Mortgage-Backed Security

A mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.

Government agencies or sponsored enterprises, Central banks, and private investment banks can issue MBSs. Ginnie Mae, Fannie Mae, and Freddie Mac are the significant players backed by the government in the US. They play an essential role in maintaining the liquidity in the mortgage market by purchasing mortgages from their originators.

• Mortgage-backed securities are financial instruments that represent an ownership claim on the cash flows generated by a pool of mortgage loans.
• Mortgage-backed securities are created by bundling individual mortgages into a single security, which is then sold to investors. The cash flows from the underlying mortgage payments are distributed to the investors.
• Mortgage-backed securities offer investors exposure to the mortgage market, enabling them to earn interest based on the principal and interest payments homeowners make.
• The risk and return characteristics of mortgage-backed securities depend on factors such as the credit quality of the underlying mortgages, prepayment risk, and prevailing market conditions.

A mortgage-backed security is an asset-backed security created when a large bank or particular financial institution buys mortgages from banks issuing them and organizes collected mortgages into different groups or bundles based on their characteristics to form a financial instrument. Individual bundles represent security similar to bonds and are tradeable in the secondary market.

In short, the mortgage-backed security meaning depicts it as a bond-like security created by bundling mortgages. In this market, banks connect property buyers, usually clients seeking home mortgage loans, and investors. As a result, the borrower’s monthly payment against the mortgage will ultimately reach investors. At the same time, the impact of certain events like default in payment, interest rate fluctuations, and prepayment will fall on the investors, not the intermediary banks.

Despite the issues caused by the 2008 financial crisis, investors still get MBSs today, mostly because people often try to pay their mortgages, so they are still reasonably reliable. After the crisis, however, it was apparent that the world needed to find a new path to make MBS safer. So, post-crisis governments tend to regulate residential MBSs much more than they did before. However, amid Covid 19 pandemic, the Federal Reserve currently holds a large portion of the MBSs to protect the economy.

There are different types of MBS like Pass-through securities, collateralized mortgage obligation, a stripped mortgage-backed security, and Collateralized Debt Obligation. Let's look into the explanation for a few significant types of MBS.

#1 - Pass-Through MBS

It is also called a mortgage pass-through instrument and is one of the most traded fundamental forms of MBS in the secondary market. The option is designed as a trust, with the cash flow from the collateral pool “passing through” to the security holder in the form of monthly principal and interest payments. It exists as either commercial or residential mortgage-backed security.

#2 - CMO

CMO is complex with the presence of tranches. Each branch represents a group of mortgages, and tranches can have different maturities or interest rates. It is different from the basic practice where MBS contains bundling of similar investments together. They may do it with several different loans that have distinct characteristics.

Let us consider the following examples and understand how does a mortgage-backed security works:

Example 1

Here is a conceptual example to make it easier to understand the topic:

In the United States, the mortgage market is highly liquid, and it is easy to get a home mortgage loan. For example, Ben wants to buy a house that costs $200,000. He can pay up to $40,000 upfront using his savings. So, Ben visits a bank and tries to get a loan. The bank evaluates Ben’s credit score. Without crossing many hurdles, he got the loan with a 20% down payment and a good FICO score.

One of the reasons behind the ease of the loan availing process is the evolution of MBS. Bank provides loans to Ben, and they sell this mortgage to government-backed entities like Fannie Mae or Freddie Mac supporting the United States home finance system. After purchasing the mortgage, they will bundle it with other loans into securities called MBS and offer the MBS to investors. Fannie Mae or Freddie Mac is not directly providing mortgages to borrowers; instead, they purchase them from the loan providers like banks. In this way, they are helping the banks to free up locked capital and increase the cash flow.

Example 2

The MBS market was one of the triggers of the financial crisis that rocked the world in 2008. During the 2000s, the United States lived through a fast real estate economic growth. As a result, prices went up as demand skyrocketed, and the regulators got too lenient while giving credit to people. It led to several big commercial banks and investment funds betting a lot on MBS because they were very profitable.

Over time, it meant that credit ratings eventually got less and less valuable, and several people who clearly couldn’t afford a house bought one. Finally, when people started to fail to pay their mortgages, the economic bubble burst, it led to a massive financial crisis, which bankrupted Lehman Brothers, one of the largest banks in the world at the time, and the U. S. government had to bail out several financial institutions, which impacted the economy and changed the world.

A mortgage-backed security is a blessing for those who have an asset or pool of assets to use as collateral to borrow finances. However, it might not be the right option for some as it involves a higher degree of risk. Let us have a look at a list of benefits and risks associated with the option, be it residential or commercial mortgage-backed security:

Benefits

• The interest rate paid on these options is more than that on the US government bonds.
• Monthly payments make these options a better finance alternative for many.
• The investor or bondholder is secure as they can claim the property in the event of default.

Risks

• As the rate of interest offered is less than the government bonds in these options, the yield is equally lower than government bonds.
• There is a prepayment risk for investors if borrowers pay the principal amount before the scheduled period. This way, the investors lose the interest that they would have received if the borrowing period continued until the scheduled time.

MBS and Collateralized Debt Obligation (CDO) are both types of asset-backed securities, but they differ in how investors deal with them and how borrowers obtain them. Let us take a look at the differences:

• While the former is the security or asset that generates returns based on the mortgage loan/loans backed by the borrowers’ properties, the latter is what derives income from the pool of underlying securities that the borrowers have.
• MBS is issued by those sponsored by the government or private entity that purchases securities from banks or lenders. CDOs, on the other hand, are issued by Special Purpose Tranche (SPT).
• MPS follows a simple payout procedure, while CDO payouts are a bit complex.

Mortgage-backed security and mortgage bond are the terms that sound and seem similar and mostly, amateur investors mistakenly use them synonymously. However, investors must know that the latter is only a type of MBS.

This has been a guide to what is Mortgage-Backed Security. Here, we explain the concept along with its examples, vs CDOs, benefits, risks, and types. You may also have a look at the following articles to learn more –

• Credit Default Swap
• Subprime Mortgage
• Spread