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What Are Non-Agency Mortgage Backed Securities (MBS) And Should I Invest In Them?

May 16, 2023 5-minute read

Author: Melissa Brock


Think you might want to invest in real estate but not sure if you want to rent an actual house or apartment complex? Non-agency mortgage-backed securities (non-agency MBS) offer another way to invest in real estate without actually having to maintain actual property.

Let's dive into the details of non-agency MBS to help you decide whether you want this type of investment to have a place in your passive income investing strategy.

What Are Non-Agency MBS?

Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) purchase mortgages that conform. These become agency MBS; those that don’t conform get purchased by private banks or private entities and become non-agency MBS, also called private-label securities.

Since the 2008 recession, a great divide has existed between mortgages that conform to the standards set by regulatory agencies like the Consumer Financial Protection Bureau (CFPB) and mortgages that don’t conform.

The rapid growth in the non-agency MBS market contributed to the 2008 recession because it ultimately catered to less creditworthy borrowers. As a result, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act created major changes to how creditors offer loans. It also included new ability-to-repay requirements, which protect all consumers from taking on loans they don’t have a way to pay back.

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What Are Mortgage-Backed Securities?

Whether purchased by a GSE or a private bank, mortgages get sorted by default risk factors and then bundled together for sale as securities to investors. When an investor buys mortgage-backed securities, they ultimately lend money to home buyers. In return, the investor receives the underlying mortgage payments, including interest and principal payments made by the borrower, as their return on investment.

These investors enjoy passive income from their investment in real estate without having to worry about responsibilities of property management.

What’s The Difference Between Agency And Non-Agency MBS?

The biggest difference between agency and non-agency MBS is that non-agency MBS are not guaranteed by the U.S. government or any government-sponsored enterprise. Non-agency MBS investors open themselves to more risk.

Agency MBS

Lenders often want to get mortgages off their own balance sheet, so conforming mortgages often get purchased after origination by GSEs – Fannie Mae, Freddie Mac and Ginnie Mae, who in turn repackage and rebundle mortgages for sale on the secondary mortgage market. The government has a direct interest in keeping lenders liquid so they can keep making mortgage loans.

The Federal Housing Finance Agency (FHFA) requires Fannie Mae and Freddie Mac to stick to specific standards to which these mortgages conform. They must buy conforming loans that do not go over the limits set by the FHFA and have other underwriting criteria. Lenders must evaluate each borrower's loan-to-value (LTV) ratio, debt-to-income ratio and credit score. In other words, these mortgages and borrowers must present the least risk of default.

Non-Agency MBS

Many prospective homeowners cannot meet the CFPB standards, so lenders who wish to lend to them must issue non-conforming loans. For example, some examples of non-conforming loans include jumbo mortgages or government-backed loans (such as VA loans, FHA loans and USDA loans). Note: These non-conforming loans also get sold after origination to keep their lenders liquid, but large, private banks purchase them instead of GSEs.

These mortgages are also bundled and repackaged into mortgage-backed securities and then sold as products like real estate investment trusts (REITs), collateralized mortgage obligations (CMOs) or pass-throughs. You might hear non-agency MBS referred to as "private-label MBS" instead.

Pass-throughs mean that investors get a percentage of the principal and interest payments equal to their investment in the trust. Pass-through MBS generates revenue through scheduled principal and interest rates and prepaid principal.

Collateralized mortgage obligations involve repackaged pass-through mortgage-backed securities. Cash flow goes in a prioritized order based on the structure of the bond. CMOs get directed into various bond classes, called tranches, which provide a time frame for expected payment.

Non-Agency RMBS

The GSEs do not buy commercial real estate mortgages, so those mortgages often get repackaged for sale by private banks. Those wishing to invest in residential properties can only buy non-agency residential MBS, or RMBS.

Non-agency RMBS involve a debt-based security backed by the interest paid on loans for residences. Pooling many loans together like this minimizes risk, similar to the way an investor might opt for investing in a mutual fund over a more inherently risky individual stock.

What Are The Risks Of Investing In Non-Agency MBS?

Non-agency MBS have a checkered history and had a hand in the subprime mortgage crisis. Take a look at a quick overview below.

A Word About The Subprime Mortgage Crisis

As mentioned, non-agency MBS earned a poor reputation as a result of the subprime mortgage crisis. Prior to the mortgage crisis, lenders originated mortgages to consumers without considering their ability to repay loans. This led to mass payment delinquencies and subsequent foreclosures. What ensued changed to the non-agency MBS standards in place today.

Dodd-Frank And The Ability To Repay

The Dodd-Frank and its Regulation Z requirement was implemented in response to the housing market collapse and subsequent financial crisis. It required creditors to consider a borrower’s ability to repay post-2008.

The CFPB changed Regulation Z, which implements the Truth in Lending Act (TILA). Regulation Z does not allow lenders to obtain higher-priced mortgage loans without regard to the consumer's demonstrated credit risk. Creditors must supply and verify borrower financial information, verify borrowers' assets or income to pay back the loan and reasonably conclude that the borrower can repay the loan using techniques such as determining a borrower's DTI, income and more.

Inherent Risks In The Housing Market

Without the CFPB protections, the risk of default is greater with non-conforming loans compared to conforming mortgages. Note that housing market indicators are difficult to analyze and future risks can be unpredictable.

For example, COVID-19 has affected the housing market and introduced huge uncertainty in the economy, which in turn makes the future of the housing market cloudier. Health concerns, stay-at-home orders and economic uncertainty caused many metro areas to experience a noticeable drop in home sales.

In April and May of 2020, nationwide home sales dropped to their lowest levels since the housing and financial crisis that began in 2007.

What Are The Rewards Of Investing In Non-Agency MBS?

Investors can reap the rewards of investing in non-agency MBS, and some investors did after the 2008 recession. Note that those windfalls have now leveled out, but non-agency MBS continue to perform well, outperforming agency MBS.

How Can I Invest In MBS Today?

Talk with your financial advisor about the risks inherent in investing in MBS, which include credit and default, interest rate, prepayment and extension risks. Then invest in the type of methods outlined below.

Investing In Agency MBS

Prospective investors who want to build their real estate portfolios can look for mortgage REITs or other bond funds backed by non-agency MBS through investment banks, financial institutions and homebuilders.

Investing In Non-Agency MBS

Since 2008, direct investment in non-agency MBS has been limited to institutional investors. If you really want to invest in non-agency MBS, you can buy into REITS, mutual funds or bond funds offered by these institutional investors.

The Bottom Line: With Greater Risk Comes The Opportunity for Greater Reward

As with any type of investment, more inherently risky investments offer the potential for greater reward than safer investments. Private-label mortgage-backed securities and mortgage-backed securities might offer a great choice if you don't actually want to manage an investment property.

GSEs purchase mortgages that conform and become agency MBS; those that don’t conform get purchased by private banks or private entities and become non-agency MBS, or private-label securities.

You can compare mortgage-backed securities to bonds. The only difference is that they give their owners the ability to reap the rewards of interest and principal received from homeowners' mortgage payments.

Prospective investors who want to build their real estate portfolios can look for mortgage REITs, mutual funds or bond funds offered by these institutional investors.

Learn more about the benefits of investing in real estate to find out if real estate investing is right for you.

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Melissa Brock

Melissa Brock is a freelance writer and editor who writes about higher education, trading, investing, personal finance, cryptocurrency, mortgages and insurance. Melissa also writes SEO-driven blog copy for independent educational consultants and runs her website, College Money Tips, to help families navigate the college journey. She spent 12 years in the admission office at her alma mater.