If I buy a mortgage backed security, what will happen to my investment if:
- The person that took out the mortgage defaults
- The person makes a prepayment
- The person refinances
- The bank that gave out the mortgage defaults
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This can help in understanding some basic details of Mortgage Based Securities. Almost all of the investment banks and financial institutions deal in them. They are risky products so people with knowledge about them, deal with them.
They aren't securitized and sold as a single product. They are divided into tranches(3 level of products) with different rate of returns and the riskiness of it and likewise rated to reflect their riskiness. Plainly speaking the senior tranches are given higher preference in terms of their principal being returned and their buy price will be higher than the other tranches. The lower tranches are serviced only after all the higher tranches are serviced and are priced lower than the upper tranches.
The person that took out the mortgage defaults
The property is foreclosed and the bank, probably sells the house to recover the mortgage. The people are reimbursed depending on the tranches they had bought i.e. the higher tranches will be paid up first and then the lower ones.
The person makes a prepayment
Same as above like being paid up.
The person refinances
Same as before like being paid up.
The bank that gave out the mortgage defaults
The MBS will still be serviced by the collateral(mortgaged houses) against which it was created. Guarantees provided by the issuer will come into play. People might have taken insurance i.e. CDS google AIG's debacle, against the bought products.