What Are Mortgage-Backed Securities (MBS)?
Jamie Johnson5-minute read
July 13, 2023
If you’re looking for opportunities to diversify your portfolio, mortgage-backed securities (MBS) could be a good option. An MBS is made up of a pool of mortgages purchased from issuing banks and then sold to investors.
An MBS allows investors to benefit from the mortgage business without needing to buy or sell home loans themselves. If you’re interested in learning more about what mortgage-backed securities are, keep reading to learn how these investments work.
What Is A Mortgage-Backed Security?
A mortgage-backed security (MBS) is an investment secured by a collection of mortgages bought by the banks that issued them. Mortgage-backed securities are bought and sold on the secondary market. An MBS is a type of asset-backed security; asset-backed securities have made mortgage financing and home loan processes easier.
Most mortgage-backed securities are issued by Fannie Mae, Freddie Mac and Ginnie Mae. These are government-sponsored enterprises that buy mortgage loans. These companies were designed to make homeownership more accessible to consumers.
Although they’re private companies and not technically government enterprises, Fannie Mae, Freddie Mac and Ginnie Mae still set guidelines that banks and lenders must follow.
History Of Mortgage-Backed Securities
The goal behind MBSs was to allow banks to sell off mortgages so they’d have more money available to lend to consumers. The addition of mortgage-backed securities paved the way for financial institutions other than banks to enter the mortgage business. Creating bonds backed by principal and interest payments on mortgages helped them take off with a new class of investors.
The problem was that while banks and financial institutions were regulated, MBSs were not. To remain competitive, many lenders began lowering their standards for who they’d give mortgages to. This contributed to the financial crisis of 2008. After the housing crisis subsided, the government tightened regulations on the financial industry.
MBSs are now regulated, and investors must receive certain information and disclosures. The financial crisis also emphasized the importance of filling mortgage-backed securities with sound assets.
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How Do Mortgage-Backed Securities Work?
With MBSs, the bank acts as the middleman between the homeowners and investors. Individual mortgages are closed by banks and sold as conventional loans. From there, they are added to a pool of similar mortgages and packaged as a mortgage-backed security. The banks then sell those mortgages on the bond market.
For starters, say you were hoping to buy a new home. First, you’d visit your bank and apply for a mortgage. The bank would charge you a fixed or variable interest rate in exchange for the money. They could keep the mortgage and continue earning principal and interest for the life of the loan. Alternatively, the bank could sell the interest and principal to a group of investors to free up some of its capital. The bank then continues to earn money by originating and servicing new mortgages.
To create an MBS, the bank will bundle your loan with hundreds or thousands of other mortgages. These loans are then sold to an investment bank as a single bond. The investment bank then sections off the loans by their quality and sells them to other investors. Loan characteristics and risk profile determine inclusion in a mortgage-backed security.
The trading of MBSs also significantly impacts mortgage rates. Mortgage characteristics and credit profiles impact bond yields, which trickles down to individual mortgage rates.
Types Of Mortgage-Backed Securities
There are two main types of mortgage-backed securities: pass-throughs and collateral mortgage obligations (CMO). Let’s look at an overview of both.
A mortgage pass-through is the most basic form of an MBS. When homeowners make their monthly mortgage payments, the principal and interest received are passed on to the investors.
This means investors receive monthly payments from interest and a partial return on the principal. However, a mortgage pass-through doesn’t change anything about the payments for the homeowners.
Collateral Mortgage Obligations
Collateralized mortgage obligations (CMOs) are more complex than mortgage pass-throughs. In a CMO, the mortgages are organized into separate tranches based on rates, risk, and maturity dates. Tranche is just another word for a segment. The different tranches are given credit ratings, which determine the mortgage-backed securities rates.
Does The Federal Reserve Buy Mortgage-Backed Securities?
The Federal Reserve had only an indirect impact on mortgage rates until 2008. Around this time, the Fed began buying MBSs directly in order to support the economy, help decrease mortgage interest rates and add liquidity to the market. This practice continued for over a decade, with the Fed amassing more than $2 trillion in MBS holdings. Recently, however, the Fed has made the decision to slowly exit the MBS market by halting its continual purchasing of bonds.
The purchase of these MBSs was helping keep mortgage rates low, which provided an economic boost because housing accounts for a significant share of the money pumped into the economy. However, cheaper financing meant higher home prices – something that is, at this point, actually detrimental. By halting its purchase of MBSs, the Fed hopes to combat inflation.
The Pros And Cons Of Investing In Mortgage-Backed Securities
Investing in MBSs comes with advantages and disadvantages, which will vary depending on the security and entity you invest in.
Before investing in an MBS, you should ensure the investment asset fits your specific needs and risk levels. Here’s an overview of some of the pros and cons of investing in these securities:
Pros Of Mortgage-Backed Securities
Here are some of the biggest advantages of investing in an MBS:
- Safe investment: MBSs tend to be a fairly safe investment since they are usually fixed-rate loans with prepayment penalties.
- Attractive yields: MBSs come with yields that tend to be higher than what you’d get by investing in U.S. government bonds. Securities with higher coupons offer the greatest potential rewards.
- Minimal credit risk: The credit risk is considered minimal for MBSs backed by government-sponsored entities.
Cons Of Mortgage-Backed Securities
Here are some potential downsides to investing in an MBS:
- Prepayment risk: There is always a risk that borrowers will make higher-than-expected monthly payments or pay their mortgage off early. They could also pay off the mortgage by refinancing, which is more common when interest rates go down.
- Interest rate risk: MBSs sometimes come with a higher interest rate risk since the price of the security can drop when interest rates
- Credit and default risk: If the borrowers fail to make their interest and principal payments, investors will experience losses. The risk level depends on the market’s strength and when the loan was issued.
- Extension risk: There’s also the risk that borrowers will decide not to make prepayments on their mortgages as initially expected. When this happens, the security may come with a lower-than-expected coupon since the principal is lower. This typically happens when Treasury rates begin going up.
The Bottom Line
Mortgage-backed securities have evolved quite a bit over the years. Thanks to increased regulation of the financial industry, MBSs are a much safer investment today than they were in the past. However, there is no risk-free investment. Before investing in any asset, you should always familiarize yourself with the potential risks and rewards.
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