Mortgage-backed Securities: Types, How They Work

How Mortgage-backed Securities Worked Until They Didn't

Realtor holding sold sign board in living room, mid section
MBS worked fine until homes prices dropped in 2006. Photo: ColorBlind Images/Getty Images

Definition: Mortgage-backed securities (MBS) are investments similar to stocks, bonds or mutual funds. Their value is secured, or backed, by the value of an underlying bundle of mortgages. When you buy an MBS, you aren't buying the actual mortgage. Instead, you are buying a promise to be paid the return that the bundle of mortgages would receive. An MBS is a derivative because it derives its value from the underlying asset.

How Does a Mortgage-Backed Security Work?

First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment bank or a quasi-governmental agency. Those include Fannie Mae, Freddie Mac or Ginnie Mae. They bundle a lot of loans with similar interest rates. They then sell a security that delivers the same payments that the bundle of loans does. That's the MBS, which is a security backed by the mortgage. The MBS is sold to institutional, corporate or individual investors on the secondary market.

The MBSs sold by the governmental agencies were particularly attractive. The agencies guaranteed the returns, and they were themselves backed by the Federal government. Those who bought a Fannie Mae or Freddie Mac MBS knew they wouldn't lose their investment. Ginnie Mae guaranteed that investors would receive their payments. (Source: SEC, Mortgage-backed Securities)

Types of Mortgage-backed Securities

The simplest MBS is the pass-through participation certificate.

It pays the holders their fair share of both principal and interest payments made on the mortgage bundle.

Banks created more complicated investment products to beat the competition. They created collateralized debt obligations and mortgage derivatives. They sliced the bundles into similar risk categories, known as tranches.

The least risky tranche contained the first one to three years of payments. Borrowers were most likely to pay the first three years. For adjustable-rate mortgages, these years also have the lowest interest rates.

Some investors preferred the riskier tranche because they have higher interest rates. Those tranches contained the fourth through seventh years of payments. As long as interest rates remain low, then risks remain predictable. If the borrower prepays the mortgage because they refinance, then the investor gets the initial investment back. The largest risk occurs when interest rates rise. Borrowers are often caught off guard when their money payment rises. They can't refinance because interest rates are higher. That's when they are most likely to default. Then the investor takes a loss. Here's Ryan Gosling explaining it from the movie The Big Short.

Mortgage-Backed Securities Changed the Housing Industry

The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage business. At first, mortgage-backed securities allowed more people to buy homes. During the real estate boom, many banks and mortgage companies made loans with no money down.

That allowed people to get into mortgages they couldn't afford. The lenders didn't care. They knew they could sell the loans, and not pay the consequences when and if the borrowers defaulted. That created an asset bubble, which then burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds, and financial institutions owned mortgage-backed securities, everyone took losses.That's what created the 2008 financial crisis.

How Mortgage-Backed Securities Went Wrong

President Johnson created mortgage-backed securities when he authorized the 1968 Charter Act. It also created Fannie Mae. He wanted to give banks the ability to sell off mortgages. That would free up funds to lend to more homeowners. He didn't expect it to remove a critical discipline for good lending practices.

Banks soon realized that they would no longer have to take the loss if the borrower didn't pay off the loan. The banks got paid for making the loan but didn't get hurt if the loan went bad. They weren't as careful about the credit-worthiness of the borrower.

Second, mortgage-backed securities allowed financial institutions other than banks to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. They had the deep pockets to wait until these loans were repaid 15 or 30 years later. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. Mortgage lenders sprang up everywhere. They also weren't too careful about the solvency of their customers. It created more competition for traditional banks. They had to lower their standards to keep the loan volume up.

Third, MBSs were not regulated. Traditionally, banks had been highly regulated by governmental agencies to make sure their borrowers were protected. MBS's and mortgage brokers were not.