What is Mortgage-Backed Security?

Government agencies or sponsored enterprises, Central banks, and private investment banks can issue MBSs. Ginnie Mae, Fannie Mae, and Freddie Mac are examples of significant players backed by the government in the US. They play an essential role in maintaining the liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more in the mortgage market by purchasing mortgages from their originators.

Key Takeaways

  • The mortgage-backed security definition portrays it as a financial instrument similar to bonds made out of mortgages bought from the banks that originated them.Large banks or authorized financial institutions collect mortgages and create MBS by grouping mortgages of similar characteristics into a bundle and selling to investors.Government agencies, government-backed enterprises, and private institutions can issue MBS, and they possess different risk, reward, and complexity levels.MBS was one of the catalysts of the 2008 financial crisis. Now, however, the market is much more regulated to avoid a similar situation.

Mortgage Backed Securities Explained

A mortgage-backed security is an example of asset-backed securityAsset-backed SecurityAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more created when a large bank or particular financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more buys mortgages from banks issuing them and organizes collected mortgages into different groups or bundles based on their characteristics to form a financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more. Individual bundles represent security similar to bonds and are tradeable in the secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more. In short, an MBS can be defined as 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.

MBS Example

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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 paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more 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 flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more.

Types of MBS

There are different types of MBS like Pass-through securities, collateralized mortgage obligationCollateralized Mortgage ObligationCollateralized Mortgage Obligations (CMOs) are a debt-security type that combines many mortgages & sell them as a single investment. Cash flow occurs when debtors repay the loans, following which the CMO investors get their returns. read more, a stripped mortgage-backed security, and Collateralized Debt ObligationCollateralized Debt ObligationCollateralized debt obligation (CDO) refers to a finance product offered by the banks to the institutional investors. Such tranches have a complex structure and derive their value from the various underlying assets like loans, mortgages and corporate bonds, which also serve as collaterals in case of default.read more. Let’s look into the explanation for a few significant types of MBS.

#1 – Pass-Through MBS

It is also known as a mortgage pass-through instrument, and it is one of the most often traded and fundamental forms of MBS in the secondary market. It 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.

#2 – CMO

CMO is complex with the presence of tranchesTranchesTranches refer to the segmentation of a pool of securities with varying degrees of risks, rewards, and maturities to appeal to investors.read more. 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.

MBS and 2008 Financial Crisis

The MBS market was one of the triggers of the financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more 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 banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more and investment funds betting a lot on MBS because they were very profitable.

Over time, it meant that credit ratingsCredit RatingsCredit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries.read more 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 economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more and changed the world.

Mortgage-Backed Securities Today

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.

This has been a guide to what is Mortgage-Backed Security (MBS) & its Definition. Here we discuss how MBS works along with its types and examples. You may also have a look at the following articles to learn more –

The risk applies to MBS as they do to other securities. Two distinct risks associated are prepayment risk and extension risk. Others include interest rate, credit, reinvestment, inflation, and default risk.

The key distinction between a mortgage and MBS is that a mortgage refers to the loan provided to the property buyer. In contrast, an MBS asset-backed security forms a stable investment for investors while generating revenue for the initial lending institutions to lend to prospective buyers.

MBSs are bond-like financial instruments backed by a pool of mortgages, which are often home loans. Several loans, typically with similar features, are pooled together for this purpose. For example, Fannie Mae develops MBS that reflects beneficial ownership interest in a pool of residential mortgages backed by multifamily (5 or more units) residential properties. Furthermore, an example of an MBS ETF is Vanguard Mortgage-Backed Securities ETF.

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