Mortgage Backed Securities: A False Sense of Security

The high positive ratings of Mortgage Backed Securities by the rating agencies gave false senses of security to numerous mutual funds, investment banks, insurance companies, and all types of investors worldwide into believing that mortgage backed securities were a safe haven as secure as US Treasuries savings bonds and even cash. This false sense of security was reinforced by the credit default swaps and insurance policies in place to offset borrower default.

The credit default swaps and borrower default insurance policies, do not insure the profit streams from the interest payments, instead protecting the original principal amounts leant to the borrower. This in theory maintains the value of principal amounts of the loans supporting the mortgage backed securities. As discussed in the securitization section, mortgages were sold at multiples in excess of the original principal amounts leant to borrowers, generating a portion of the losses sustained to investor portfolios.

How Does this Effect Your 401k?

The losses to our 401K accounts for example and the collapse in value to the mortgage backed securities, is similar to a collapse of a companies share price. The less appealing the shares are for purchase, the lower the drop to share prices. Those who purchased the shares at the higher prices sustain the losses when the share price drops. The greater the drop the greater the sustained losses to investors. Hence the losses to our 401K’s.

However all is not lost. When factoring in the credit default swaps and the insurance policies to hedge against borrower default, the principal amounts of the underlying mortgages are preserved. The sale of the mortgage notes in multiples beyond the original mortgage principals is what has been devalued, and eroded away at our investments and 401K’s.