How MBS work
A bank originates 1,000 mortgages totalling £200 million. Rather than holding them on its balance sheet, it sells them to a special purpose vehicle (SPV), which packages them into a security and sells tranches to investors. The SPV receives all mortgage payments and distributes them by seniority: the senior tranche gets paid first and receives a lower yield; the junior ("equity") tranche absorbs first losses but earns higher returns. This "tranching" was designed to create AAA-rated paper from a pool of individually lower-quality mortgages — by ensuring senior investors would only lose money if an implausibly large fraction of mortgages defaulted.
The originate-to-distribute model and its failure
Pre-2008, the "originate-to-distribute" model saw mortgage lenders sell loans to securitisers immediately after origination, eliminating their credit risk. This destroyed the incentive to verify borrower quality — lenders were paid on volume, not performance. The result: widespread "NINJA" loans (No Income, No Job, No Assets). Rating agencies, paid by the issuers they rated, used models that badly underestimated correlated default risk (assuming house prices couldn't fall nationally). When subprime defaults began rising in 2006, the models were catastrophically wrong.
CDOs and CDO-squareds: amplification
The mezzanine tranches of subprime MBS — too risky for pension funds but too complex for retail investors — were bundled into Collateralised Debt Obligations (CDOs). A CDO's senior tranche was then rated AAA by the same agencies, again using correlation models that underestimated joint default probability. CDO-squareds packaged mezzanine tranches of CDOs. By the time the underlying mortgages started defaulting, the losses had been amplified through multiple layers of leverage into products held by banks, insurance companies, and money market funds globally. AIG's near-failure came from writing credit default swaps on these CDOs.
Agency MBS: the surviving market
Not all MBS are the same. Agency MBS — backed by Fannie Mae, Freddie Mac, or Ginnie Mae — carry an explicit or implicit US government guarantee and remain the largest segment of the $11 trillion US MBS market. They performed well through the crisis. The lesson from 2008 is specifically about private-label subprime MBS, not the agency MBS market, which continues to function as an efficient mechanism for transferring mortgage credit risk into capital markets.
"The financial crisis was not caused by MBS per se — it was caused by the corruption of the origination chain, the failure of ratings models, and leverage stacked on top of leverage." — A post-crisis regulatory retrospective
What this means for you
MBS analysis requires understanding prepayment risk (borrowers refinance when rates fall, returning capital at the worst time for investors), extension risk (duration extends when rates rise as prepayment slows), credit risk (for non-agency paper), and the specific collateral pool characteristics. For fixed income investors, agency MBS remain an important asset class offering yield over Treasuries with minimal credit risk. The lessons of 2008 have shaped every aspect of structured product regulation since.