A little over 10 years ago, few people had heard of mortgage-backed securities (MBS). Yet that changed when MBS brought the global financial system to its knees. Today, they’re still a pivotal part of the system, with the US Federal Reserve (Fed) the largest holder. Franklin Templeton Fixed Income Group’s Paul Varunok explains how MBS fit into the Fed’s future plans and gives his outlook for the asset class.

Ten years ago, the United States was in the depths of a financial crisis that is still a sensitive topic for many borrowers who lost their homes and for many investors who saw their portfolios fall as the crisis spread across the globe.

Before the crisis, the United States hadn’t experienced a national housing correction in at least four decades.1 Many groups, including homeowners, mortgage originators and credit rating agencies, seemed to discount the possibility that home prices would fall.

In addition, not much attention had been paid to the risks of subprime lending or the mortgage-backed securities (MBS) backed by subprime loans before the crisis. Then, mortgage delinquencies and foreclosures rose, and home prices and MBS began to fall.

What are MBS?

eMBS are bonds that represent an ownership interest in a pool of residential mortgage loans. Homeowners make mortgage payments that are ultimately pooled each month and then “passed through” to MBS holders in the form of principal and interest cash flows.

MBS are classified as either agency MBS or non-agency MBS.