A Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business without the need to directly buy or sell home loans.
Mortgages are sold to institutions such as an investment bank or government institution, which then package it into an MBS that can be sold to individual investors. A mortgage contained in an MBS must have originated from an authorized financial institution.
When an investor buys a mortgage-backed security, he is essentially lending money to home buyers. In return, the investor gets the rights to the value of the mortgage, including interest and principal payments made by the borrower.
Selling the mortgages they hold enables banks to lend mortgages to their customers with less concern over whether the borrower will be able to repay the loan. The bank acts as the middleman between MBS investors and home buyers. Typical buyers of MBS include individual investors, corporations, and institutional investors.
Types of Mortgage-Backed Securities
There are two basic types of mortgage-backed security: pass-through mortgage-backed security and collateralized mortgage obligation (CMO).
1. Pass-through MBS
The pass-through mortgage-backed security is the simplest MBS, structured as a trust, so that principal and interests payments are passed through to the investors. It comes with a specific maturity date, but the average life may be less than the stated maturity age.
The trust that sells pass-through MBS is taxed under the grantor trust rules, which dictates that the holders of the pass-through certificates should be taxed as the direct owners of the trust apportioned to the certificate.
2. Collateralized Mortgage Obligation (CMO)
Collateralized mortgage obligations comprise multiple pools of securities, also known as tranches. Each tranche comes with different maturities and priorities in the receipt of the principal and the interest.
The tranches are also given separate credit ratings. The least risky tranches offer the lowest interest rates while the riskier tranches come with higher interest rates and, thus, are generally more preferred by investors.
How a Mortgage-Backed Security Works
When you want to buy a home, you approach a bank to give you a mortgage. If the bank confirms that you are creditworthy, it will deposit the money into your account. You will then be required to make periodic payments to the bank according to your mortgage agreement. The bank may choose to collect the principal and interest payments, or it may opt to sell the mortgage to another financial institution.
If the bank decides to sell the mortgage to another bank, government institution, or private entity, it will use the proceeds from the sale to make new loans. The institution that buys the mortgage loan pools the mortgage with other mortgages having similar characteristics, such as interest rates and maturities.
It then sells these mortgage-backed securities to interested investors. It uses the funds from the sale to buy more securities and float more MBS in the open market.
The Role of Government in MBS
As a response to the Great Depression of the 1930s, the government established the Federal Housing Administration (FHA) to help in the rehabilitation and construction of residential houses. The agency assisted in developing and standardizing the fixed-rate mortgage and popularizing its usage.
In 1938, the government created Fannie Mae, a government-sponsored agency, to buy the FHA-insured mortgages. Fannie Mae was later split into Fannie Mae and Ginnie Mae to support the FHA-insured mortgages, Veterans Administration, and Farmers Home Administration-insured mortgages.,
In 1970, the government created another agency, Freddie Mac to perform similar functions to those performed by Fannie Mae.
Freddie Mac and Fannie Mae both buy large numbers of mortgages to sell to investors. They also guarantee timely payments of principal and interest on these mortgage-backed securities. Even if the original borrowers fail to make timely payments, both institutions still make payments to their investors.
The government, however, does not guarantee Freddie Mac and Fannie Mae. If they default, the government is not obligated to come to their rescue. However, the federal government does provide a guarantee to Ginnie Mae. Unlike the other two agencies, Ginnie Mae does not purchase MBS. Thus, it comes with the lowest risk among the three agencies.
The Role of MBS in the 2008 Financial Crisis
Low-quality mortgage-backed securities were among the factors that led to the financial crisis of 2008. Although the federal government regulated the financial institutions that created MBS, there were no laws to directly govern MBS themselves.
The lack of regulation meant that banks could get their money right away by selling mortgages immediately after making the loans, but investors in MBS were essentially not protected at all. If the borrowers of mortgage loans defaulted, there was no sure way to compensate MBS investors.
The market attracted all types of mortgage lenders, including non-bank financial institutions. Traditional lenders were forced to lower their credit standards to compete for home loan business.
At the same time, the U.S. government was pressuring lending institutions to extend mortgage financing to higher credit risk borrowers. This led to the creation of massive amounts of mortgages with a high risk of default. Many borrowers simply got into mortgages that they eventually could not afford.
With a steady supply of, and increasing demand for, mortgage-backed securities, Freddie Mac and Fannie Mae aggressively supported the market by issuing more and more MBS. The MBS created were increasingly low-quality, high-risk investments. When mortgage borrowers began to default on their obligations, it led to a domino effect of collapsing MBS that eventually wiped out trillions of dollars from the US economy. The effects of the sub-prime mortgage crisis spread to other countries around the globe.
We hope you enjoyed reading CFI’s guide to a mortgage-backed security. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: