mortgage-backed security

A mortgage-backed security is a security, typically a bond, that produces periodic cash flows, using repayments from mortgage loans to fund such payments.

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Between 2003 and 2006, unusually large numbers of subprime mortgage loans were pooled, packaged, and sold to investors in the form of bonds, which became known as mortgage-backed securities. In return for paying an up-front principal amount, these investors received periodic payments (usually quarterly), in the same manner as the holders of a traditional bond. By 2006, approximately 63 percent of all subprime loans were being sold and packaged in this fashion. When a wave of subprime mortgage loan defaults began in 2007, the value of these mortgage-backed securities began to plummet. This was because the cash flows that "securitized" the bonds (i.e., the periodic monthly payments from the subprime loans) were substantially lower than anticipated, given the numerous loan defaults. This, in turn, caused a shortfall in funds available to pay the interest mandated by the securities, bringing with it massive numbers of defaults by the issuers of the securities. Eventually, the securities holders brought literally hundreds of class action lawsuits against the directors and officers of the banks that made the subprime loans and the investment bankers who packaged the loans into securities.