What are Mortgage Backed Securities (MBS)?

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Mortgage-backed securities (MBS) are portions of the mortgage market that investors can buy from banks. This investment strategy allows people to profit from mortgages without directly buying or selling properties. Let’s explore how MBSs work and the risks involved.

When someone buys a home, they usually get a loan from a bank. These loans are then combined and bought by larger financial entities to create MBSs.

MBSs derive their value from the underlying assets, which are the gathered home loans. They can be traded in the secondary market and are typically issued by government agencies like Fannie Mae, Freddie Mac, and Ginnie Mae, as well as investment banks. Individuals, corporations, and institutional investors can purchase these securities.

MBSs and their role in the U.S. economy

You may remember hearing about MBSs during the global financial crisis in 2008 and 2009. The U.S. Treasury provided a $700 billion bailout, and the Federal Reserve purchased MBSs to address the credit crunch.

However, MBSs have been around since 1970 when Ginnie Mae was established. These securities, backed by the U.S. government, were introduced to generate funding and promote affordable housing. Fannie Mae and Freddie Mac also started issuing MBSs shortly after. As of 2023, mortgage-backed securities issuance stood at $991.3 billion.

Understanding how mortgage-backed securities work

To understand MBSs, it helps to know how a home loan becomes a security.

Step 1: Securing a mortgage

When someone buys a home, they take out a mortgage from a bank. The bank charges interest on the loan. The bank can either earn interest until the loan is fully repaid or choose to sell the loan.

Step 2: The bank sells the loan

The bank might transfer the loan to a larger financial entity or government agency like Fannie Mae. This strategy provides liquidity and risk mitigation for the bank. Now, Fannie Mae owns the principal and interest on the mortgages, while the bank still earns profits from fees without the risk of default. Banks can accumulate thousands of mortgage loans and sell them to financial institutions or federal agencies.

Step 3: The loans are bundled and sold

Fannie Mae then places these mortgage-based securities on the secondary market for purchase by private or institutional investors. An MBS must be issued by a government-sponsored enterprise or a private financial company. Fannie Mae issues both mortgage-backed securities and corporate coupon bonds.

Mortgage-Backed Securities: Exploring Types

Mortgage-backed securities (MBSs) come in two main forms: pass-through securities and collateralized mortgage obligations (CMOs).

  1. Pass-through securities:

These simpler MBSs function as trusts. They collect and distribute principal and interest payments from borrowers to investors. Typically, they have a defined maturity of 15 or 30 years, but can be shorter. Investors receive income from partial principal payments, interest payments, and prepaid principal.

  1. Collateralized mortgage obligations (CMOs):

CMOs are more complex than pass-through securities. Cash flows from pass-through securities are divided into three bond classes, or ‘tranches,’ with varying rates, risks, and maturity dates. The tranches are rated to determine interest rates. Higher-risk tranches have higher interest rates, while lower rates offer more security. CMOs distribute principal payments among different classes, creating a pay-down schedule for residential and commercial MBSs.

Investing in MBSs: The Benefits

Investing in MBSs offers advantages for investors:

  • High returns: Fixed-rate MBSs generally provide higher yields than government bonds. CMOs, though riskier, can offer even greater returns. MBSs provide monthly payouts compared to bonds that only pay at maturity.
  • Security: MBSs, especially those backed by the federal government, are considered secure investments. Borrower defaults do not necessarily result in losses for investors.
  • Reduced credit risk: MBS creditworthiness depends on the quality of underlying mortgages. MBSs backed by federal agencies or government-sponsored enterprises typically have low credit risk, enhancing credit quality.

However, Investing in MBSs: The Risks

Investing in MBSs is not without risks:

  • Prepayment risk: Early mortgage pay-offs, such as refinancing, can disrupt investor income flow.
  • Interest rate impact on price: Rising mortgage rates can lower MBS prices. Higher rates may decrease mortgage applications, affecting the mortgage market and MBS prices.
  • Payment default risk: In the event of borrower default, the investor bears the risk. However, federally backed mortgages may offer some protection against payment disruptions.

Opportunities in Mortgage-Backed Securities

In conclusion, mortgage-backed securities offer a great opportunity for savvy real estate investors to profit from the mortgage industry without the need for direct involvement in property acquisition or administration. 

Please note that the views expressed in this write-up are for general information purposes only and should not be considered as specific advice or recommendations for any individual, security, or investment product. The perspectives shared in this commentary are subject to change without prior notice. For more information, please refer to Foothold’s disclaimers.

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