What is a Mortgage Backed Security (MBS)?

Definition
Mortgage Backed Security (MBS): this security is created when mortgages are collected and placed into a pool of mortgage loans.  Bonds, backed by the mortgage pool, are sold to institutions or public  investors  and receive a share of interest and principal payments on mortgage loans. These securities can be guaranteed by the Government.

Role in the Housing Crisis
Almost all types of mortgage loans had high default rates during the housing crisis, but subprime loans had delinquency rates many times the rate of conventional loans.  For instance, in January of 2010, Subprime Adjustable Rate Mortgages (ARM) has delinquency rates of 42.7%, while loans created by Freddie Mac had delinquency rates of only 4%.

For the most part, subprime lending and securitization occurred through the banking system and Wall Street. The repeal of Glass Steagal made it easier for Wall Street Investment Banks to interact with banking customers, originating loans and packaging them into subprime securities.  Often, these loans contained substandard documentation and lower underwriting standards.  Even so, the loans carried AAA ratings from rating agencies, indicating that they were the highest investment quality.  Conventional thinking, at the time was that Mortgage Backed Securities carried the lowest risk, regardless of the underwriting standards.

Even though loans created by Freddie Mac have lower delinquency rates, the government backed mortgage giants Fannie Mae and Freddie Mac loaded up on subprime securities in 2007, at the urging of Congress. They were more than willing to invest in Wall Street's subprime AAA rated securities, as they found themselves losing market share to lenders like Countrywide, GMAC, and WAMU who were churning out the securities as fast as they could make them.

The voracious appetite of investors lead to excess amounts of funds flowing into mortgage lending and a bubble was created. The bubble popped in late 2008, as unemployment began to rise. After 2008, for several years, the only Mortgage Backed Securities (MBS) being sold into the market were backed by the explicit guarantee of the government. Private lenders were either insolvent, or unwilling to lend.