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 are investments that are secured by mortgages. They’re a type of asset-backed security. A security is an investment that is traded on a secondary market.  It allows investors to benefit from the mortgage business without ever having to buy or sell an actual home loan. Typical buyers of these securities include institutional, corporate or individual investors.

When you invest in an MBS, you are buying the rights to receive the value of a bundle of mortgages. That includes the monthly payments and the repayment of the principal. Since it is a security, you can buy just a part of the mortgage. You receive an equivalent portion of the payments. 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. It uses the money received from the investment bank to make new loans.

The investment bank adds the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company designed for that purpose. It's called a Special Purpose Vehicle or Special Investment Vehicle. That keeps the mortgage-backed securities separate from the bank's other services. The SPV markets the mortgage-backed securities.

The mortgages stay in the SPV. 

Government agencies are also involved in most mortgage-backed securities. These are Fannie MaeFreddie Mac and Ginnie Mae. Fannie Mae and Freddie Mac both buy and sell MBS. The federal government guarantees the payments. Those who bought an MBS knew they wouldn't lose their investment.

Ginnie Mae also guarantees that investors would receive their payments. (Source: "Mortgage-backed Securities," SEC.)

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.

In the early 2000s, the MBS market grew very competitive. Banks created more complicated investment products to attract customers. For example, they developed collateralized debt obligations for loans other than mortgages. But they also applied this derivative strategy to MBS.

The investment banks sliced the mortgage 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 remained low, then risks remained predictable. If the borrower prepaid the mortgage because he or she refinanced, then investors received their initial investment back.

Risk grew when interest rates rose. Borrowers of adjustable-rate mortgages were caught off guard when their payments rose. They couldn't refinance because interest rates were higher. That meant they were more likely to default. The investors lost everything. Here's Ryan Gosling explaining it in 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 businesses. 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. It 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 Lyndon 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. 

LBJ didn't expect the Charter Act to remove 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 borrowers.

Mortgage-backed securities also allowed non-bank financial institutions to enter the mortgage business. Before MBS, 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 MBS 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 compete.

Worst of all, MBS were not regulated. The federal government regulated banks to make sure their depositors were protected. But those rules didn't apply to MBS and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all.