Mortgage-Backed Securities, Their Types, and How They Work

How Mortgage-Backed Securities Worked Until They Didn't

A banker looks over mortgage-backed security data.

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Mortgage-backed securities (MBS) are investments that are secured by mortgages. They’re a type of asset-backed security. A security is an investment made with the expectation of making a profit through someone else's efforts. 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, and individual investors.

When you invest in an MBS, you are buying the right to receive the value of a bundle of mortgages. That includes the monthly mortgage payments and the repayment of the principal. Since it is a security, you can buy just a part of a mortgage. You receive an equivalent portion of the payments.

How a Mortgage-Backed Security Works

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 (SPV) or Special Investment Vehicle (SIV). That keeps the mortgage-backed securities separate from the bank's other services. The SPV markets the mortgage-backed securities. 

MBS Types

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 structured securities market grew very competitive. Investment banks created more complicated investment products to attract customers. For example, they developed collateralized debt obligations (CDOs) for loans other than mortgages. They also developed a more complex version of the mortgage-backed security, the collateralized mortgage obligation (CMOs).

A CMO is constructed by slicing a pool of mortgages into similar risk categories, known as tranches. The least risky tranches have more certain cash flows and a lower degree of exposure to default risk, while riskier tranches have more uncertain cash flows and greater exposure to default risk. However, the elevated level of risk is compensated with higher interest rates, which are attractive to some investors.

CMOs are sophisticated investments. Many investors lost money on CMOs and CDOs during the 2006 mortgage crisis. Borrowers with adjustable-rate mortgages were caught off guard when their payments rose due to the rising interest rates. They couldn't refinance because interest rates were higher, which meant they were more likely to default. When borrowers defaulted, investors lost the money they invested in the CMO or CDO.

How 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, some lenders didn't take the time to confirm that borrowers could repay their mortgages. That allowed people to get into mortgages they couldn't afford. These subprime mortgages were bundled into private-label MBSs.

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.

Private-Label MBSs

Private-label MBSs were more than 50% of the mortgage finance market in 2006.

Mortgage-Backed Securities and the Housing Crisis

President Lyndon Johnson paved the way for modern-day mortgage-backed securities when he authorized the 1968 Housing and Urban Development Act, which also created Ginnie Mae. Johnson wanted to give banks the ability to sell off mortgages, which would free up funds to lend to more homeowners. 

Mortgage-backed securities allowed non-bank financial institutions 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. The number of lenders increased. Some offered mortgages that didn't look at a borrower's job or assets. This created more competition for traditional banks. They had to lower their standards to compete.

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

MBSs Today

After the housing crisis, the U.S. government increased regulations in several areas. Residential MBSs are now regulated. MBSs must provide disclosures to investors on several points. In response to the new requirements, there are fewer registered MBSs other than the ones offered by Fannie Mae and Freddie Mac.

MBSs can be an attractive investment. If all goes well, they provide ongoing income. These investments can be complex, though, so it's essential to research potential MBS investments carefully.