Mortgage-backed securities (MBS) are investment products similar to bonds, consisting of a bundle of home loans and other real estate debt bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.
Key Takeaways
- Mortgage-backed securities (MBS) turn banks into intermediaries between homebuyers and the investment industry.
- Banks sell bundled loans at a discount for MBS inclusion, which are then marketed to investors as collateralized bonds.
- An MBS’s safety is contingent on the underlying mortgage loans.
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Unraveling Mortgage-Backed Securities (MBS)
MBS are a form of asset-backed securities created by pooling together mortgages exclusively. Investors essentially lend money to homebuyers by purchasing MBS, which can be traded through brokers with varying minimum investment requirements.
The 2007-08 subprime mortgage meltdown highlighted the vulnerability of MBS, which depend on the soundness of backing mortgages. An MBS also goes by the names mortgage-related security or mortgage pass-through.
Banks act as intermediaries, granting mortgages and then selling them at a discount. This transforms the mortgages into tradable MBS, aiding banks and investors as long as all stakeholders - borrowers, banks, and credit agencies - maintain due diligence.
Today, for an MBS to be marketable, it must be issued by a government-sponsored enterprise (GSE) or a private financial company, originate from regulated financial institutions, and earn top ratings from accredited credit rating agencies.
Types of Mortgage-Backed Securities
1. Pass-throughs
- Structured as trusts, distributing collected mortgage payments to investors.
- Maturity: usually five to 30 years.
- Actual lifespan may vary based on mortgage payment rates.
2. Collateralized Mortgage Obligations (CMOs)
- Composed of multiple pools of securities called tranches.
- Tranches receive distinct credit ratings that influence investor returns.
A Glimpse into The History of Mortgage-Backed Securities
Initiated by the Housing and Urban Development Act of 1968, which established Ginnie Mae, MBS began revolutionizing the market. Ginnie Mae’s first retail MBS came out in 1970, and the first private MBS was released by Bank of America in 1977.
The Role of MBS in the Financial Crisis of 2007-2008
MBS significantly contributed to the financial crisis of 2007-2008 by pushing banks to lower lending standards and encouraging risky investments. When the housing market faltered, the value of MBS and the associated collateralized debt obligations (CDOs) plunged, disrupting global financial markets.
The Crisis
Freddie Mac and Fannie Mae’s support of subprime mortgages degraded MBS quality, leading to widespread defaults as home prices peaked and borrowers couldn’t keep up.
The Bailout
The U.S. Treasury allocated a $700 billion bailout and the Federal Reserve engaged in substantial MBS purchases to stabilize the market and the economy.
Advantages and Disadvantages of Mortgage-Backed Securities
Advantage: Attractive Yield
- Fixed interest rates higher than government bonds.
- Monthly, rather than lump-sum payments, enhancing cash flow.
Advantage: Safe Investment
- Considered lower risk, especially with federal guarantees.
- Offers diversification beyond corporate and government securities markets.
Disadvantage: Prepayment Risk
- Early loan repayments or refinancings reduce expected returns.
Disadvantage: Interest Rate Risk
- Sensitive to interest rate changes; rising rates can decrease MBS profitability.
Summary of Pro and Cons:
Pros
- Consistent income with monthly payouts
- Diversification
- Lower correlation with stock market and corporate bonds
Cons
- Returns vulnerable to borrower behaviors and interest rates
Mortgage-Backed Securities Today
MBS still represent a robust investment avenue, with markets active under cautious investor scrutiny. The Federal Reserve continues to phase out its prior large MBS holdings incrementally.
FAQ about Mortgage-Backed Securities
What Are the Types of Mortgage-Backed Securities (MBS)?
- Pass-throughs and CMOs, with their respective structures and maturities.
What’s the Relationship Between MBS and a Bank?
- Banks sell mortgages as MBS, acting as a connection between homebuyers and investors.
What Is an Asset-Backed Security (ABS)?
- ABS is collateralized by pooled assets, producing steady income akin to a bond.
The Bottom Line
An MBS offers investors a way to gain from the housing market’s steady growth through pooled mortgage payments, affording exposure distinct from typical corporate or debt securities.
Related Terms: asset-backed securities, financial crisis, bonds.
References
- Federal Deposit Insurance Corp. “Origins of the Crisis”, Page 6 (Page 4 of PDF).
- International Financing Review. “1977: US$100M Deal for Bank of America: The First Private MBS”.
- Congressional Research Service, via Federation of American Scientists, Project on Government Secrecy. “Introduction to U.S. Economy: Housing Market”, Pages 1–2.
- U.S. Department of the Treasury. “Troubled Assets Relief Program (TARP)”.
- Investor.gov, U.S. Securities and Exchange Commission. “Mortgage-Backed Securities and Collateralized Mortgage Obligations”.
- U.S. Securities and Exchange Commission. “Asset-Backed Securities”.
