Mortgage-backed Securities Basics – How It Works, Types Benefits and Examples

Last Updated: June 2, 2019
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In financial terms, a security is a type of asset that has monetary value and which investors can trade on the secondary market.In today's article, our main focus will be mortgage-backed securities – what exactly are mortgage-backed securities, their intricate mechanism, types, benefits, examples and potential risks.

In financial terms, security is a type of asset that has monetary value and which investors can trade on the secondary market.

The secondary market is the place where you can buy or sell previously bought or purchased assets. Depending on the underlying asset, there are different types of securities – stock, bonds, mortgages, etc.

In today’s article, our main focus will be mortgage-backed securities – their intricate mechanism, types, benefits and potential risks.

What is Mortgage-backed security (MBS)?

Mortgage-Backed security (MBS) is a financial instrument which is backed by a mortgage. So to speak, in this case the underlying asset is a mortgage. This is an investment option that enables investors to benefit from the real estate market without taking out a bank loan or buying the property itself. These securities are also referred to as “pass-through certificates” and “mortgage pass-throughs”.

The mechanism behind MBS is simple: when you buy security you actually lend the money to the borrower of the loan. Both institutional and individual investors avail of this investment opportunity.

For example, many banks use this technique to make sure their customers are protected.

Mortgage-backed Securities Basics – How It Works, Types Benefits and Examples

How do Mortgage-Backed Securities Work?

Now you know some basic information about MBS. What is the intricate mechanism behind MBS? In order to get the idea, I will give you an example.

Usually, when people want to buy a property they take out a loan called mortgage; the property is the collateral. This means that the bank might take the property should the borrower fail to make payments.

Let’s imagine the following situation:

A borrower takes out a $100,000 mortgage from bank USU. Banks usually keep the mortgage as a part of their portfolio, and they collect the monthly payments following the agreed-upon schedule. Sometimes, however, they might sell the mortgage in order to obtain some fresh cash. They will eventually use this money to give more loans to more borrowers and earn interest.

So, the bank has sold your mortgage to a government body or a private company.

Usually, the company that buys the mortgage puts the loans together into different categories with similar characteristics and “pools” them.

For instance, mortgages that have the same interest rate or maturity will be in one “pool.” Consequently, this company starts selling securities that represent parts of these mortgages. They sell them on the secondary market and the money is used for more purchases and investment in mortgages.

Do not worry if you have a mortgage with a bank that has sold it to another entity. The monthly payment will be directed from the bank to the company that owns the mortgage. They, on the other hand, give this money to the security holders. Of course, both the bank and the security issuer take some fees from the monthly payment.

Types Of Mortgage-Backed Securities

Before we delve deeper into the types of MBS, it’s good to say that mainly government agencies issue securities. In the USA, these are primarily the  Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

All three agencies are backed by the US government so investors needn’t worry about their payments. Because of that, these MBS are very secure. Of course, there are some private companies that also issue securities, which are known as private-label mortgage securities. Their credit ratings, however, tend to be much lower than securities issued by government agencies.

Now, let’s take a look at the two main types of MBS:

1. Pass-Through Participation Certificates (aka pass-throughs)

That’s a long name but actually is quite easy to understand.

As I earlier mentioned, the company that issues the security pools many mortgages together. In this type, an investor (a security holder) of a pass-through can have a fair portion of both the principal and interest payments of the pooled mortgages.

2. Collateralized Mortgage Obligations

The mechanism of these is more complex.

This type combines interest and principal payments from several different pools of mortgages, not only one as is the case with the pass-throughs. As a result, companies issue additional securities that have different maturity and coupons.

Benefits of Mortgage-backed Securities

Mortgage-backed securities offer quite a few benefits to investors. They are:

High Credit Rating

Standard & Poor’s and Moody’s are the two major credit rating agencies, and they rate different assets.

Many people prefer investing in MBS because they often have “AAA” rating. This means that for example, Standard & Poor’s have given this security the highest rating. This, on the other hand, means that the investment is secure and probably investors will have to face no risk.

Regular and Attractive Income

Just like bonds, MBS offer their holders a monthly or semi-annual income.

Because of that, the compounding effect of reinvestment increases with each year. Many people often compare the performance of agency MBS with another safe asset – US treasuries. In comparison to MBS, 3-, 5-, and 10-year treasuries generate lower returns.

Liquidity and Efficiency

If an asset is not liquid, the chances are high you won’t be able to sell it and lose money because of the fluctuating prices. However, agency MBS are quite liquid and are more efficient than, for instance, home loans or lines of credit.

Steady Sharpe Ratio

Simply put, the Sharpe ratio (or Sharpe index) is a tool that measures the risk-adjusted returns of a particular asset.

It’s no secret that the MBS sector has been quite consistent when it comes to its Sharpe ratio, again compared to US treasuries. This means that mortgage-backed securities are somewhat resistant to all the fluctuations in the financial markets.

Mortgage-backed Securities – The Risks

Repayment Risk

The most serious risk associated with MBS is the so-called prepayment risk.

As the word “prepayment” suggests, this is the risk that arises if the borrower decides to pay off his debt in advance. For instance, a couple that owns a house decides to move to another state and sells their house and repays the loan. Because of that, investors will receive an early return and won’t be able to benefit from a longer steady income and interest payments.

The general rule is that when interest rates go down, the risk of prepayment is at its highest.

Why? Well, lower interest rates will stimulate many borrowers to refinance their mortgages.

MBS And The 2008 Financial Crisis

Everyone remembers the global financial crisis of 2007. It started with the “eruption” of the housing market in the USA and wreaked havoc all over the world causing many people to lose their homes and experience financial setbacks. Talking about the real estate bubble, it’s no surprise mortgage-backed securities played a significant role in the process.

How?

Previously in the article, I explained the mechanism of an MBS: simply put, a bank sells someone’s mortgage to another company. This is how banks get more and more cash which they can lend to other people.

Back in 2007, banks started selling mortgages and getting more and more money. Therefore, they started lending this money to subprime borrowers, which always poses a serious risk. On the other hand, due to their high rating and the growing real estate market, more and more investors became interested in buying MBS.

The SubPrime Affect

The role of government agencies should not be underestimated. Both Fannie Mae and Freddie Mac actively participated in the process by purchasing more and more mortgages and issuing more and more MBS. This led to the declining quality of the MBS during that time. Consequently, subprime borrowers started to default and this “tsunami” hit the market and led to its collapse. When people defaulted on their mortgages, the security holders suffered great losses.

Logically, many investors tried to get rid of their MBS investments, which additionally worsened the situation. That would have led to a complete nightmare if it hadn’t been for the Fed which bought $1.75 trillion in MBS. The US government launched a program (Troubled Asset Relief Program) which aimed at buying “toxic” assets and inject banks and other institutions with fresh cash. Eventually, the economy normalized but the memories are still fresh.

Bottom Line

Mortgage-backed securities are a great way to benefit from the housing market indirectly; instead of borrowing money and buying a house, you can simply purchase a security. This will give you the chance to have a regular income while being able to quickly sell them.

Even though most investors consider them a safe and secure investment, one should carefully approach MBS. One of the main concerns is the so-called prepayment risk. MBS have also contributed to financial crises before, so be wise in making your investments.