Mortgage-Backed Security Explained

Mortgage-Backed Security Explained

A mortgage-backed security or MBS is a type of security or financial instrument. To be more specific, it is an asset-backed security made up of a bundle of mortgages or home loans issued by banks and sold to investors. An MBS is essentially a securitization of mortgages.

The principle behind MBS is simple. Banks act as middlemen between investors and homebuyers. A specific bank lends home loans to individual consumers and then bundle all mortgages to sell them to investors at a discount. In essence, investors are actually the ones lending money to homebuyers.

Three Major Types of Mortgage-Backed Securities

There are three major types of MBS: pass-throughs, collateralized mortgage obligations or CMOs, and stripped mortgage-backed security or SMBS. Mortgage pass-through securities are structured trusts or a pool of fixed-income securities backed by a package or mortgages. Banks collect mortgage payments from homebuyers or borrowers and pass them through to investors.

On the other hand, CMOs are tranches or pooled and bundled mortgages organized by their risk profiles. Because they are complex financial instruments, they have different principal balances, interest rates, maturity dates, and potential of repayment defaults. Investors earn from CMOs through principal and interest payments based on predetermined agreements.

An SMBS involves using mortgage payments in two parts: to partly pay down the loan principal and partly pay the loan interest. There are two subtypes of SMBS. An interest-only SMBS is a bond with cash flows backed by the interest component of mortgage payments while a principal-only SMBS is a bond with cash flows backed by the principal repayment component of mortgage payments.

Advantages and Disadvantages of Mortgage-Backed Securities

The Primary Benefits of MBS

Most investors consider these securities backed by mortgages as safe for two reasons. First, the market value of real estate properties naturally appreciates. Second, if ever homeowners defaulted from their loans, banks or lenders could easily cease their real estate properties and resell them in the market.

Another advantage of MBS is that it gives banks or lenders an incentive to pursue prospective homebuyers. Selling these securities to investors makes credit available to the public, thereby making loans accessible to more individuals, promoting homeownership, and supporting businesses related to real estate development.

The Primary Problems with MBS

MBS has criticisms due to their probable disadvantages. Note that the popularity of MBS was the root cease of the U.S. Subprime Mortgage Crisis that triggered the 2007-2008 Financial Crisis. The growing demand for these securities during the 2000s compelled banks to relax their lending standards and encourage the public to secure home loans regardless of their credit rating.

It is also worth mentioning that an MBS is only as sound as the mortgages that back it up. Although it is generally a low-risk and high-return investment, its future performance remains dependent on different market and macroeconomic factors. Remember that economic downturns could affect the capacity of homebuyers to pay their mortgages.