Mortgage-Backed Securities MBS: Definition, Uses

As with any investment, we recommend reaching out to a financial advisor to build the best investment strategy for you. MBS can be a good investment for those seeking fixed-income returns, but they carry risks like interest rate fluctuations and prepayment risk. Bankrate.com is an independent, advertising-supported publisher and comparison service. We are compensated in exchange for placement of sponsored products and services, or by you clicking on certain links posted on our site. Therefore, this compensation may impact how, where and in what order products appear within listing categories, except where prohibited by law for our mortgage, home equity and other home lending products. Other factors, such as our own proprietary website rules and whether a product is offered in your area or at your self-selected credit score range, can also impact how and where products appear on this site.

The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases. As of the second quarter of 2011, there was about $13.7 trillion in total outstanding US mortgage debt. This can be confusing because a security derived from an MBS is also called an MBS.

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The least risky tranches have more certain cash flows and a lower degree of exposure to default risk. At the same time, riskier tranches have more uncertain cash flows and greater exposure to default risk but offer higher interest rates to attract investors. Collateralized mortgage obligations are influenced by interest rate changes as well as economic conditions, like foreclosure rates, refinance rates, as well as the rates and amounts at which properties are sold. Therefore, each tranche has a different size and maturity date, and bonds with monthly coupons (with principal and interest rate payments) are issued against it.

Likewise, they may be inclined to lower rates to attract borrowers when MBS prices are high. If the MBS was not underwritten by the original real estate and the issuer’s guarantee, the rating of the bonds would be much lower. To short mortgage-backed securities, investors follow a strategy of selling securities they don’t own with the expectation of buying them back later at a lower price, thereby profiting from the price difference. Shorting MBS involves risks like market volatility, potential unlimited losses, borrowing costs, timing, liquidity challenges, and regulatory considerations. It’s crucial to understand these risks and have a strategy for managing them. Pass-throughs are constructed as trusts in which mortgage payments are received and passed through as principal and interest payments to bondholders.

When a company or government issues a traditional bond, they are essentially borrowing money from investors (the people buying the bond). As with any loan, interest payments are made and then principal is paid back at maturity. However, with a mortgage-backed security, interest payments to investors come from the thousands of mortgages that underlie the bond — specifically, the repayments in interest and principal the mortgage holders make each month. Today, an MBS can only mortgage backed securities meaning be issued by a government-sponsored enterprise (GSE) or a private financial company to be sold on the markets.

But unfortunately, the MBS created were increasingly low-quality, high-risk investments. Low-quality MBSs were among the factors that led to The Great Recession of 2008. Even though the U.S. federal government regulated the financial institutions that assembled MBSs, there was a lack of laws governing them directly.

As mortgage holders began to default, the price of MBSs plummeted, leading to an eventual government bailout. The first modern-day mortgage-backed security was issued in 1970 by the Government National Mortgage Association, better known as Ginnie Mae. Its MBSs were — and still are — actually backed by the U.S. government, with a guaranteed income stream.

What is the relationship between a mortgage-backed security and a bank?

Keep in mind that the COUPON YIELD of a particular MBS only determines the rate of return of whatever principal amount remains in the MBS pool purchased by the investor. Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired. Suppose you paid $104.00 for the right to collect interest on a $100.00 loan. If the borrower pays you back before their first interest payment, now you’ve earned $100.00 for your $104.00 investment!!! You’re realizing a MUCH lower yield than another investor whose borrowers keep their loan for several years. MBS represents pooled mortgage loans, whereas bonds are debt securities issued by corporations or governments.

What are the types of mortgage-backed securities?

We’ll then leave you better able to decide whether they have a place in your own portfolio and that of the nation. Typical buyers of these securities include institutional, corporate, and individual investors. However, if the homeowner defaults, the investor who paid for the mortgage-backed security won’t get paid, which means they could lose money. We discuss the institutional environment, security design, MBS risks and asset pricing, and the economic effects of mortgage securitization. We also assemble descriptive statistics about market size, growth, security characteristics, prepayment, and trading activity.

The Role of MBS in the 2008 Financial Crisis

MBSs are also sensitive to changes in interest rates on loans and mortgages. If interest rates rise, fewer people will take out mortgages, causing the housing market to decline. For investors, mortgage-backed securities have some advantages over other securities. They pay a fixed interest rate that is usually higher than U.S. government bonds. Moreover, they typically offer monthly payouts, while bonds offer a single lump-sum payout at maturity. In what follows, we take you through the details of what these investments are, why they exist, and their place in the markets of the 2020s.

Commercial mortgage-backed securities (CMBS) vs. residential mortgage-backed security (RMBS)

• Mortgages are sold to institutions like investment banks or government entities, which package them into MBS that can be sold to individual investors.
• If interest rates rise, fewer people will take out mortgages, causing the housing market to decline.
• Still, regardless of the state of the economy, MBSs are likely to exist in some form.
• The Federal Reserve, which bought large amounts of MBS during and after the financial crisis, has slowly sold off its holdings.
• Subprime borrowers started to default, which is the failure to repay a loan.

This structure was perceived to mitigate the impact of defaults on any single investor or the issuing bank. Collateralized mortgage obligations are organized by slicing a pool of mortgages into similar risk profiles known as tranches. Tranches are given different credit ratings and generally have different principal balances, interest rates, maturity dates, and the potential for repayment defaults.

• CMOs take the cash flow from pass-throughs and segregate it into different bond classes known as tranches, which provide a time frame, or window, during which repayment is expected.
• The implicit and sometimes explicit government support provides a level of confidence in MBS, making them attractive to investors.
• If your loan servicer changes soon after you’ve gotten a mortgage, it’s probably because the loan’s been packaged into a mortgage-backed security.
• Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired.

Are Mortgage-Backed Securities a good investment?

One of the most common ways this happens is by bundling many mortgages together into a package for investors. Depending on the issue, the secondary market for MBSs are generally liquid, with active trading by dealers and investors. Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage-backed securities. Prepayment risk is highly likely in the case of an MBS and consequently cash flows can be estimated but are subject to change. While the lender may sell the loan, it may also retain the right to service the mortgage, meaning it earns a small fee for collecting the monthly payment and generally managing the account. So, you may continue to pay your lender each month for your mortgage, but the real owner of your mortgage may be the investors who hold the mortgage-backed security containing your loan.

We all grew up with the idea that banks make loans and then hold those loans until they mature. But the reality is that there’s a high chance your lender is selling the loan into what’s known as the secondary mortgage market. Here, aggregators buy and sell mortgages, finding the right kind of mortgages for the security they want to create and sell to investors. If your loan servicer changes soon after you’ve gotten a mortgage, it’s probably because the loan’s been packaged into a mortgage-backed security.