What Are Mortgage-Backed Securities?

Mortgage-Backed Securities Explained

A banker looks over mortgage-backed security data.
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Mortgage-backed securities (MBS) are bonds that are secured by mortgages. It allows investors to benefit from the mortgage business without ever having to buy or sell an actual home loan. When you invest in an MBS, you are buying the right to receive the value of a bundle of mortgages.

Learn how these investments are created and how they contributed to the subprime housing crisis.

Definition and Examples of Mortgage-Backed Securities

Mortgage-backed securities are a specific type of asset-backed security. In other words, they're a kind of bond that's backed by real estate like a residential home. The investor is essentially buying a mortgage so they can collect monthly payments in place of the original lender.

Typical buyers of these securities include institutional, corporate, and individual investors. However, if the homeowner defaults, the investor who paid for the mortgage-backed security won't get paid, which means they could lose money.

  • Acronym: MBS

A security is an investment made with the expectation of making a profit through someone else's efforts. In the case of mortgage-backed securities, the investor attempts to profit through the efforts of a mortgage lender.

How a Mortgage-Backed Security Works

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.

After the housing crisis, the U.S. government increased regulations in several areas, including residential MBSs. 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.

How an MBS Is Created

The MBS process starts when a bank or mortgage company makes a home loan. That lender then sells that loan to an investment bank. It uses the money received from the investment bank to make new loans.

While the lender starts the process over with a new mortgage for a new customer, the investment bank takes the original loan and adds it to a bundle of mortgages with similar interest rates.

After the investment bank creates a bundle of similar mortgages, it puts the bundle in a special company designed to create an MBS. These companies are called Special Purpose Vehicles (SPVs) or Special Investment Vehicles (SIVs). That keeps the mortgage-backed securities separate from the bank's other services. The SPV markets these mortgage-backed securities to investors.

For the investor buying the MBS, it's similar to any other bond. The investor pays a price to acquire the bond and receives income while holding the bond. In theory, the customer pays off their mortgage, and the MBS investor profits.

Types of Mortgage-Backed Securities

While all mortgage-backed securities are essentially the same product—a bond—there are some variations on the product that investors can choose from.

Pass-Through Participation Certificate

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.

Collateralized Debt Obligation

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) which could include any type of loan. To the investor, these products function like an MBS, even though they may or may not contain mortgages.

Collateralized Mortgage Obligation

Around the time CDOs were created, investment banks also developed a more complex version of the mortgage-backed security, the collateralized mortgage obligation (CMOs).

These complicated investments are 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.

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.

What It Means for Individual Investors

The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage businesses. At first, mortgage-backed securities created more demand to lend out money, which allowed more people to buy homes.

However, this got out of hand during the real estate boom, when 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.

Private-Label MBSs

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

These subprime mortgages created an asset bubble that 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.

Key Takeaways

  • Mortgage-backed securities are a type of bond in which an investor buys a mortgage from a mortgage lender.
  • When all goes well, an MBS investor collects monthly mortgage payments until the loan is fully repaid, but there is the risk of default.
  • While once fairly unregulated, the government increased its scrutiny of mortgage-backed securities after 2006's subprime mortgage crisis.