A
derivative whose value is derived from unpaid
mortgages. This entitles the owner to a claim on the
principal and
interest payments on the particular mortgages backing the security. MBSs pay an
interest rate that is usually related to the interest rates the homeowners are paying on their mortgages. The equivalent of the
coupon on a mortgage-backed security is a percentage of the interest and principal paid on the mortgages backing the security. An obvious
risk to an MBS is the possibility that interest rates may decline, causing homeowners to
refinance their mortgages. This provides
capital to MBS holders, but it comes at a time when purchasing more MBSs would
yield less due to the decline in interest rates. More complicated versions of MBSs include the
collateralized mortgage obligation and the
mortgage derivative. These attempt to reduce the risk associated with declines in interest rates.
Another risk associated with mortgage-backed securities is the possibility that a substantial number of mortgages will
default. A main proximate cause of the
credit crunch, which began in 2006-2007, was the fact that many mortgage-backed securities backed by
subprime mortgages began to default. See also:
Credit risk,
Liquidity risk,
Credit crunch.