In 2008, the term MBS was common when referring to the banking crisis that gripped the western world, when Lehman Brothers collapsed. They held a portfolio of Mortgage Backed Securities that turned out to be of much lower value, and were also highly illiquid. These Mortgage Backed Securities, are effectively collections of mortgages, and thus are ‘debt instruments’.

With the growth in the sophistication of mortgage finance, a home owner today, that has financed the home purchase by a mortgage, that debt (the mortgage loaned against the house)could be backing up a publicly traded security. Yes a mortgage could form a part of a Mortgage Back Security traded on the stock market. Today a high percentage of individual mortgages originated by banks and other lenders are ultimately pooled and used as collateral to issue mortgage-backed securities (MBS), which are then sold to investors, like investment banks, pension funds, insurance companies who then derive an income.

The mechanism to create a Mortgage Backed Security is a process called Securitisation of an asset. That was covered in an earlier article I published.

A mortgage-backed security are bonds that are backed by pools of mortgage loans. In the most basic type of MBS, homeowners’ mortgage payments are passed through to the bondholder, meaning the bondholder receives monthly payments that include both capital and interest. This is a key difference between mortgage backed security and other bonds such as UK Gilts, which pay interest every six months or annually and return the whole capital principal at maturity.
In the USA, the mortgage backed security market is the largest component of the U.S. Bond Market, with about £ 5.6 Trillion [$8.9 Trillion] in mortgage-related debt outstanding. (interesting comment that £5.6 Trillion is 4 times the UK GDP !!) As I said, mortgages are the largest segment of the U.S. bond market, accounting for 26% of all bond market debt outstanding.
However the trading of these securities, that then were passed from bank to bank, all turned sour, when the deck of cards collapsed. What do I mean by that ?
Simple, as soon as the mortgage holder stops paying the mortgage, the whole stack collapses, and the holder of the mortgage backed security, is effectively holding a worthless asset (or a lot less in value) as in the US, where this started, the actual underlying asset, the property that the loan is secured against, had sharply fallen in price, so the loan is larger than the property (bricks and mortar) thus negative equity.

These mortgage backed security then become a lot less valuable, and the media has referred to them as Toxic Assets.