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Mortgage derivatives are a type of financial investment instrument that depend on the underlying value of home mortgages. Investors buy and sell shares of these derivatives, which share many characteristics with traditional stocks and mutual funds. While investing in derivatives can help companies mitigate risk, they can also lead to substantial financial losses. Mortgage derivatives based on subprime loans were a major contributor to the recession and mortgage crisis in the United States (US) during the early 21st century.
The credit derivatives market is a large portion of the global financial market, and mortgage derivatives are simply a small portion of this credit market. Each group of mortgage derivatives represents a large number of mortgage loans, and may include hundreds or even thousands of individual home mortgages. By pooling loans together in this way, banks help provide home ownership opportunities to more people while reducing their own risk of financial loss if buyers fail to meet their payment obligations.
When individuals wish to secure a home loan, they meet with a bank or lender to apply for a mortgage. Banks loan the money to the individual, then essentially sell the loans to investment or derivatives firms. The bank pays the firm a fee for this service, and in return, the derivatives firm agrees to take responsibility for ensuring the bank receives payment on the loan. The banks lose much of the potential reward associated with these loans, but also relieve themselves of a great deal of risk. Instead, both the potential rewards and risks are absorbed by the investment firm.
Investment firms perform complex calculations to help them decide whether to take on specific groups of mortgage derivatives. They analyze the mortgages based on the value of the homes, the interest rate, and the likelihood that each homeowner will default. If the expected loss is less than the expected reward, the firm will decide to take on the derivatives. In this case, the investment firm and its investors could earn large profits if all homeowners make payments as agreed, or if property values go up. These firms can also lose money if homeowners default on the loans, or if property values decline.
Many of the problems associated with mortgage derivatives involve subprime mortgages, or loans made to buyers with poor credit. In an effort to meet aggressive profit and growth goals, some banks may grant mortgages to borrowers who are unlikely to repay them. This could include people with unverified income, those buying homes at inflated prices with no equity, or buyers who have a poor history of repaying loans they take out. When this happens, the derivatives and investment firms lose money. During a recession or other economic crisis, many homeowners could default on their loans, leading to a significant financial loss for banks, investment firms, and homeowners.
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