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.
Related or Semi-related Video
Finance: What is Adjustable-Rate Mortgag...17 Views
Finance allah shmoop What is adjustable rate mortgage or arm
Well here's an arm and here's a leg and that's
What Renting the money to buy a home costs you
Yeah Okay Eight r m stands for adjustable rate mortgage
The rate well that's The interest cost of the money
or the cost of renting that money to buy the
home Well the rate isn't it fixed in this case
like five point seven percent for thirty years Where you
know in advance that your monthly payments going to be
nine hundred forty three bucks a month or whatever it
is that would be a fixed mortgage a fixed number
You can count on it for all three hundred sixty
payments And then the house is all yours So that's
fixed then what's adjustable like yes the interest rate changes
But how does it change Well in a standard arm
there is some global standard on which the rates are
often price like lie bore the london interbank borrowing offering
rate It's one of the key things that price is
the cost of renting money all around the world with
the actual rate of libel or is generally reserved for
banks like super cheap cost of renting money to banks
who are very likely to pay back the money with
no hassle that rate is more or less what banks
pay for running the money along with blue chip customers
in real life The banks then mark up a premium
on top of the rate that they're paying to rent
the money to themselves And then they resell or re
rent that money teo their prized customers So the pricing
of bank my views in renting money to joe six
pack could be something like lie boer plus three percent
or three hundred basis points So if libel or is
it didn't say two and a half percent today the
adjustable rate might be five and a half percent and
all that's great honor given alone It might mean that
for a while you're paying seven hundred twelve dollars a
month for your house payment wonderfully cheap and in fact
banks market these low rates initially to help people be
able to afford tto by that new home and live
of the dream You know the american dream usually with
an arm there's a teaser rate that starts really low
Like at live or live or plus ten basis points
or something like ridiculously cheap for six months or a
year something like that Then it has an incremental set
of step ups in interest costs and venit adjust with
the markets usually upward maybe upward by a lot Remember
there's a reason it's called a teaser rate but then
if we get inflation or a you know just bank
nervousness for there are weird effects from brexit or the
volume of transactions going through london or something weird happens
Well then the liquidity drops and interest rates rise So
now lie board goes up and up and up to
four and a half percent and wealth contractually in your
mortgage paperwork you have to pay live or plus three
hundred basis points no matter what So now that's seven
and a half percent interest on the dough you borrowed
and well we're that toe happen It's likely that your
monthly payment has skyrocketed from seven hundred twelve dollars a
month is something more like twelve hundred dollars a month
or more Can you handle that big of a payment
Well have you done a fixed rate loan at nine
Hundred forty three dollars a month Well you'd still be
paying on that number but you rolled the dice with
an arm and now you owe big bills There go
that arm and a leg thing we warned you about 00:03:26.033 --> [endTime] eh
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