Mortgage-backed securities are bond-like investments made up of a pool of mortgages. When you purchase a mortgage-backed security, you’re buying a small portion of a collection of loans that a government-sponsored entity or a financial institution has packaged together for sale.
Investors may refer to these loans as MBS, which stands for mortgage-backed securities. Investing in mortgage-backed securities allows investors to get exposure to the real estate market without taking direct ownership of properties or making direct loans to borrowers. Mortgage-backed securities offer benefits to other stakeholders as well, namely loan-issuing banks, private lenders, and investment banks who issue them.
Mortgage-backed securities have a stained reputation due to their role in the housing market collapse in 2008. However, that crisis led to increased regulation, and depending on your investment goals, there may be a case for including mortgage-backed securities in a diversified portfolio.
What Is a Mortgage-Backed Security?
Mortgage-backed securities are asset-backed investments, in which the underlying assets are mortgages.
Government entities and some financial institutions issue mortgage-backed securities by purchasing mortgages from banks, mortgage companies, and other loan originators and combining them into pools, which they sell to investors.
The financial institution then securitizes the pool, by selling shares to investors who then receive a monthly distribution of income and principal payments, similar to bond coupon payments, as the mortgage borrowers pay off their loans.
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How a Mortgage-Backed Security Works
When dealing with mortgage-backed securities, banks essentially become middlemen between the homebuyer and the investment industry.
The process works as follows:
1. A bank or mortgage company originates a home loan.
2. The bank or mortgage company sells that new loan to an investment bank or government-sponsored entity, and uses the sale money to create new loans.
3. The investment bank or government-sponsored entity combines the newly purchased loan into a bundle of mortgages with similar interest rates.
4. This investment bank assigns the loan bundle to a Special Purpose Vehicle (SPV) or Special Investment Vehicle (SIV) which securitizes the bundles of loans. This creates a separation between the mortgage-backed securities and the investment bank’s primary services.
5. Credit rating agencies review the security and rate its riskiness for investors. The SPV or SIV then issues the mortgage-backed securities on the trading markets.
When the process operates as intended, the bank that creates the loan maintains reasonable credit standards and makes a profit by selling the loan. They also have more liquidity to make additional loans to others. The homeowner pays their mortgage on time and the mortgage-backed securities holders receive their portion of the principal and interest payments.
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Who Sells Mortgage-Backed Securities?
While some private financial institutions issue mortgage-backed securities, the majority come from government-sponsored entities. Those include Ginnie Mae, the Government National Mortgage Association; Fannie Mae, the Federal National Mortgage Association; and Freddie Mac, the Federal Home Loan Mortgage Corporation.
The U.S. government backs and secures Ginnie Mae’s mortgage-backed securities, guaranteeing that investors will receive timely payments. Fannie Mae and Freddie Mac do not have the same guaranteed backing, but they can borrow directly from the Treasury when needed.
What Are the Risks of Investing in Mortgage-Backed Securities?
Like all alternative investments, mortgage-backed securities carry some risks that investors must understand. One such risk is prepayment risk, in which mortgage borrowers pay off their mortgages (often because they move or refinances), reducing the yield for the holder of the MBS. Mortgage defaults could further decrease the value of mortgage-backed securities.
Other risks include housing market fluctuations and liquidity risk.
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Types of Mortgage-Backed Securities
There are several different types of mortgage-backed securities.
A Pass-Through Participation Certificate or Pass-Through is the simplest type of MBS. They are structured as trusts, in which a servicer collects mortgage payments for the underlying loans and distributes them to investors.
Pass-through mortgage-backed securities typically have stated maturities of five, 15, or 30 years, though the term of a pass-through may be lower. With pass-throughs, holders receive a pro-rata share of both principal and interest payments earned on the mortgage pool.
Residential Mortgage-Backed Securities (RMBS)
Residential mortgage-backed securities are mortgage-backed securities based on loans for residential homes.
Commercial Mortgage-Backed Securities (CMBS)
Commercial mortgage-backed securities are mortgage-backed securities based on loans for commercial properties, such as apartment buildings, offices, or retail spaces or industrial properties.
Collateralized Debt Obligations (CDOs)
These securities are similar to mortgage-backed securities in that CDOs are also asset-backed and may contain mortgages, but they may also include other types of debt, such as business, student, and personal loans.
Collateralized Mortgage Obligations (CMO)
CMOs or Real Estate Mortgage Investment Conduits (REMICs) is a more complex form of mortgage-backed securities. A CMO is a pool of mortgages with similar risk categories known as tranches. Tranches are unique and can have different principal balances, coupon rates, prepayment risks, and maturity rates.
Less-risky tranches tend to have more reliable cash flows and a lower probability of being exposed to default risk and thus are considered a safer investment. Conversely, higher-risk tranches have more uncertain cash flows and a higher risk of default. However, higher-risk tranches are compensated with higher interest rates, which can be attractive to some investors with higher risk tolerance.
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Mortgage-Backed Securities and the 2008 Financial Crisis
Mortgage-backed securities played a large role in the financial crisis and housing market collapse that began in 2008. By 2008, trillions of dollars in wealth evaporated, prominent companies like Lehman Brothers and Bear Stearns went bankrupt, and the global financial markets crashed.
At the time, banks had gotten increasingly lenient in their credit standards making risky loans to borrowers. One reason that they became more lenient was because they were able to sell the loans to be packaged into mortgage-backed securities, meaning that the banks faced fewer financial consequences if borrowers defaulted.
When home values fell and millions of homes went into foreclosure, the value of all those mortgage-backed securities and CDOs plummeted, indicating that they had been riskier assets than their ratings indicated. Many investors lost money; many homeowners foreclosed on their homes.
An important lesson from that time is that mortgage-backed securities have risks associated with the underlying mortgage borrower’s ability to pay their mortgage.
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Residential mortgage-backed securities now face far more government scrutiny than they did prior to the financial crisis. MBS mortgages must now come from a regulated and authorized financial institution and receive an investment-grade rating from an accredited rating agency. Issuers must also provide investors with disclosures including sharing information about their risks.
Investors who want exposure to mortgage-backed securities but don’t want to do the research or purchases themselves might consider buying an exchange-traded fund (ETF) that focuses on mortgage-backed securities.
Mortgage-backed securities are complex investment products, but they have benefits for investors looking for exposure to the real estate debt without making direct loans. While they do have risks, they may have a place as part of a diversified portfolio for some investors.
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