Mortgage-Backed Security : Meaning, Work, Types & Advantages

What is Mortgage-Backed Security?

Mortgage-backed security (MBS) is a special type of investment tied to home loans. Instead of directly buying or selling mortgages, investors buy into MBSs, which are created when lenders sell batches of mortgages to aggregators. These aggregators bundle the mortgages into securities, which investors can then buy. Investors receive regular payments from the interest and principal payments made by homeowners. There are different types of MBSs, like pass-through securities and collateralized mortgage obligations, each with its complexity. MBSs are traded on the secondary market, giving investors a chance to earn money based on how well the mortgages perform.

Geeky Takeaways:

• MBSs represent investments tied to home loans, created when lenders sell batches of mortgages to aggregators who bundle them into securities for investors.
• Government initiatives, like the Federal Housing Administration (FHA) and Fannie Mae, are aimed at standardizing mortgages and enhancing housing accessibility.
• Entities like Freddie Mac and Fannie Mae purchase mortgages, bundle them into MBSs, and offer assurances of timely payments to investors.
• The financial crisis of 2007 was worsened by the increase of low-quality MBSs, leading to significant economic repercussions globally.

History of Mortgage-Backed Security

Mortgage-backed securities originated in the late 1960s after the Housing and Urban Development Act of 1968 led to the establishment of Ginnie Mae, permitting banks to sell mortgages to third parties. This innovation enabled institutional funds to bundle loans into MBSs. By 2010, the MBS market had grown rapidly, reaching over $9 trillion in outstanding issuances. However, the market’s role in the 2007 financial crisis, fueled by declining MBS quality and borrower defaults, led to significant economic repercussions. Despite their tumultuous history, MBSs remain a vital component of the financial landscape, with ongoing efforts to strengthen regulatory oversight and risk management practices.

How Mortgage-Backed Security Work?

Mortgage-backed securities serve as a pivotal financial instrument where banks facilitate transactions between homeowners and investors. When individuals seek mortgages, banks extend loans, which are later combined with similar mortgages to create MBSs. These securities are then sold to investors in the bond market. As homeowners make monthly mortgage payments, investors receive a portion of the interest and principal. Additionally, the trading of MBSs significantly influences mortgage rates, with underlying mortgage attributes and credit profiles shaping bond yields, thereby exerting an impact on individual mortgage rates. This process ensures liquidity in the mortgage market while offering investors opportunities to earn income from the mortgage business without directly owning the underlying loans.

Types of Mortgage-Backed Securities

1. Pass-throughs: Pass-throughs represent the simplest form of mortgage-backed securities, where investors receive homeowners’ monthly mortgage payments directly. This straightforward structure ensures that investors receive monthly payments consisting of interest and a portion of the principal repayment. However, this arrangement doesn’t alter the payment schedule for homeowners, who continue making their regular mortgage payments without any change. Pass-throughs are favored by investors seeking steady, predictable cash flows and are relatively low in complexity compared to other MBS structures.

2. Collateralized Mortgage Obligations (CMOs): CMOs present a more intricate structure compared to pass-throughs. In a CMO, mortgages are segmented into separate tranches based on various factors, such as risk levels, interest rates, and maturity dates. These tranches are assigned credit ratings, dictating the rates at which the mortgage-backed securities are issued. CMOs are designed to mitigate prepayment risk by segregating cash flows into distinct bond classes known as tranches. This segmentation offers investors greater payment predictability and a more reliable rate of principal pay-down, enhancing the attractiveness of these securities in the market. CMOs provide investors with options to tailor their investment preferences based on risk tolerance and desired returns, offering flexibility in portfolio management.

Role of Government in Mortgage-Backed Securities

1. Government Housing Initiatives: In response to the economic challenges of the Great Depression in the 1930s, the government took steps to address housing needs by establishing the Federal Housing Administration (FHA). This agency aimed to facilitate the rehabilitation and construction of residential properties, particularly by developing and standardizing fixed-rate mortgages, making homeownership more accessible.

2. Evolution of Government Agencies: In 1938, the government introduced Fannie Mae, initially tasked with purchasing FHA-insured mortgages. Over time, Fannie Mae evolved, leading to the creation of Ginnie Mae, which focused on supporting various government-backed mortgages, including those insured by the Veterans Administration and Farmers Home Administration. Subsequently, Freddie Mac was established in 1970 to complement Fannie Mae’s functions, contributing to the stability and liquidity of the mortgage market.

3. Role of Freddie Mac and Fannie Mae: Freddie Mac and Fannie Mae play pivotal roles in the mortgage market by purchasing a significant volume of mortgages, which they bundle into mortgage-backed securities for sale to investors. Additionally, they provide assurances of timely principal and interest payments on these securities, offering investors a level of security even in cases of borrower default.

4. Government Support and Risks: Although Freddie Mac and Fannie Mae operate with government charters, they do not have direct government guarantees. In the event of their default, the federal government is not obligated to provide financial assistance. Conversely, Ginnie Mae benefits from government backing, ensuring timely payments on MBS, albeit without directly purchasing them. This distinction positions Ginnie Mae as the least risky among the three agencies, providing investors with a higher level of confidence and stability.

