What is a mortgage-backed security?
A mortgage-backed security, or MBS, may sound complex, but the basic idea behind it is simple: A mortgage-backed security is like a bond created out of mortgages.
With a traditional bond, a company or government borrows money and issues a bond to investors, promising to repay it over time. In a mortgage-backed security, however, payments to investors come from the thousands of mortgages that underlie the bond.
Mortgage-backed securities offer key benefits to the players in the mortgage market, including banks, investors and even borrowers themselves.
How do mortgage-backed securities work?
Mortgage-backed securities consist of a group of mortgages that has been structured, or securitized, to pay out interest like a bond. MBSs are created by companies called aggregators, including institutions such as Fannie Mae or Freddie Mac. They buy loans from lenders, including big banks, and structure them into a mortgage-backed security.
While we all grew up with the idea that banks make loans and then hold those loans until they mature, the reality is that there’s a high chance that your lender is selling the loan into what’s known as the secondary mortgage market. Here, aggregators buy and sell mortgages, finding the right kind of mortgages for the security they want to create and sell on to investors.
Think of a mortgage-backed security like a giant pie with thousands of mortgages thrown into it. The creators of the MBS may cut this pie into potentially millions of slices — each perhaps with a little piece of each mortgage — to give investors the kind of return and risk they demand.
The aggregators may create many different kinds of bond slices from the pool of mortgages, from very safe, low-return bonds up through riskier but higher-return sets of bonds.
Mortgage-backed securities typically pay out to investors on a monthly basis, like the mortgages behind the securities. But, unlike a typical bond where you receive interest payments over the bond’s life and are then returned your principal, a MBS may often pay both principal and interest over the life of the security, so there won’t be a lump sum payment at the end of the MBS’s life.
Mortgage-backed securities and the housing market
So why do mortgage-backed securities make sense for the players involved in the mortgage industry? Mortgage-backed securities actually make the industry more efficient, meaning it’s cheaper for each party to access the market and get its benefits:
- Lenders: By selling their loans, banks can focus on generating fees for underwriting, allowing them to more efficiently use their capital. They often require borrowers to meet conforming loan standards so that they can sell mortgages to aggregators. They can also sell the loans they might not want to keep, while retaining those they prefer.
- Aggregators: Aggregators package mortgages into MBSs and earn fees for doing so. They may give mortgage-backed securities features that appeal to certain investors. A steady supply of conforming loans allows aggregators to structure MBSs cheaply.
- Borrowers: Because aggregators demand so many conforming loans, they increase the supply of these loans and push down mortgage rates. So, borrowers may be able to enjoy greater access to capital and lower mortgage rates than they otherwise would.
Of course, easier access to financing is beneficial for the housing industry, which can build and sell more houses to consumers who are able to access credit more cheaply.
Investors like mortgage-backed securities, too, because these bonds may offer certain kinds of risk exposure that the investors, mainly big institutional players, want to have. Even the banks themselves may invest in MBSs, diversifying their exposure from just a local market.
While the lender may sell the loan, it may also retain the right to service the mortgage, meaning it earns a small fee for collecting the monthly payment and generally managing the account. So, you may continue to pay your lender each month for your mortgage, but the real owner of your mortgage may be the investors who hold the mortgage-backed security containing your loan.
Types of mortgage-backed securities
Mortgage-backed securities may have many features depending on what the market demands. The creators of MBSs think of their pool of mortgages as streams of cash flow that might run for 10, 15 or 30 years — the typical length of mortgages. But the bond’s underlying loans may be refinanced, and investors are repaid their principal and lose the cash flow over time.
By thinking of the characteristics of the mortgage as a stream of risks and cash flows, the aggregators can create bonds that have certain levels of risks or other characteristics. These securities can be based on both home mortgages (residential mortgage-backed securities) or on loans to businesses on commercial property (commercial mortgage-backed securities).
There are different types of mortgage-backed securities based on their structure and complexity:
In this type of mortgage-backed security, a trust holds any mortgages and allocates mortgage payments to its various investors depending on what share of the securities they own. This structure is relatively straightforward.
Collateralized mortgage obligation (CMO)
This type of MBS is a legal structure backed by the mortgages it owns, but it has a twist. Think of the pie metaphor again. From a given pool of mortgages, a CMO can create different classes of securities that have different risks and returns. For example, it can create a safe class of bonds that are paid before other classes of bonds. The last and riskiest class is paid out only if all the other classes receive their payments.
Stripped mortgage-backed securities (SMBS)
This kind of security basically splits the mortgage payment into two parts, the principal repayment and the interest payment. Investors can then buy either the security paying the principal (which pays out less at the start but grows) or the one paying interest (which pays out more but declines over time).
These structures allow investors to invest in mortgage-backed securities with certain risks and rewards. For example, an investor could buy a relatively safe slice of a CMO and have a high chance of being repaid, but at the cost of a lower overall return.
Mortgage-backed securities today
While mortgage-backed securities were at the center of the global financial crisis in 2008 and 2009, they continue to be an important part of the economy today because they serve real needs and provide tangible benefits to players across the mortgage and housing industries.
Not only does securitization of mortgages provide increased liquidity for investors, lenders and borrowers; it also offers a way to support the housing market, which is one of the largest engines of economic growth in the U.S. A strong housing market often bolsters a strong economy and helps employ many workers.
While you might not deal with a mortgage-backed security in your daily life, they’re part of the machinery that keeps the financial system running and helps borrowers access capital more cheaply. It can be useful to understand that the MBS market has a powerful influence over how to qualify for a conforming loan, and who gets money and for how much.