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

How Mortgage-Backed Securities Worked Until They Didn't

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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. An MBS is a derivative because it derives its value from the underlying asset.

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 MBS market grew very competitive. Banks created more complicated investment products to attract customers. For example, they developed collateralized debt obligations (CDOs) for loans other than mortgages. But they also applied this derivative strategy to MBSs. These are called collateralized mortgage obligations (CMOs).

Investment banks slice the mortgage bundles into similar risk categories, known as tranches. The least risky tranches contain the first one to three years of payments. Borrowers are more likely to pay during the first three years. For adjustable-rate mortgages, these years also have the lowest interest rates.  

Some investors prefer riskier tranches because they have higher interest rates. Those tranches contain the fourth through seventh years of payments. As long as interest rates remain low, the risks remain predictable. If borrowers prepay the mortgage because they refinance, investors received their initial investment back.

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 created mortgage-backed securities when he authorized the 1968 Housing and Urban Development Act. It 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.

Article Sources

  1. Securities and Exchange Commission. "Mortgage-Backed Securities." Accessed Jan. 12, 2020.

  2. Utah Department of Commerce Division of Securities. "What Is a Security?" Accessed Jan. 12, 2020.

  3. Securities and Exchange Commission. "Derivatives." Accessed Jan. 12, 2020.

  4. FINRA. "Mortgage-Backed Securities." Accessed Jan. 12, 2020.

  5. FEDS Notes. "Collateralized Loan Obligations in the Financial Accounts of the United States." Accessed Jan. 12, 2020.

  6. FDIC. "The Subprime Credit Crisis of 07." Accessed Jan. 12, 2020.

  7. Georgetown University Law Center. "Explaining the Housing Bubble," Page 7. Accessed Jan. 12, 2020.

  8. Ginnie Mae. "Our History." Accessed Jan. 12, 2020.

  9. Wharton. "The Real Causes—and Casualties—of the Housing Crisis." Accessed Jan. 12, 2020.

  10. Securities and Exchange Commission. "Asset-Level Disclosure Requirements for Residential Mortgage-Backed Securities." Accessed Jan. 12, 2020.