Mortgage-Backed Securities: Definition, Features, and Types

Mortgage-backed securities (MBS) became a household name during the 2007 economic crash. MBS was established to boost the American housing market, but it led to its collapse in 2006-07. 

Mortgage-backed securities are asset-backed, secured by a pool of mortgages. MBS mortgages are sold to either government agencies or investment banks, which compile these mortgages into a bond. These securities are then sold to investors. 

What Is MBS?

MBS is a process where individual mortgages are pooled into a bond. Investors buy these bonds. MBS mortgages can be commercial or residential. The securities are issued either by government or private agencies.

The government-sponsored enterprises (GSEs) like Freddie Mac and Fannie Mae regulate the agencies. The collateralized mortgage obligations (CMOs) or collateralized debt obligations (CDOs) issue the shares of MBS.

Each MBS share is unique and has a different preference level for debt repayment schemes. Therefore, an investor’s level of risk or success depends on the kind of shares they have bought.

How Do Mortgage-Backed Securities Work?

MBSs are financial instruments that benefit investors. It pools individual mortgage loans together and creates investment products based on them. Here’s a stepwise breakdown of how mortgage-backed securities work:

1. Origination of Mortgage Loans: Banks, lenders, and other financial institutions originate mortgage loans. They issue these loans to individuals and homeowners or to refinance residential properties. The borrowers provide the properties as collateral for the loans.
2. Pooling the Loans: The originating institution combines multiple individual mortgage loans into a pool. In addition, pooled loans have similar characteristics like interest rates, maturities, and risk profiles. The pooling process allows for diversification and spreads the risk across a more significant number of loans.
3. Creation of Mortgage-Backed Securities: The pool of mortgage loans serves as collateral for mortgage-backed securities. Investment banks or financial institutions package MBS to represent ownership interests in the underlying pool of mortgages.
4. Cash Flows and Payments: The holders of mortgage-backed securities receive the distributed cash flows as homeowners make their monthly mortgage payments. This payment includes the principal amount and interest portions of the mortgage payments. Investors also receive a proportional share of the payments based on their investment, as the cash flow distribution is typically on a pro-rata basis.
5. Secondary Market Trading: MBS are bought and sold on the secondary market. Also, it provides liquidity to investors who want to sell their MBS holdings or allows new investors to purchase MBS.

Additionally, MBS prices in the secondary market fluctuate based on market conditions and changes in interest rates.

Types of Mortgage-Backed Securities

Each type of mortgage-backed security carries its unique characteristics and risks. Below are the different types of mortgage-backed securities:

1. Pass-Through Securities: In this mortgage-backed security, the investors receive a pro-rata share of the cash flows from the mortgage.
2. Collateralized Mortgage Obligations (CMOs): Here, the MBS are divided into multiple tranches with different risks and return profiles.
3. Stripped Mortgage-Backed Securities: In this type of mortgage, the principal and interest payments are separated into different securities. It is also known as principal-only (PO) and interest-only (IO) securities.
4. Agency MBS: These securities are issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.
5. Non-Agency MBS: These securities are issued by private agencies and carry high risks.
6. Residential Mortgage-Backed Securities (RMBS): MBS backed by residential mortgage loans commonly used in the housing market.
7. Mortgage-Backed Securities Indexes: These indexes track the performance of MBS in the market, and provide benchmarks for investors.
8. Real Estate Mortgage Investment Conduits (REMICs): This is a special tax structure used for certain types of MBS, benefits investors and issuers.
9. Hybrid Mortgage-Backed Securities: It combines different types of loans on fixed-rate and adjustable-rate mortgages, within the same pool.

Mortgage-Backed Securities and the 2007 Financial Crash

The increase in private (Non-Agency) securitization in the early 2000s created an extraordinary capacity for new mortgages. Mortgage loan originators started lowering credit standards to fill this capacity.

Additionally, this made securitization more risky as borrower default chances increased. Let’s understand the factors associated with MBS which led to the 2007 crisis:

• Entry of Private Entities: Initially, only government-sponsored enterprises (GSEs) provided securitization for a mortgage. However, with the housing market boom, private entities (non-agency) also started selling mortgage securities. They surpassed GSEs in no time.
• Increased Home Prices: The private entities surpassed the GSEs in selling securities, which led to more liquidity. Increased liquidity led lenders to offer credit to more borrowers. Moreover, this led to a steep increase in home prices and reduced affordability.
• Payment Defaults and the Crisis: The Financial Crisis Inquiry Commission (FCIC) listed early payment default as an early sign of collapse. An early payment default occurs when a borrower is more than 60 days delinquent within the first year of the mortgage.

To sum it up, the decision to include private firms in the securitization market risked the entire chain. An upsurge in liquidity led to a conflict of interest between mortgage loan originators and underwriters.

The Pros and Cons of MBS Investment

Every investment option also has its advantages & disadvantages. Let’s find out the pros & cons of MBS investment:

Pros of Investing in MBS:

1. Regular Income: MBS provides a steady income stream for investors through monthly cash flows from homeowners’ mortgage payments.
2. Diversification: MBS offers diversification benefits by investing in a pool of mortgage loans. It also spreads the risk associated with it across various borrowers and properties.
3. Potential for Higher Yields: Lower-ranked tranches of MBS may offer higher yields to investors willing to take on additional risk.
4. Liquidity: You can buy and sell MBS on the secondary market. It would benefit investors with liquidity and the ability to adjust their investment positions.
5. Government Backing: With the support of government-sponsored enterprises, agency MBS carries an implied guarantee that lowers credit risk.

Cons of Investing in MBS:

1. Interest Rate Risk: Fluctuations in interest rates can impact the value of MBS. Increased rates will decrease the prepayments, and prolong the investment’s duration.
2. Prepayment Risk: Homeowners refinancing or selling their properties ahead of schedule can lead to early repayment of the underlying mortgage loans. However, this would prevent the investor’s cash flow.
3. Complexity: The structure and various tranches of MBS can be complex. It requires investors to understand the collateral and associated risks thoroughly.
4. Market Volatility: Market conditions, economic factors, and investor sentiments impact MBS prices.
5. Lack of Transparency: The underlying mortgage loans may have limited transparency. So it`s challenging to assess the quality and risk of the collateral.

Bottom Line

Investors earn hefty returns from a range of benefits that come from mortgage-backed securities. Benefits such as ample liquidity attract potential investors.

Having said that, we advise you to evaluate your financial condition and the pros and cons of MBSs before investing.

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