A mortgage-backed security is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations and collateralized debt obligations. A mortgage bond is a bond backed by a pool of mortgages on a real estate asset such as a house.
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Mortgage Backed Securities
Mortgage backed securities are types of asset-backed securities which are secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Mortgage-backed securities are an instrument that help grow ones portfolio by allowing them to lend, invent, and borrow.
What are Mortgage Backed Securities?
Mortgage backed securities, or MBSes, derive their value from mortgages. They are excellent commodities for brokerage, resale and trade, or can be held solely for investment purposes. For instance, a bank that wants to lend to customers who don't have many assets might use MBSes to make its portfolios more viable. By acting as an intermediary between an investment company and a would-be homeowner or business borrower, the bank facilitates lending opportunities that might not exist otherwise. Since many banks fund their lending activities by borrowing from enterprises known as warehouse lenders, it's in their best interest to keep their credit free and clear so that they can continue lending money and earning origination fees from borrowers.
Like all securities, MBSes are debt obligations. Although they may differ from other investment vehicles because they're more commonly attached to residential properties instead of investment or commercial assets, they still represent legally valid claims on a borrower's principal and interest payments. Investors typically receive payments on a monthly basis.
How a Mortgage-Backed Security Works
First, a bank or mortgage company makes an initial home loan. The bank then sells that loan to an investment bank. It uses the money received from the investment bank to make new loans.
The investment bank adds the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company designed for that purpose, called a Special Purpose Vehicle (SPV) or Special Investment Vehicle (SIV). That keeps the mortgage-backed securities separate from the bank's other services.
Why Invest in Mortgage-backed Securities?
MBSes usually offer significantly higher yields than bonds that are issued by national treasuries and private corporations. MBSes also come with credit quality ratings and offer more flexibility than many other fixed-income investment options. The MBS market is known for its high liquidity, which usually outpaces all other sectors besides U.S. Treasury bonds in terms of transaction volume.
Investment Risk of Mortgage-Backed Securities
Of course, no opportunity is flawless. One of the most common risks that investors face with MBSes is what happens when the borrower deviates from the payment plan.
If a borrower prepays their mortgage, or repays it in full before the specified date, then the investor won't receive as much interest as they usually would have. Prepayment can also happen when borrowers refinance their mortgages, which many do when their mortgage interest rates exceed national interest rates due to market fluctuations.
Another risk is known as a credit risk, which is what happens when the borrower doesn't repay the loan. Credit risks not only increase the likelihood that the investor won't get their money but also heighten the chances that the investor will have to spend more cash on collection activities. Although prepayment risks are a bit harder to anticipate, credit risks often correspond to a borrower's credit rating.
Mortgage-Backed Securities and the Housing Crisis
The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage businesses. At first, mortgage-backed securities allowed more people to buy homes. During the real estate boom, some lenders didn't take the time to confirm that borrowers could repay their mortgages. That allowed people to get into mortgages they couldn't afford. These subprime mortgages were bundled into private-label MBSs.
That created an asset bubble. It burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds, and financial institutions owned mortgage-backed securities, everyone took losses. That's what created the 2008 financial crisis.
Mortgage-backed securities allowed non-bank financial institutions to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. They had the deep pockets to wait until these loans were repaid 15 or 30 years later. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. The number of lenders increased. Some offered mortgages that didn't look at a borrower's job or assets. This created more competition for traditional banks. They had to lower their standards to compete.
Worst of all, MBSs were not regulated. The federal government regulated banks to make sure their depositors were protected, but those rules didn't apply to MBSs and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all.
How to Trade Mortgage-Backed Securities
Mortgage-backed securities offer a range of investment opportunities, and this includes different trading methods. Since investors can purchase them from private, governmental or government-backed enterprises, they satisfy a variety of portfolio goals and needs. Here's a quick introduction to the fundamentals.
How our MBSes Traded
A significant number of lenders sell their mortgages to third-party institutions that specialize in investments. These entities are commonly referred to as mortgage aggregators. Such sales typically occur soon after the mortgages are issued because banks don't make much profit by holding onto loans and receiving interest. From here, brokers package the loans into MBSes and other structures. Then, they can sell them to wholesalers via mortgage brokers or directly to the public. MBS pools can also be divided into shares prior to sale.
One appealing aspect of MBSes is that they're usually traded like stocks, fixed-income securities and other vehicles, but there are some important distinctions to understand. With stock transactions, share prices are pegged to the value of an instrument at the moment of its trade. With MBSes, sellers usually publish rate sheets that detail how much the devices are worth and stick to these price schemes until new rates get put out. In most cases, lenders issue these sheets in accordance with predetermined pricing changes.
After the housing crisis, the U.S. government increased regulations in several areas. Residential MBSes are now regulated. MBSes must now provide disclosures to investors on several points. In response to the new requirements, there are fewer registered MBSes other than the ones offered by Fannie Mae and Freddie Mac.
MBSes are an attractive investment. It it goes well, they provide ongoing passive income. These investments can be complex, though, so it is vital to reserach potential mortgage-backed securities investments thoroughly.