Mortgage-Backed Securities (MBS) Definition: Types of Investment

What Is a Mortgage-Backed Security (MBS)?

Mortgage-backed securities (MBS) are investment products similar to bonds. Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them. Investors in mortgage-backed securities receive periodic payments similar to bond coupon payments.

Understanding Mortgage-Backed Security (MBS)

Mortgage-backed securities (MBS) are variations of asset-backed securities that are formed by pooling together mortgages exclusively. The investor who buys a mortgage-backed security is essentially lending money to home buyers. An MBS can be bought and sold through a broker. The minimum investment varies between issuers.

As became glaringly obvious in the subprime mortgage meltdown of 2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up. An MBS may also be called a mortgage-related security or a mortgage pass-through.

Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on its balance sheet and loses nothing if the homebuyer defaults sometime down the road.

This process works for all concerned as everyone does what they're supposed to do. That is, the bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time, and the credit rating agencies that review MBS perform due diligence.

In order to be sold on the markets today, an MBS must be issued by a government-sponsored enterprise (GSE) or a private financial company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings issued by an accredited credit rating agency.

Types of Mortgage-Backed Securities

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations (CMO).

1. Pass-throughs: Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors. They typically have stated maturities of five, 15, or 30 years. The life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that make up the pass-through.
2. Collateralized mortgage obligations (CMO): CMOs consist of multiple pools of securities, which are known as slices or tranches. The tranches are given credit ratings, which determine the rates that are returned to investors. Tranches within an MBS can have different credit risk profiles.

History of MBS

Mortgage-backed securities were introduced after the passage of the Housing and Urban Development Act in 1968. The act created the Government National Mortgage Association, or Ginnie Mae, which was split off from Fannie Mae.

The new body allowed banks to sell their mortgages to third parties so that they would have more capital to lend out and originate new loans. This in turn made it possible for institutional funds to buy up and package many loans into an MBS.

Ginnie Mae introduced the first mortgage-backed securities for the retail housing market in 1970. The first private MBS was introduced by Bank of America in 1977.

MBS and the Financial Crisis of 2007/2008

Mortgage-backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth, bring down Lehman Brothers, and roil the world financial markets.

In retrospect, it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost.

The Crisis

That was the beginning of the subprime MBS. With Freddie Mac and Fannie Mae aggressively supporting the mortgage market, the quality of all mortgage-backed securities declined, and their ratings became meaningless. Then, in 2006, housing prices peaked.

Subprime borrowers started to default, which is the failure to repay a loan. As a result, the housing market began its long collapse. More people began walking away from their mortgages because their homes were worth less than their loans. Even the conventional mortgages underpinning the MBS market saw steep declines in value. The avalanche of non-payments meant that many MBSs and collateralized debt obligations (CDOs) based on pools of mortgages were vastly overvalued.

The losses piled up as institutional investors and banks tried and failed to unload bad MBS investments. Credit tightened, causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of collapse.

The Bailout

The U.S. Treasury stepped in with Congress to authorize a $700 billion financial system bailout intended to ease the credit crunch. Also, the Federal Reserve bought $4.5 trillion in MBS over a period of years while the Troubled Asset Relief Program (TARP) injected capital directly into banks.

Some of the measures of the bailout included the following:

• Nearly $250 billion to stabilize the banking industry
• $27 billion to stabilize the credit markets
• $80 billion to support the U.S. auto industry
• Almost $70 billion to bail out the insurance giant, AIG for the American International Group
• $46 billion was allocated to help struggling families avoid home foreclosure, which is when a mortgage lender or bank seizes a borrower's home due to nonpayment of the loan

On Oct. 3, 2010, the authority to initiate new financial commitments ceased, essentially ending any new bailouts under the TARP program.

Also, in 2010, Congress authorized the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act reduced the initial amount of the $700 billion authorized for the TARP program to $475 billion.

Advantages and Disadvantages of MBS

Attractive Yield

For investors, mortgage-backed securities have some advantages over other securities. They pay a fixed interest rate that is usually higher than U.S. government bonds. Moreover, they typically offer monthly payouts, whereas bonds offer a single lump-sum payout at maturity.

Safe Investments

Mortgage-backed securities are also considered relatively low-risk, especially once seasoned. If an MBS is guaranteed by the federal government, investors do not have to absorb the costs of a borrower's default. Moreover, they also offer diversification from the markets of corporate and government securities.

Prepayment Risk

If borrowers fail to repay their loans, the investor may ultimately lose money. Also, if borrowers pay off their loans early or refinance their loans, that can also have a negative impact on expected returns. The weighted average coupon (WAC) can estimate the pre-payment characteristics of a pool of underlying mortgages. The WAC will change periodically as mortgages are paid off.

Interest Rate Risk

MBSs are also sensitive to changes in the interest rates on loans and mortgages. If interest rates rise, fewer people will take out mortgages causing the overall value of the housing market to decline.

Mortgage-Backed Securities Today

Mortgage-backed securities are still bought and sold today. There is a market for them again simply because people generally pay their mortgages if they can. The Fed still owns a huge chunk of the market for MBSs, but it is gradually selling off its holdings.

Even CDOs have returned after falling out of favor for a few years post-crisis. The assumption is that Wall Street has learned its lesson and will question the value of MBSs rather than heedlessly buying them. Time will tell.

The Bottom Line

A mortgage-backed security is a type of investment vehicle composed of a large basket of mortgages. As each homeowner pays off their loans, the loan payments provide a steady income stream for investors who hold the MBS. These securities may be particularly attractive to investors who seek exposure to the housing market, rather than ordinary corporate or debt securities.