Mortgage backed securities

What Is Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are a type of asset-backed security (ABS) that represents an investment in a pool of mortgage loans. These fixed income instruments are created when a financial institution, such as a bank or a government-sponsored enterprise, bundles together hundreds or thousands of individual residential or commercial mortgages. These bundled mortgages are then sold to investors as a single security. The investors in a mortgage-backed security receive payments of principal and interest derived from the monthly mortgage payments made by the underlying borrowers. This process, known as securitization, transforms illiquid loans into tradable securities, enhancing liquidity within the housing market and broader capital markets.

History and Origin

The modern U.S. mortgage-backed securities market emerged in 1970 with the issuance of the first agency MBS pool by Ginnie Mae (Government National Mortgage Association).⁷ Prior to this, most mortgages were held on the balance sheets of financial intermediaries, such as savings and loans. The development of MBS allowed for the decoupling of mortgage lending from mortgage investing, enabling a wider range of investors to participate in the mortgage market. Over time, government-sponsored enterprises like Fannie Mae and Freddie Mac also became significant issuers of agency MBS, guaranteeing timely principal and interest payments to investors. The market for mortgage-backed securities experienced substantial growth, particularly in the decades leading up to the 2008 financial crisis.

Key Takeaways

• Mortgage-backed securities are debt instruments backed by pools of residential or commercial mortgages.
• Investors in MBS receive cash flows from the principal and interest payments made by the underlying mortgage borrowers.
• MBS are a key component of the fixed income market, offering investors exposure to real estate.
• Key risks associated with MBS include prepayment risk, interest rate risk, and, for non-agency MBS, credit risk.
• The Federal Reserve has historically been a significant purchaser of agency MBS as a tool for monetary policy.

Interpreting Mortgage-Backed Securities

Interpreting mortgage-backed securities involves understanding the various risks and characteristics that influence their value and performance. Unlike a traditional bond, the cash flows of an MBS are not entirely predictable due due to factors like borrower prepayments. Investors must consider several key risks. Prepayment risk arises when homeowners pay off their mortgages earlier than expected, often due to refinancing at lower interest rates or selling their homes. This can return principal to MBS investors sooner, potentially forcing them to reinvest at lower yields. Conversely, when interest rates rise, borrowers are less likely to prepay, which can extend the duration of the MBS and make it less attractive to investors seeking higher current yields.

Credit risk is another crucial factor, especially for non-agency mortgage-backed securities, which lack the explicit or implicit government guarantee of agency MBS. If underlying borrowers default on their loans, investors in non-agency MBS may face losses. Liquidity risk, while generally low in the vast U.S. agency MBS market, can become a concern during periods of market stress, making it difficult to buy or sell these securities at desired prices. Investors typically analyze the weighted average coupon (WAC) and weighted average maturity (WAM) of the underlying mortgage pool to gauge the expected cash flow characteristics of an MBS.

Hypothetical Example

Consider a hypothetical MBS issued by a government-sponsored enterprise. This MBS represents a pool of 1,000 residential mortgages, each with an original loan amount of $300,000, a 30-year term, and a fixed interest rate of 4.5%. The total outstanding principal balance of this pool is $300 million.

An investor purchases a tranche of this mortgage-backed security for $1 million. Each month, as the 1,000 homeowners make their mortgage payments, a portion of these payments (consisting of principal and interest) is collected by a servicer. After deducting servicing fees and guarantee fees, the remaining cash flow is passed through to the MBS investors, including our hypothetical investor.

If interest rates fall to 3.0%, many homeowners in the pool might choose to refinance their mortgages. This would lead to higher-than-expected principal payments flowing to the MBS investor, representing prepayment risk. The investor would then receive their principal back sooner and would need to reinvest those funds at the new, lower prevailing interest rates. Conversely, if rates rise, prepayments would slow, extending the duration of the security.

