A mortgage-backed certificate (MBC) is a type of asset-backed security (ABS) that represents claims on the principal and interest payments made by borrowers on a pool of underlying mortgage loans. These securities are created by the process of securitization, in which mortgage loans are bundled together and sold as an investment product. Investors in mortgage-backed certificates receive periodic payments, which are derived from the cash flows generated by the mortgages in the pool.
How Mortgage-Backed Certificates Work
-
Mortgage Pooling: Financial institutions pool together a large number of individual mortgages that they have issued. These mortgages share similar characteristics in terms of interest rates, maturity dates, and credit quality.
-
Securitization: The pooled mortgages are then packaged into a special purpose vehicle (SPV) or trust that owns the pool. This entity issues mortgage-backed certificates representing claims on the cash flows from the mortgage pool.
-
Distribution of Payments: Payments of interest and principal from the borrowers of the underlying mortgages are collected by the service of the SPV or trust. These payments are then distributed to investors in the mortgage-backed certificates according to the terms of the securitization agreement.
-
Tranche Structure: Mortgage-backed certificates often come in different classes or tranches, each with its risk and return profile. Senior tranches generally receive payment first and have the lowest risk, while junior tranches absorb any losses first.
Types of Mortgage-Backed Certificates
Pass-Through Certificates
These are the most common type of mortgage-backed certificates where investors receive their proportionate share of all principal and interest payments made by the borrowers.
Example: If you own 1% of a pass-through security, you receive 1% of the principal and interest payments from the pool.
Collateralized Mortgage Obligations (CMOs)
CMOs are more complex and involve multiple tranches that distribute cash flow based on a predetermined prioritization.
Example: A CMO might have different tranches such as A, B, and C, where tranche A receives cash flows before tranche B, and tranche B before tranche C.
Historical Context
Mortgage-backed certificates and the development of the secondary mortgage market have been crucial in maintaining liquidity in the housing market. The secondary mortgage market allows financial institutions to sell the mortgage-backed securities they have issued, thereby freeing up capital to offer more home loans. Key developments include:
- 1970s: The Government National Mortgage Association (Ginnie Mae) issued the first mortgage-backed securities.
- 1980s: The market evolved with the creation of private-label securities and the notable role of Freddie Mac and Fannie Mae.
Applicability and Uses
MBCs are widely used by institutional investors such as pension funds, insurance companies, and mutual funds to achieve portfolio diversification and targeted income. They also benefit from the relatively predictable cash flows associated with mortgage payments.
Comparisons and Related Terms
- Mortgage-Backed Security (MBS): A broader term that includes MBCs and other mortgage-related financial instruments.
- Secondary Mortgage Market: The marketplace where MBCs and other related securities are traded after their initial issuance.
FAQs
Q1: What is the difference between mortgage-backed certificates and mortgage bonds? A: Mortgage-backed certificates are a type of MBS that usually represent a direct claim on the cash flows from pooled mortgages, whereas mortgage bonds are secured by mortgages and represent a debt obligation of the issuer.
Q2: How do changes in interest rates affect mortgage-backed certificates? A: Changes in interest rates can impact the prepayment rates of the underlying mortgages, which in turn affects the cash flows to investors. Rising interest rates typically reduce prepayment rates, while falling rates can lead to higher prepayments.
Q3: What are the risks associated with mortgage-backed certificates? A: The primary risks include interest rate risk, credit risk, and prepayment risk. Each of these can affect the timing and amount of payments received by investors.
References
- Fabozzi, Frank J. Handbook of Mortgage-Backed Securities. 7th Edition. Oxford University Press, 2016.
- Ginnie Mae. “Ginnie Mae Mortgage-Backed Securities.” Accessed August 2024. Ginnie Mae.
Summary
Mortgage-backed certificates play a vital role in the financial markets by allowing investors to gain exposure to the residential mortgage market’s cash flows. By converting bundles of mortgages into tradable securities, these instruments help maintain the availability of mortgage money for home financing and offer a balanced investment vehicle for various financial entities.
