Behind Mortgages: What are MBS and CDOs?

This section is a summary of this article from Investopedia.

According to Investopedia, the size of the household mortgage market in the US is worth roughly $14 trillion, that’s a lot of debt! And the agency mortgage backed security market is worth just over $9 trillion. This means, when an individual has a mortgage in the US, it’s very likely it will no longer be in the hands of the bank, and instead it is bundled with other mortgages as a mortgage backed security (MBS) and sold to investors!

This is quite the process, done by the hands of a line of “major players” in the secondary mortgage market.

It goes: originator -> aggregator -> securities dealer -> investor.

The process begins with the mortgage originator, aka banks or mortgage brokers. They try to acquire customers.

Once several mortgages have been originated, they are aggregated using an aggregator. The aggregator forms pools of mortgages and make them marketable (a process called securitisation). Company examples include Fannie Mae and Freddie Mac, both government sponsored enterprises (GSEs),(more on agency vs non agency MBS later).

After the MBS has been created by the aggregator, it is sold to the next company: the securities dealer, who sells the MBS onto investors. But, “[securities dealers at these desks do all kinds of creative things with MBS” like… creating CDOs (important for later!)

Now, the last “player” in the line: the investor! Examples include, “foreign governments, pension funds, insurance companies, banks, GSEs, and hedge funds are all big investors in mortgages.”

You may associate the name “mortgage backed security” with the 2008 financial crisis, but today it continues to be a fundamental part of the financial system for various reasons that I will get into briefly. However, today there are increased regulations and audits on MBS. Additionally, most are backed by the US government, thus are considered a safe investment.

However, not all MBS are backed by the US government:
Agency MBS: “issued or guaranteed by government sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.”
Non-Agency MBS: “Issued by private entities, not backed by government guarantees.” (Higher returns though).