Practical Applications

Mortgage-backed securities serve several critical functions in financial markets and investing. For investors, MBS offer a way to gain exposure to the housing market and diversify portfolios, often providing yields higher than those of comparable U.S. Treasury bonds due to the embedded prepayment and extension risks. Institutional investors, such as pension funds, insurance companies, and mutual funds, are major participants in the MBS market, using these securities to match liabilities and generate income. Banks and other depository institutions are also significant investors in agency MBS, holding approximately 32% of the total, while the Federal Reserve is the single largest agency MBS investor.⁶

Beyond investment, MBS facilitate the flow of credit to households by providing lenders with a mechanism to sell off mortgages and free up capital for new loans. This securitization process has significantly expanded the availability of mortgage financing. The Federal Reserve has extensively utilized mortgage-backed securities as a monetary policy tool, particularly during periods of economic distress. For instance, in response to the 2008 financial crisis and the COVID-19 pandemic, the Federal Open Market Committee (FOMC) directed the Federal Reserve Bank of New York to conduct large-scale asset purchase programs of agency MBS.⁴, ⁵ These quantitative easing measures aimed to support mortgage and housing markets, lower interest rates, and improve overall financial market conditions. By late 2021, the Federal Reserve's holdings of agency MBS equaled $2.5 trillion.³

Limitations and Criticisms

Despite their role in enhancing liquidity and credit availability, mortgage-backed securities have faced significant criticism, particularly in the wake of the 2008 financial crisis. One primary concern is the potential for moral hazard within the "originate-to-distribute" model. Critics argue that when lenders can quickly sell off mortgages into MBS pools, they may have less incentive to rigorously screen borrowers or maintain strict lending standards, as the credit risk is transferred to investors. Research suggests a link between increased securitization, particularly of subprime mortgages, and lax screening practices, leading to higher default rates for securitized loans.²

The complexity of some MBS structures, especially those that bundle riskier, non-agency mortgages into collateralized mortgage obligations (CMOs) with multiple tranches, made it difficult for investors to fully assess the embedded risks. During the housing market downturn leading to the 2008 crisis, declining home prices triggered widespread defaults, which significantly impacted these complex mortgage-backed securities. This led to substantial losses for investors and contributed to the broader financial crisis.¹ The interconnectedness of the MBS market with the global financial system meant that failures in this sector rapidly propagated, causing systemic issues. While agency MBS carry government guarantees, the sheer volume of these guarantees has also raised concerns about potential taxpayer exposure during severe market downturns.

Mortgage-Backed Securities vs. Asset-Backed Securities

While all mortgage-backed securities are a type of asset-backed security (ABS), the terms are not interchangeable. The distinction lies in the type of underlying assets.

An asset-backed security is a broader category of financial instruments backed by a pool of various illiquid assets other than mortgages. For example, a bond backed by auto loans would be an ABS, but not an MBS. Mortgage-backed securities are specialized ABS that derive their cash flows specifically from real estate-secured loans. The unique characteristics of mortgages, particularly the borrower's option to prepay, introduce specific risks like prepayment risk that are central to MBS valuation. While ABS share the securitization process with MBS, the analytical techniques and risk considerations can differ based on the behavior of the underlying asset pool.

FAQs

What is the primary difference between agency MBS and non-agency MBS?

Agency MBS are guaranteed by U.S. government agencies like Ginnie Mae or government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, offering a high degree of credit quality. Non-agency MBS are issued by private financial institutions and do not carry government guarantees, meaning they have higher credit risk.

How do interest rates affect mortgage-backed securities?

Interest rates significantly impact MBS. When interest rates fall, homeowners are more likely to refinance their mortgages, leading to higher prepayment rates for the MBS. This means investors receive their principal back sooner and may have to reinvest at lower yields, a concept known as prepayment risk. Conversely, when rates rise, prepayments slow down, extending the duration of the MBS.

What is prepayment risk in the context of MBS?

Prepayment risk is the risk that the principal of an MBS will be returned to the investor sooner than expected. This typically happens when borrowers refinance their mortgages due to lower interest rates or sell their homes. This risk can be unfavorable if the investor must then reinvest the principal at a lower yield.

Are mortgage-backed securities considered safe investments?

Agency mortgage-backed securities, due to their government or GSE guarantee, are generally considered to have low credit risk and are highly liquid. However, they are still subject to interest rate risk and prepayment risk, which can affect their overall return. Non-agency MBS carry higher credit risk and are considered less safe.

How did MBS contribute to the 2008 financial crisis?

During the run-up to the 2008 financial crisis, a significant volume of non-agency mortgage-backed securities was issued, often backed by subprime mortgages with lax lending standards. When the housing market declined and defaults surged, the value of these MBS plummeted, causing widespread losses for financial institutions and contributing to systemic instability.