What Is Mortgage-Backed Securities?
Mortgage-backed securities (MBS) are a type of fixed-income securities that represent claims on the cash flows generated by pools of mortgage loans. They belong to a broader category of financial instruments known as structured finance. The creation of mortgage-backed securities involves a process called securitization, where individual mortgage loans are bundled together and then sold as marketable securities to investors. These securities allow investors to receive periodic payments, similar to bond coupon payments, derived from the principal and interest paid by homeowners on the underlying mortgages26.
History and Origin
The concept of securitizing mortgages began to gain traction in the United States to enhance liquidity in the housing market. Before securitization, banks would hold mortgages on their books, limiting their ability to issue new loans25. The groundwork for modern mortgage-backed securities was laid with the Housing and Urban Development Act of 1968, which restructured the Federal National Mortgage Association (Fannie Mae) and created the Government National Mortgage Association (Ginnie Mae)24.
In 1970, Ginnie Mae developed the first mortgage-backed security, which pooled numerous loans and allowed them to be used as collateral for a security that could be sold in the financial markets22, 23. Ginnie Mae's guarantee of timely principal and interest payments made these early mortgage-backed securities attractive to a wider range of investors, effectively channeling investment capital into the housing sector. Ginnie Mae securities are unique in being explicitly backed by the "full faith and credit" of the U.S. government, distinguishing them from those issued by other government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac21.
Key Takeaways
- Mortgage-backed securities (MBS) are debt instruments representing an investment in a pool of mortgage loans.
- Investors in MBS receive periodic payments derived from the principal and interest paid by homeowners.
- The securitization process transforms illiquid mortgage loans into tradable securities, increasing liquidity in the housing finance system.
- MBS can be issued by government agencies (like Ginnie Mae) or government-sponsored enterprises (like Fannie Mae and Freddie Mac), known as "agency MBS," or by private entities ("private-label MBS")20.
- The market for mortgage-backed securities is one of the largest and most liquid global fixed-income markets, with trillions of dollars in outstanding securities19.
Interpreting Mortgage-Backed Securities
When evaluating mortgage-backed securities, investors consider several factors. A key characteristic is their cash flow, which is typically distributed monthly to bondholders18. Unlike traditional bonds with predictable coupon payments, the cash flow of an MBS is influenced by the prepayment behavior of the underlying mortgages. If interest rates fall, homeowners may refinance their mortgages, leading to an increase in prepayments and a faster return of principal to MBS investors, a phenomenon known as prepayment risk17. Conversely, if interest rates rise, prepayments may slow down, extending the security's duration. Investors also assess the credit risk associated with the underlying mortgages, although agency MBS carry a lower credit risk due to government or GSE guarantees16.
Hypothetical Example
Consider an investment firm that purchases a mortgage-backed security representing a pool of 1,000 residential mortgages, each with an average remaining balance of $200,000 and an average interest rate of 4.5%. The total value of the underlying mortgage pool is $200 million.
As homeowners make their monthly mortgage payments, the interest and a portion of the principal are collected by a servicer. This servicer then "passes through" the proportionate share of these collected funds to the holders of the mortgage-backed security. If, for instance, in a given month, $800,000 in interest and $400,000 in scheduled principal are collected from the pool, along with an additional $100,000 in prepaid principal (from homeowners refinancing or selling their homes), the MBS investors would collectively receive $1.3 million that month. This monthly distribution provides investors with a steady stream of income, albeit one that can fluctuate due to prepayments on the underlying loans. The investment firm, as a holder of this mortgage-backed security, would receive its pro-rata share of these payments15.
Practical Applications
Mortgage-backed securities play a crucial role in various aspects of finance and investing. They serve as significant investment vehicles for a wide range of institutional investors, including pension funds, insurance companies, and banks, who seek consistent income and often a yield higher than that offered by U.S. Treasury bonds.
