Mortgage backed security mbs

What Is Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is a type of fixed-income security that represents an investment in a pool of mortgage loans. These loans, typically residential mortgages, are bundled together and then sold as financial instruments to investors. This process, known as securitization, transforms illiquid individual loans into marketable securities, falling under the broader category of Structured Finance. Investors in an MBS receive periodic interest payments and principal repayments as borrowers make their monthly mortgage payments on the underlying mortgage loans. The value and performance of a mortgage-backed security are influenced by factors such as prevailing interest rates, borrower prepayment behavior, and the default risk of the pooled mortgages.

History and Origin

The genesis of mortgage-backed securities can be traced back to efforts to create a more liquid and efficient housing finance market. Prior to the widespread adoption of MBS, banks often held mortgages on their balance sheets, limiting their capacity to issue new loans. The concept gained significant traction with the establishment of government-sponsored entities (GSEs). The Government National Mortgage Association (Ginnie Mae), a U.S. government-owned corporation established in 1968 within the Department of Housing and Urban Development, played a pivotal role. In 1970, Ginnie Mae developed and guaranteed the first mortgage-backed security, which allowed lenders to pool loans as collateral for a security that could be sold in the secondary market. This innovation provided a mechanism for lenders to replenish funds more quickly, enabling them to originate more mortgages and thereby expanding access to affordable housing¹⁰, ¹¹.

Key Takeaways

• Mortgage-backed securities (MBS) are financial instruments backed by a pool of mortgage loans.
• They allow investors to gain exposure to the housing market and receive regular income from mortgage payments.
• MBS can be issued by government-sponsored enterprises (GSEs) like Ginnie Mae, Fannie Mae, and Freddie Mac (agency MBS), or by private financial institutions (non-agency MBS).
• Key risks associated with MBS include prepayment risk (borrowers paying off mortgages early) and interest rate risk.
• The securitization process underlying MBS enhances liquidity in the mortgage market, benefiting both lenders and borrowers.

Interpreting the Mortgage-Backed Security

Interpreting a mortgage-backed security involves understanding its cash flow characteristics and the factors that influence its price and yield. Unlike traditional bonds, MBS cash flows are not perfectly predictable due to the underlying mortgages. Homeowners can prepay their mortgages by refinancing, selling their homes, or defaulting. This uncertainty introduces prepayment risk for MBS investors.

When interest rates decline, borrowers are more likely to refinance their mortgages, leading to faster prepayments for MBS investors. This means investors receive their principal back sooner than expected, which can be reinvested at lower prevailing rates, reducing their overall yield. Conversely, when interest rates rise, prepayments tend to slow down, as refinancing becomes less attractive. This extends the average life of the MBS, which can also be disadvantageous if investors could have earned higher yields elsewhere. Therefore, analyzing a mortgage-backed security requires careful consideration of its sensitivity to interest rate changes and projected prepayment speeds.

Hypothetical Example

Consider a pool of 1,000 residential mortgage loans, each with an original principal balance of $200,000, for a total pool value of $200 million. A financial institution bundles these mortgages and issues a mortgage-backed security backed by this pool. An investor purchases a $100,000 share of this MBS.

Each month, as the 1,000 homeowners make their mortgage payments (comprising both principal and interest), these payments are collected by a servicer. The servicer then passes these funds, minus a servicing fee, to the MBS investors on a pro-rata basis. If, for instance, in a given month, the homeowners collectively pay $1,000,000 in principal and interest, the investor who owns $100,000 of the $200 million MBS (representing 0.05% of the pool) would receive 0.05% of those payments, or $500. This payment stream continues until all the underlying mortgages are paid off, refinanced, or defaulted upon.

Practical Applications

Mortgage-backed securities play a crucial role in modern financial markets, serving various purposes for different participants. For lenders, MBS allow them to remove mortgage loans from their balance sheets, freeing up capital to originate new loans and reducing their exposure to interest rates and default risk. This continuous cycle supports the housing market by ensuring a steady flow of funds for new home purchases.

For investors, MBS offer a way to invest in the housing market and receive regular income. Major investors in MBS include banks, mutual funds, pension funds, and international investors. The Federal Reserve, for instance, has historically held significant amounts of agency MBS as part of its monetary policy operations, particularly during and after the 2008 financial crisis, to provide support to mortgage and housing markets and foster improved financial conditions⁸, ⁹. These purchases aimed to increase the money supply and reduce interest rates, thereby stimulating economic growth⁷.

The U.S. MBS market is one of the largest and most liquid global fixed-income securities markets, with trillions of dollars in outstanding securities and significant daily trading volumes⁶. Information for investors regarding MBS, including their structure and risks, is provided by regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA)⁵.

Limitations and Criticisms

Despite their benefits, mortgage-backed securities are not without limitations and have faced significant criticism, particularly in the wake of the 2008 financial crisis. One primary criticism revolves around the complexity of some MBS structures, which can make it difficult for investors to fully assess the underlying risks. The pooling of diverse loans, including subprime mortgages with higher default risk, into complex instruments contributed to the crisis.

Another significant area of concern was the role of credit rating agencies, which were accused of assigning overly optimistic ratings to many MBS, including those backed by subprime mortgages. This reportedly led institutional investors to mistakenly trust these ratings, resulting in substantial losses when the housing market declined and defaults surged³, ⁴. Furthermore, the prepayment risk inherent in MBS introduces uncertainty into cash flow projections, making them more challenging to value accurately compared to traditional bonds. While some research challenges the narrative that improper ratings of residential mortgage-backed securities (RMBS) were the major factor in the financial crisis, it is clear that losses on these securities were magnitudes larger than expected for highly-rated assets¹, ².

Mortgage-Backed Security (MBS) vs. Collateralized Mortgage Obligation (CMO)

While often used interchangeably by the public, a Mortgage-Backed Security (MBS) and a Collateralized Mortgage Obligation (CMO) are distinct, though related, financial instruments in the realm of Structured Finance. An MBS is a fundamental security that represents a direct, pro-rata claim on the cash flows from a pool of mortgages. Investors in a basic "pass-through" MBS receive a share of the principal and interest payments as they are collected from the underlying borrowers.

A CMO, on the other hand, is a more complex derivative of an MBS. It takes a pool of mortgages (or a pool of MBS) and divides the expected principal and interest payments into multiple classes or "tranches." Each tranche has a different priority for receiving cash flows, a different maturity, and often a different risk and yield profile. For example, some tranches might receive principal payments first, while others receive them later, making them more or less sensitive to prepayment risk. This structuring allows CMOs to cater to a wider range of investor preferences regarding risk and return, but also adds a layer of complexity not present in a simple MBS.

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 marketable securities, providing liquidity to the mortgage market and allowing banks to free up capital for new lending. It also offers investors a way to gain exposure to the housing market and receive regular income.

Who issues mortgage-backed securities?

Mortgage-backed securities are typically issued by government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, and Ginnie Mae (known as agency MBS), or by private financial institutions (known as non-agency MBS). Agency MBS are generally considered to have higher credit quality due to explicit or implicit government backing.

What are the main risks of investing in MBS?

The main risks associated with investing in a mortgage-backed security include prepayment risk (when borrowers pay off their mortgages early, leading to faster-than-expected principal returns), and interest rate risk (changes in interest rates affecting the value and desirability of the MBS). Default risk of the underlying loans is also a factor, particularly for non-agency MBS.

How do MBS investors receive payments?

Investors in a mortgage-backed security receive periodic payments that represent their share of the principal and interest payments made by the borrowers on the underlying pooled mortgages. These payments are typically distributed monthly, providing a steady income stream.