What Is Mortgage Backed Securities?
Mortgage backed securities (MBS) are a type of asset-backed security that represent claims to the cash flows from pools of mortgage loans. As a core component of fixed income investments, MBS are created through a process known as securitization, where individual mortgage loans are aggregated and then sold to a government agency or investment bank. This entity then issues securities, the mortgage backed securities, that grant investors a share of the principal and interest payments made by the borrowers on the underlying mortgages in the pool. Essentially, investors in mortgage backed securities are lending money to homebuyers.26
History and Origin
The concept of mortgage backed securities originated in the United States as a way to increase liquidity in the housing market and ensure a continuous flow of capital for homeownership. Prior to their widespread adoption, banks often had to retain mortgages on their balance sheets, which limited their capacity to issue new loans. The Government National Mortgage Association (Ginnie Mae), a U.S. government corporation, is credited with developing and guaranteeing the very first MBS products in 1970.25 These initial mortgage backed securities were based on mortgages insured by government agencies like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), providing a "full faith and credit" guarantee of the U.S. government for timely payments to investors.23, 24 This innovation allowed for many loans to be pooled and used as collateral in a security that could be sold in the secondary market, thereby providing a greater flow of capital into the housing finance market.20, 21, 22
Key Takeaways
- Mortgage backed securities are financial instruments backed by a pool of real estate mortgage loans.
- They allow investors to receive periodic payments from the underlying mortgage principal and interest.
- Issuers typically include government agencies (like Ginnie Mae) and government-sponsored enterprises (like Fannie Mae and Freddie Mac), as well as private entities.
- MBS are subject to various risks, including prepayment risk and interest rate risk.
- The market for mortgage backed securities is among the largest fixed-income markets globally, playing a significant role in housing finance.19
Formula and Calculation
The valuation of mortgage backed securities is complex due to the unpredictable nature of mortgage prepayments. However, the fundamental concept involves discounting the expected future cash flows from the underlying pool of mortgages. These cash flows consist of both principal and interest payments.
The present value (PV) of an MBS can be conceptually represented as:
Where:
- (PV_{MBS}) = Present Value of the Mortgage Backed Security
- (CF_t) = Expected cash flow (principal and interest) in period (t)
- (r) = Discount rate or required yield
- (N) = Total number of periods until maturity of the last mortgage in the pool
This formula is simplified as it doesn't account for the variability in cash flows due to prepayments or defaults, which are significant factors in MBS valuation. Advanced models incorporate sophisticated assumptions about borrower behavior and market conditions to project these cash flows more accurately.
Interpreting the Mortgage Backed Securities
Interpreting mortgage backed securities involves understanding the characteristics of the underlying loan pool and the structure of the security itself. Key factors include the types of mortgages (e.g., fixed-rate, adjustable-rate, subprime), the credit quality of the borrowers, and the geographic concentration of the properties. For agency MBS, the explicit or implicit government guarantee significantly reduces credit risk.18
Investors also analyze the MBS's sensitivity to interest rate changes and the likelihood of mortgage prepayments. When interest rates fall, homeowners are more likely to refinance their mortgages, leading to faster prepayments for MBS investors. Conversely, rising interest rates can slow prepayments. This makes the effective duration of an MBS variable, a characteristic known as negative convexity. Understanding these dynamics is crucial for investors assessing the potential returns and risks of these investment vehicles.
Hypothetical Example
Imagine a financial institution pools 1,000 residential mortgage loans, each with an average outstanding balance of $200,000, a 30-year term, and a 5% interest rate. The total value of the pool is $200 million. This institution then creates a mortgage backed security, effectively dividing the $200 million pool into smaller, investable units.
An investor might purchase a $100,000 portion of this MBS. As the 1,000 homeowners make their monthly mortgage payments, a pro-rata share of these payments (consisting of both principal and interest) is passed through to the investor. If a few homeowners refinance their loans due to lower interest rates, the investor receives a larger principal payment sooner than expected. Conversely, if some homeowners default, and the MBS is not government-guaranteed, the investor's cash flows could be negatively impacted. This illustrates how the cash flows from a mortgage backed security are directly tied to the performance of the underlying debt obligations.
