Mortgaged Backed Securities Literature review Example | Topics and Well Written Essays - 4750 words

Mortgaged Backed Securities - Literature review Example There are three classes of securities issued and traded, and these are assets backed securities (ABS), mortgage-backed securities (MBS) and collateralized debt obligations (CDO) (Blum & Dingell, 1997). As there are several kinds of securities, the primary focus of this section is the securities issues backed by mortgages – MBS. Understanding MBS is essential because it represents the largest portion of securitization in the United States (Nomura, 2006). In addition, apprehending MBS enables one to know the other forms of securitisation, as MBS is the â€Å"original source of securitisation technology†(Nomura, 2006, p. 2). In this regard, as the aim of the research is to gain a deeper understanding of MBS and to know the correlation between MBS and Subprime crisis, this segment of the research will be divided into four sections. The first part will deal with the concept of MBS. This includes the elucidation of the structures, benefits and risks attributed to MBS. The sec ond section will be delving on the credit rating analysis of MBS while the third part will deal with the development of MBS in the United States and its primordial role in the subprime crisis. Finally, the fourth section will be the summary. Mortgage-Backed Securities Mortgages are loans issued against real estate (Hu, 2001). This serves as the backbone of MBS (Stein, Belikoff, Levin & Tian, 2010). As such, a brief discussion of mortgage loans is provided, since, it serves as the condition with which MBS works or thrives. Mortgage loans in the United States are normally fixed in 30-year payment plan. This means that 360 equal payments are to be made by the borrower within that payment scheme. It is assumed in fixed payment that after the 30 –year period both the principal and the interests are paid (Stein et al., 2010). An important facet of mortgage loan is the borrower’s right to prepay his loan. This means that when the interest rates fall, the borrower can have the option of refinancing his loan at a lower rate. While, when the interest rates increase, the borrower can locked-in at a lower rate. Although the fixed-rate mortgage loan is most common mortgage loan, there is also the adjustable-rate mortgage loan (ARM) and the hybrid. ARM offers borrowers the chance to choose a loan that has an adjustable interest rate. The adjustable interests rate can be annually or semi-annually and it is determined by published market index like yields on US Treasury securities. In order to encourage borrowers, some lenders use ‘teaser rates’. Teaser rates are low initial rates, which last until the first adjustments (Nomura, 2006). On the other hand, the hybrid is the combination of fixed rate and ARM. The scheme provides for fixed interests rate for a first several years and then it is converted into semi-annual or annual adjustable rate. Several plans have been offered under the hybrid. There is ‘5/1’, ‘7/1’ and the à ¢â‚¬Ëœ10/1’ hybrids. However, regardless whether it is ARM or hybrid, what is significant is that, just like fixed rate loan , these types of mortgage loans allows or provides the opportunity to the borrower the prepay the loan when the conditions are favourable to the borrower. In this sense, there are two important elements in mortgage loans. First, is the certainty of the borrower’s obligation to make 360 monthly equal payments for a period of 30-years and second is the borrower’s right to prepay the loan when conditions are favourable, which means that borrowers can prepay their mortgage balance in full or in part anytime (Gangwani, 1998) Mortgage Backed Securities: In focus MBS are asset