratings to MBSs that were much riskier than anyone predicted.

Because they were based on multiple mortgages, and because everyone assumed that housing prices were relatively stable, people assumed that the default risk for the underlying mortgages were very predictable (and relatively low). In the fine tradition of the guy in the cop movie who starts counting down the days until retirement, right before he gets shot at the end of the second act, everyone on Wall Street basically said, "How could all these people stop paying their mortgages at the same time? That would be unprecedented! Ridiculous! Pass the goat cheese and caviar canapés!"

But then the housing market started to collapse. A bunch of people did, in fact, stop paying their mortgages, all at the same time. What's more, the rush of money into MBSs encouraged a lot of companies to give a lot mortgages to a lot of people who, in hindsight, probably should have kept on renting for awhile.

Most of the mortgage-backed securities turned out to be trash...and companies were caught holding a lot of investments they couldn't sell at any price. The contagion spread to the rest of the economy, eventually prompting a bailout and sparking the Great Recession.

But that one really bad meal doesn't mean the whole investment class is forever toxic. A market still exists for mortgage-backed securities, though people are much more wary than they once were about risk levels.