1. A homebuyer obtains a mortgage f

1. A homebuyer obtains a mortgage from a lender (typically a bank). The lender transfers the money
into the homebuyer’s account. The mortgage may be obtained through an intermediary – a broker.
2. The homebuyer repays the loan amount in accordance with an agreed schedule.
3. The lender considers holding the mortgage in its portfolio (i.e. simply collect the interest and principal
payments over the next several years) or selling it. The lender elects to sell the mortgage (to raise
finance to make other loans) to a government-sponsored enterprise such as Fannie Mae or Freddie
Mac, or a private entity such as financial institutions or Wall Street investment firms (investment
banks).
4. The investment bank groups the mortgage with similar mortgages it has already purchased (referred
to as pooling the mortgages). The mortgages in the pool have common characteristics (similar interest
rates, maturities, etc.). The investment bank then prepares for sale securities that represent an interest
in the pool of mortgages, of which the homebuyer’s mortgage is a small part (called securitising the
pool). The products for sale are called mortgage-backed securities (MBSs).
5. Prior to the sale of the MBSs, credit rating agencies (such as Standard & Poor’s, Moody and Fitch) gave
ratings to every type of bond according to its risk. Letter grades mark the safety of the investments.
AAA (the best rating) is given to the safest ones, for example government bonds. Of note is that the
credit rating agencies awarded most MBSs an AAA rating.
6. The investment bank then sells the MBSs to investors in the open market. With the funds from the
sale of the MBS, the investment bank can purchase more mortgages and create more MBSs for a fee.
7. Investors demanded MBSs as they were considered safe investments that paid a higher rate of return
than Treasury bills (during the boom period) when defaults were minimal.
8. When the homebuyer makes monthly mortgage payments to the lender, the lender keeps a fee and
sends the rest of the payment to the investment bank. The investment bank in turn takes a fee and
passes what is left of the principal and interest payment along to the investors who hold the MBS.