Definition
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a collection of mortgages. This collection, or pool, of mortgages is packaged by the originating bank or other financial institution and sold to investors. The MBS then generates cash flow for the investors as the underlying mortgages are paid off by the borrowers.
Key Takeaways
- Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a collection of mortgages. These grouped mortgages, or mortgage loans, are often gathered into a pool by financial institutions and sold to investors.
- Investors profit from the MBS through the interest and principal payments they receive from the underlying mortgages. However, this means that the risk of borrowers defaulting on their loans is also transferred to the investors.
- The value and risk of a MBS can be affected by various factors, including the quality of the underlying mortgages, the prevailing interest rates, the economic conditions, and more. Hence, understanding these factors is essential for accurate risk assessment and effective investment strategy.
Importance
Mortgage-Backed Security (MBS) is a critical finance term as it represents an asset-backed investment where the asset is a pool or group of home loans.
These securities play an indispensable role in housing finance and the broader financial markets.
Banks and other lending institutions use Mortgage-Backed Securities to eliminate the risks associated with mortgage loans, thus allowing the re-lending of capital to new borrowers.
In addition, MBS offer an investment opportunity with income generation via interest and principal repayments, diversification and liquidity benefits to institutional and individual investors.
However, the importance of understanding MBS also lies in the risks involved, which became notably evident during the 2008 financial crisis, where misinterpretations of these complex securities contributed to a global economic downturn.
Explanation
Mortgage-Backed Security (MBS) serves a significant function in creating liquidity in the real estate market. These financial products allow banks to free up capital by selling mortgages on the secondary market, which can then be utilized for issuing more loans to new home buyers and other borrowers, improving the overall cash flow in the economy.
By allowing this flow of capital, MBS promotes homeownership by making mortgages more widely available and could also stabilize mortgage rates. MBS also provide an investment opportunity for individuals, institutions, and governments.
The investors in Mortgage-Backed Securities purchase the rights to collect on a pool of mortgages, receiving both the principal and interest payments made by the homeowners. This provides the investors with a steady and predictable stream of income, and also diversifies their investment portfolio.
However, it’s noteworthy that these securities bear a risk, as defaults on mortgages can result in losses for the investors.
Examples of Mortgage-Backed Security
Freddie Mac and Fannie Mae: These two U.S. government-sponsored entities are some of the primary issuers of mortgage-backed securities. They buy mortgages from lenders, combine them into packages of loans (often with similar characteristics, such as interest rate or maturity date), and then sell those packages as mortgage-backed securities to investors. The money they raise from selling these securities is then used to buy more mortgages from lenders, which helps keep the mortgage market liquid.
Ginnie Mae – Ginnie Mae also guarantees mortgage-backed securities, but even more directly than Freddie Mac and Fannie Mae do. Unlike the experience during the financial crisis, where Fannie Mae and Freddie Mac needed a government bailout, Ginnie Mae’s MBS were guaranteed by the full faith and credit of the U.S. government. For example, if homebuyers whose mortgages were included in a Ginnie Mae MBS were to default on their loans, Ginnie Mae would be on the hook to make sure that the investors in that MBS still received their expected payments.
Commercial Banks: Large commercial banks, like the Bank of America, JPMorgan Chase, and Wells Fargo, employ investment divisions that actively trade and create mortgage-backed securities. These banks often service the mortgages they securitize, meaning that the mortgage payments are sent to them. The bank takes a small percentage of the payment as a servicing fee and forwards the rest to the MBS investors. If a homeowner defaults, the bank is responsible for foreclosing and selling the home. The losses are passed onto the MBS investors.
Mortgage-Backed Security FAQ
What is a Mortgage-Backed Security?
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. Investors purchase these securities, profiting from the interest that is paid on the mortgage loans.
Who invests in Mortgage-Backed Securities?
A wide range of investors such as mutual funds, pension funds, insurance companies, and individual investors invest in Mortgage-Backed Securities for their potential to earn higher yields relative to other investments and for the risk diversification they can add to a portfolio.
What types of Mortgage-Backed Securities are there?
There are two main types of Mortgage-Backed Securities – pass-throughs and collateralized mortgage obligations (CMOs). Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors, while CMOs are structured as debts of a legal entity and offer various risk profiles to investors.
What are the risks associated with Mortgage-Backed Securities?
Like all investments, Mortgage-Backed Securities carry risks. These risks include interest rate risk, prepayment risk, extension risk, and default risk. It’s important for investors to understand these risks and potentially seek advice from financial professionals.
How are Mortgage-Backed Securities created?
Mortgage-Backed Securities are created when various financial institutions package a home loan and other types of financial products together, and sell them to investors. These packages are then traded on stock exchanges.
Related Entrepreneurship Terms
- Collateralized Mortgage Obligation (CMO)
- Principal and Interest Payments (P&I)
- Prepayment Risk
- Residential Mortgage-Backed Security (RMBS)
- Tranche
Sources for More Information
- Investopedia – Detailed finance-related topics including Mortgage-Backed Security.
- The Balance – Offers a comprehensive overview of various finance and investment terms.
- Federal Reserve – The US central bank offers a plethora of finance-related information.
- U.S. Securities and Exchange Commission – A government body that handles regulations related to securities including Mortgage-Backed Securities.
