What are mortgage-backed securities?

Mortgage-backed securities (MBS) function as a financial investment, like bonds, crafted from a bundle of residential mortgages. These securities are acquired from issuing banks and traded to investors in the secondary market, with a significant share issued by government-sponsored entities such as Freddie Mac, Fannie Mae, and Ginnie Mae. These entities play a vital role in facilitating accessible homeownership by acquiring mortgage loans.

The essence of MBS lies in empowering banks to offload mortgages, enabling them to have more funds available for lending to borrowers. This opens the door for institutions beyond traditional banks to dive into the mortgage business. It’s worth noting that individuals might unknowingly be part of an MBS, as their mortgages could be pooled and sold to investors.

How does an MBS work?

• The bank mediates the MBS between the homeowners and borrowers. 
• Banks sell individual mortgages as conventional loans.
• These mortgages are added to a pool of similar mortgages as an MBS. 
• These are sold in the bond market to an investment bank.
• When you take out a mortgage through a bank, the bank charges you interest for the loan and may keep the principal and interest from the mortgage themselves or sell it to investors for additional capital. 
• The bank earns money by originating and servicing new mortgages.
• The investment bank categorizes the loans by quality before selling them to investors depending on the loan characteristics and risk profile. 
• MBS trading a; so affects mortgage rates as mortgage characteristics and credit profiles impact bond yield.
• With MBS, investors don’t have to buy or sell home loans themselves to benefit from the interest. Investors get their interest payments from borrowers’ monthly interest and principal repayments. 

Types of MBS: 

There are two types of mortgage-backed securities: pass-throughs and collateral mortgage obligations (CMO).

• Pass-throughs: The most straightforward MBS type, pass-throughs operate by transferring homeowners’ monthly mortgage payments, including interest and principal, directly to investors. Investors receive interest and partial principal payments, while homeowners remain unaffected by this process.
• Collateral mortgage obligations (CMO): CMO mortgages are more complex as they are categorized into tranches or segments on rates, risk, and maturity dates. These segments are given credit ratings which decide the MB rates.

Let’s take a look at some of the pros and cons of an MBS:

Pros: 

• MBSs are fixed-rate safe investments with prepayment penalties. 
• They have higher yields than traditional government bonds. Higher coupons usually come with more rewards. 
• MBSs are backed by government-sponsored entities and so come with relatively lower credit risks. 

Cons:

• There is a risk that borrowers may make higher monthly payments and pay off their mortgages early. They may also choose to refinance if the interest rates go down. 
• The interest rate may also increase if the security price lowers. 
• Investors will lose out if borrowers don’t make their monthly mortgage payments. This also depends on the market strength and when the loan was issued. 
• Borrowers may also decide against mortgage prepayments. So their security may come with a lower coupon, mainly when the Treasury rates increase.