Beyond direct investment, MBS are integral to the broader financial system and monetary policy. For example, the Federal Reserve frequently utilizes mortgage-backed securities as a tool for implementing monetary policy, especially during periods of economic instability or recovery. In response to the 2008 financial crisis and the COVID-19 pandemic, the Federal Reserve undertook large-scale asset purchase programs, acquiring substantial quantities of agency MBS to support housing markets and improve conditions in financial markets more generally12, 13, 14. These purchases aimed to lower long-term interest rates and inject liquidity into the economy. As of June 2024, the Federal Reserve held approximately $2.3 trillion of agency MBS, representing a significant portion of the outstanding balance in the agency MBS market.11.
Limitations and Criticisms
Despite their utility, mortgage-backed securities come with certain limitations and have faced significant criticism, particularly in the aftermath of the 2008 financial crisis. A primary concern is their susceptibility to prepayment risk. While prepayment can be beneficial in a declining interest rate environment, rapid prepayments can force investors to reinvest their principal at lower yields, a challenge known as reinvestment risk. Conversely, in a rising interest rate environment, homeowners are less likely to refinance, extending the duration of the MBS and making them less attractive than newer, higher-yielding investments.
A major criticism emerged from the 2008 crisis, where complex mortgage-backed securities, particularly those backed by subprime mortgages, were identified as a significant contributing factor. Many of these securities received high credit ratings despite containing high-risk underlying loans, leading to substantial losses for investors when widespread defaults occurred9, 10. The opacity and complexity of some MBS structures, especially those that repackaged other MBS into collateralized mortgage obligations (CMOs) or collateralized debt obligations (CDOs), made it difficult for investors to accurately assess the true risk. This lack of transparency and the mispricing of risk ultimately contributed to a widespread loss of confidence in the financial markets. The Federal Deposit Insurance Corporation (FDIC) has extensively documented how the interconnectedness and opaque nature of these securitization chains magnified risks and led to a freezing of credit markets8.
Mortgage-Backed Securities vs. Collateralized Debt Obligation
While both mortgage-backed securities (MBS) and collateralized debt obligation (CDO) are types of structured finance products, they differ in the nature of their underlying assets. An MBS is specifically backed by a pool of mortgage loans. Its cash flows are directly tied to the principal and interest payments made by homeowners. A CDO, on the other hand, is a broader and often more complex type of asset-backed security that derives its value from a diversified pool of debt instruments. While a CDO can include mortgage-backed securities as part of its underlying collateral, it can also hold other types of debt, such as corporate bonds, auto loans, credit card receivables, or other asset-backed securities. The confusion between them arose significantly during the 2008 financial crisis because many CDOs were constructed using tranches (slices with different risk/return profiles) of subprime mortgage-backed securities, magnifying the risk across the financial system7.
FAQs
What is the primary purpose of a mortgage-backed security?
The primary purpose of a mortgage-backed security is to transform illiquid mortgage loans into tradable securities, providing liquidity to mortgage lenders and allowing a wider range of investors to participate in the housing finance market5, 6.
How do investors earn money from mortgage-backed securities?
Investors in mortgage-backed securities receive periodic payments, typically monthly, which consist of a proportionate share of the principal and interest payments made by the homeowners whose mortgages are in the underlying pool4.
What is "prepayment risk" in MBS?
Prepayment risk is the risk that homeowners will pay off their mortgages earlier than expected, often due to refinancing when interest rates fall, or when selling their homes. This results in the early return of principal to MBS investors, who then have to reinvest the funds, potentially at lower prevailing interest rates3.
Are all mortgage-backed securities guaranteed by the government?
No, not all mortgage-backed securities are guaranteed by the government. "Agency MBS" are issued by U.S. government agencies like Ginnie Mae (which carries the full faith and credit guarantee of the U.S. government) or by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac (which have implicit government backing but not a direct guarantee). "Private-label MBS" are issued by private financial institutions and carry no government backing, generally exposing investors to higher credit risk1, 2.