Mortgage-Backed Securities Explained for Dummies

What is a mortgage-backed security (MBS)?

Mortgage-backed security (MBS) is a type of bond that is secured by a mortgage or a bundle of mortgages.

Mortgage-backed securities (MBSs) comprise two types of MBSs, namely:

• Residential mortgage-backed securities (RMBSs), which are backed by residential mortgages, usually for family homes.
• Commercial mortgage-backed securities (CMBSs), which are secured by large commercial loans, are referred to as conduit loans.

The article focuses on residential mortgage-backed securities (RMBSs). Hence, unless otherwise mentioned, the term ‘mortgage-backed security’ and its plural, as well as the abbreviations ‘MBS’ and ‘MBSs’ are used with regard to RMBSs.

Features of mortgage-backed security (MBS)

• It is created by financial institutions such as banks, investment banks, other investment entities, or government institutions, which bundles mortgages (bought from authorised financial institutions (lenders)) together.
• A mortgage-backed security is sold to, inter alia, securities businesses, government agencies, individual and institutional investors, and corporations.
• An MBS can be bought and sold via a broker.
• It is traded on the secondary market.
• An MBS enables an investor to benefit from the mortgage business without the requirement to directly buy or sell home loans.
• It is collateralized by the mortgages, including residential mortgages, which are pooled together.
• An MBS is an investment (debt security) similar to a bond, allowing investors to receive periodic payments similar to bond coupon payments.
• Investing in an MBS gives an investor the right to receive the value of a collection of mortgages.

Understanding the process of mortgage-backed security (MBS)

The first step in the process of an MBS is when a mortgage lender, also referred to as a mortgagee, grants a mortgage (loan) to a borrower, also called a mortgagor, to buy a residential property.

The mortgage lender then sells the mortgage to an MBS issuer, such as a government agency, a private securities firm, or an investment bank. The lender uses the money received to provide new mortgages to borrowers.

Essentially, an MBS transforms the mortgage lender into an intermediary between the borrower (homebuyer) and the investment industry.

The MBS issuer bundles the mortgage together with other mortgages acquired to create a mortgage-backed security. Typically, the mortgages are pooled together based on their similar characteristics, such as interest rates and maturity dates.

The MBS issuer then sells the MBS to an interested investor such as a private or institutional investor, or a corporation. The issuer uses the proceeds from the sale to buy more mortgages from mortgage lenders in order to create and sell more mortgage-backed securities.

For an investor buying an MBS, it is the same as with any other bond. The investor pays an amount to become the holder of the bond, receiving income while holding the bond. Theoretically, the homeowner pays off his or her mortgage, while the MBS investor generates profits.

Unlike holders of traditional fixed-income bonds, most MBS bondholders receive monthly interest payments – not semi-annually. The reason for this is that homeowners (whose mortgages serve as the underlying collateral for the MBS) pay the instalments on their mortgages monthly, not every six months.

Types of mortgage-backed securities

Two of the most basic types of mortgage-backed securities are pass-throughs and collateralized mortgage obligations (CMO).

• Pass-throughs

The pass-through, short for the pass-through participation certificate, is the most basic form of mortgage-based security.

They are structured as trusts in which mortgage payments are collected and the principal and interest payments distributed (passed through) to investors.

They typically have stated maturities of 30 years, 15 years, and 5 years. However, the average duration of a pass-through may be much less than its stated maturity life because they ‘pass through’ the principal payments on the mortgages. Their average life depends upon the paydown history of the bundle of mortgages underlying the bond.

• Collateralized mortgage obligations (CMOs)

CMOs are a complex type of pass-through MBSs. Instead of distributing interest and principal payments to an investor from a bundle of mortgages or securities with similar features, CMOs comprise numerous pools of securities, referred to as tranches or slices.

The tranches are given separate credit ratings which determine the rates that are passed through to investors:

1. The least risky tranches have the lowest interest rates but more certain cash flows and a lower chance of default risk.
2. The riskier tranches are subjected to more uncertain cash flows and have greater exposure to default risk. However, they offer higher interest rates, which compensate for the higher risk, making them more attractive to some investors.

Each tranch has its own set of rules, determining how interest and principal payments are distributed to investors.

Keep in mind, CMOs could include any type of loan, nevertheless, they may or may not contain mortgages.

Pros of mortgage-backed securities (MBSs)

• MBSs offer attractive yields that tend to be higher than what an investor would get by investing in government bonds.
• Low credit risk, especially those backed by government-sponsored entities.
• They can provide great diversification to investment portfolios.
• They distribute monthly pay-outs, allowing investors to receive extra income each month.
• MBSs are usually fixed-rate loans, making them a fairly safe investment.
• ‘Mortgage-back securities helped move interest rate out of the banking sector and facilitated greater specialization among financial institutions.’ (Wikipedia)
• Commercial mortgage-backed securities (CMBSs) are subjected to more strict underwriting standards since the 2008 fiscal crisis.

Cons of mortgage-backed securities

• Residential mortgage-backed securities (RMBSs), as well as commercial mortgage-backed securities (CMBSs), are subjected to credit and default risk. If the underlying borrowers fail to make their principal and interest payments, investors will suffer losses.
• Sometimes, MBSs involve the possibility of interest rate risk, causing the price of the underlying security to drop when interest rates increase.
• Extension risk occurs when borrowers decide not to make prepayments on their mortgages as initially anticipated. The effect is that the security provides a lower-than-expected coupon because the principal amount is lower.
• Prepayment risk refers to the risk that mortgagors (borrowers) will make payments that are higher than initially expected.

This article does not intend to provide investment or trading advice. Its aim is only informative.