Practical Applications
Mortgage backed securities are widely used in financial markets for several purposes. They serve as a crucial funding mechanism for the housing market, providing liquidity to mortgage lenders by allowing them to sell originated loans and free up capital for new lending.17
Central banks, such as the Federal Reserve, have also used MBS as a tool for monetary policy. During periods of economic stress, like the 2008 financial crisis and the COVID-19 pandemic, the Federal Reserve implemented large-scale asset purchase programs that included agency mortgage backed securities.14, 15, 16 These purchases aimed to provide support to mortgage lending and housing markets, foster improved conditions in financial markets, and maintain accommodative financial conditions.11, 12, 13 For instance, from March 2020 through June 2021, the Federal Reserve significantly increased its agency MBS holdings to restore smooth market function and support the continued flow of credit to mortgage borrowers.9, 10 Information on these operations is often published by Federal Reserve Banks, such as the Federal Reserve Bank of New York.8
Limitations and Criticisms
Despite their role in housing finance, mortgage backed securities carry notable limitations and have faced significant criticism, particularly in the wake of the 2008 financial crisis. One primary concern is prepayment risk, where borrowers pay off their mortgages earlier than expected (e.g., through refinancing or selling their homes), leading to unpredictable cash flows for investors. Conversely, extension risk arises when prepayments slow down, lengthening the effective maturity of the MBS.
A major criticism emerged during the subprime mortgage crisis of 2007-2010.7 The crisis was fueled by the widespread issuance of private-label mortgage backed securities backed by high-risk, or "subprime," mortgages.6 Many of these MBS were initially rated highly by credit rating agencies but subsequently experienced massive downgrades as defaults surged, leading to significant losses for investors and contributing to a severe economic recession.5 This highlighted concerns about the complexity and opacity of some MBS structures, particularly those that repackaged lower-rated tranches into new securities. The Federal Reserve History website provides an in-depth look at how the expansion of mortgages to high-risk borrowers and the subsequent rise in delinquencies and foreclosures contributed to this period of turmoil.4
Mortgage Backed Securities vs. Collateralized Debt Obligation
While both mortgage backed securities (MBS) and Collateralized Debt Obligation (CDO) are types of securitized products, they differ in their underlying collateral and structure. An MBS is directly backed by a pool of mortgage loans. The cash flows generated from these mortgages are passed through to the MBS investors.
A CDO, on the other hand, is a broader and often more complex type of structured finance product. Its collateral can consist of various types of debt instruments, including corporate bonds, auto loans, credit card receivables, and critically, other asset-backed securities like mortgage backed securities. This means a CDO can hold tranches of multiple MBS, often from different mortgage pools. CDOs are typically structured into different classes, or tranches, each with varying levels of risk and return, where lower-priority tranches absorb losses first. During the subprime mortgage boom, CDOs became vehicles for refinancing MBS, and by 2004, mortgage backed securities accounted for more than half of the collateral in CDOs, contributing to their central role in the financial crisis.
FAQs
What is an agency MBS?
An agency MBS is a mortgage backed security issued or guaranteed by a U.S. government agency (like Ginnie Mae) or a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac. These are generally considered to have lower credit risk than private-label MBS because of the government or GSE backing.3
How do mortgage backed securities generate income for investors?
Investors in mortgage backed securities receive periodic payments, typically monthly, which are derived from the principal and interest payments made by the homeowners on the underlying mortgages in the pool.2
What are the main risks associated with investing in MBS?
The primary risks for mortgage backed securities investors are prepayment risk (homeowners paying off their mortgages early, reducing future interest payments) and interest rate risk (changes in interest rates affecting the value of the MBS). There is also credit risk, though this is significantly mitigated for agency MBS due to government or GSE guarantees.
Are MBS considered safe investments?
The safety of a mortgage backed security largely depends on its issuer and the quality of the underlying mortgages. Agency MBS, backed by the U.S. government or government-sponsored enterprises, are generally considered very safe due to the implicit or explicit guarantee.1 Private-label MBS, which lack such guarantees, can carry significantly higher credit risk and were a major factor in the 2008 financial crisis.