I recently watched The Big Short, a film about the housing crisis caused by mortgage backed securities in the United States of America. I describe less of what happened in the movie, focusing more on what and how the crisis occurred.
The American Dream is a national ethos of the United States, the set of ideals in which freedom includes the opportunity for prosperity and success. Wikipedia
Americans love to follow this ethos, own a car, a house, and live a self fulfilling life. The best part is that the government supports them, and why not, spender are basically bringing the money back to the government in taxes. The US government supports the housing market.
To understand what mortgage bonds are we first need to understand how home loans work. A home loan works in a simple manner, an individual wants to buy a house (which they can't afford) approaches a commercial bank to borrow money. The banks checks the borrower's credibility, which can include their income, credit history, and the assets that they own. After confirming that there is a low risk, they borrower will probably pay back the money with an interest of course.
If in case the borrower isn't able to payback the money, then the bank can take their house, the collateral or mortgage, and sell it to recover the money. Now, there isn't just one individual who wants to buy a house, there are probably a few thousands.
Nowadays, large investment banks buys these mortgages from the commercial banks. For the commercial banks it is a no-brainier to just sell them for easy, instant, and guaranteed profit (no risk). The money that borrowers pay now goes to the investment bank. The investment bank bundles up a number of mortgages into something called as a special purpose entity.
A special purpose entity is nothing but some mortgage papers setup to receive yearly cash inflows by the people who are paying their home loan principle plus the interest. Now comes the fun stuff. The investment bank then issues shares of these special purpose entities, these shares are called mortgage-backed securities.
Now there is always a possibility that some borrower may default on their loan obligation. So, the bank seizes the mortgage/asset (house in this case) and tries to sell it off to recover the amount quickly.
"Who the hell doesn't payback their mortgage" is a quote said in the film, this makes sense as people don't want to go homeless all of a sudden. But, this is just an assumption made on that a commercial bank would only lend money to those that are highly likely to pay back their mortgages.
Remember how commercial banks made easy money just by selling these mortgages to the investment banks, well they got a bit greedy. The commercial banks started lending money to whoever wanted the money, without even checking the borrower's credibility, ability to payback the loans with interest. Of course why would they, as they were transferring risk to the investment banks.
Michael Burry, a hedge fund manager is best known for being one of the first investors to foresee and profit from the subprime mortgage crisis that occurred between 2007 and 2010.