Mortgage-Backed Security and the Financial Crisis of 2007–2008

1. Causes of the Financial Crisis: The financial crisis of 2008 was exacerbated by various factors, including the proliferation of low-quality mortgage-backed securities. While financial institutions creating MBS were regulated by the federal government, there were no specific laws governing the MBS themselves, leaving investors vulnerable. Banks could quickly offload mortgages to obtain immediate funds, but investors in MBS lacked adequate protection in case of borrower defaults, as there was no reliable compensation mechanism.

2. Impact of Regulation and Market Dynamics: The absence of stringent regulations attracted diverse mortgage lenders, including non-bank financial entities, leading traditional lenders to relax credit standards to remain competitive. Concurrently, governmental pressure on lending institutions to extend mortgage financing to higher-credit-risk borrowers resulted in a surge of risky mortgages. Many borrowers, enticed by easy credit, obtained mortgages beyond their financial means, contributing to the risk profile of the mortgage market.

3. Role of Freddie Mac and Fannie Mae: Freddie Mac and Fannie Mae, responding to the growing demand for mortgage-backed securities, aggressively expanded their MBS issuance, flooding the market with increasingly low-quality and high-risk investments. As mortgage defaults surged, the market experienced a cascade of MBS failures, causing significant economic damage. The subsequent collapse of trillions of dollars in MBS value reverberated globally, triggering a widespread financial crisis that affected economies worldwide.

Advantages of Mortgage-Backed Security 

1. Cash Flow Stability: MBS provides investors with cash flow guarantees backed by US government agencies, ensuring a level of security in their investment. This assurance of consistent cash flows enhances investor confidence in MBS as a reliable income source.

2. Portfolio Diversification and Risk-Adjusted Returns: Investing in MBS offers the potential for attractive risk-adjusted returns and portfolio diversification. Their historical performance and lower volatility compared to similar fixed-income sectors make them an appealing option for investors looking to balance risk and return in their investment portfolios.

3. Abundant Investment Opportunities: The broad investable universe of agency MBS presents investors with a large opportunity set for security selection. Actively managing portfolios by rotating across coupons and MBS subsectors, coupled with effective duration management, can generate additional returns relative to benchmark indices.

4. Historical Outperformance: Over longer investment horizons, agency MBS has historically outperformed US Treasury bonds, making them an attractive option for investors seeking stable returns. This track record of consistent performance enhances the appeal of MBS as a reliable investment choice.

5. Diversification Benefits and Low Correlation: Agency MBS exhibits a lower correlation with equities compared to corporate bonds, offering diversification benefits and a reduced correlation to stock market movements. This low correlation to stocks helps mitigate portfolio risk and provides investors with a balanced exposure to different asset classes.

Disadvantages of Mortgage-Backed Security

1. Risk of Default: Mortgage-backed securities are vulnerable to the risk of default by homeowners, particularly during economic downturns or housing market crises. Defaults can result in a decline in the value of MBS, affecting investor returns negatively. Understanding the factors contributing to default rates is pivotal for assessing this risk effectively.

2. Prepayment Risk: Homeowners have the option to prepay their mortgages, which can disrupt the anticipated cash flows for MBS investors. Prepayments often occur when interest rates decrease, leading to diminished returns for investors holding MBS. Implementing strategies to manage prepayment risk is crucial for investors seeking to mitigate its impact on their portfolios.

3. Complexity: Collateralized Mortgage Obligations, a category of MBS, can be intricate with various tranches and structures, posing challenges for some investors in comprehending the associated risks. The complexity of CMOs may deter certain investors from engaging in these securities. Seeking expert guidance or thorough due diligence is advisable for investors navigating the complexities of CMO investments.

4. Market Volatility: MBS prices are sensitive to fluctuations in interest rates and market conditions, resulting in volatility in the value of these securities. Such volatility can impact investor returns and introduce uncertainty into the market environment. Employing risk management techniques tailored to market volatility can help investors safeguard their portfolios against adverse market movements.

5. Liquidity Risk: Mortgage-backed securities may encounter liquidity risk, especially during periods of market turmoil when selling these securities swiftly may be difficult without significant price concessions. This liquidity risk exposes investors to potential challenges in quickly liquidating their MBS holdings.

Mortgage-Backed Security – FAQs

What do mortgage-backed securities entail in India?

Mortgage-backed securities in India represent asset-backed securities supported by a pool of mortgages. This process involves shifting the credit risk from the primary lender, typically the originating bank, to an investment bank.

Who pioneered mortgage-backed securities?

Lewis S. Ranieri, often hailed as the father of mortgage-backed securities, along with Anthony J., is credited with founding mortgage-backed securities. Lewis S. Ranieri is a former bond trader and currently serves as the chairman of Ranieri Partners.

Are mortgage-backed securities government-supported?

While entities such as Fannie Mae and Freddie Mac can issue and guarantee mortgage-backed securities, the guarantee provided by Freddie Mac is not supported by the government.

How are mortgage-backed securities utilized in the present day?

Proceeds from mortgage-backed securities are utilized to extend loans to other borrowers, including subsidized loans for low-income or high-risk borrowers. This aspect of liquidity makes MBS a liquid product. Furthermore, mortgage-backed securities aid banks in mitigating risk by transferring the risk of non-payment (default) associated with mortgage loans.