A Mortgage-backed Security (MBS) is a type of asset-backed security that is secured by a collection, or pool, of mortgages. These securities are created by pooling multiple mortgage loans and selling shares or participation certificates in the pool to investors. The mortgage payments from the borrowers are then passed through to MBS holders, typically in the form of periodic payments.
Types of Mortgage-backed Securities
Pass-Through Securities
Pass-through MBSs are the simplest form of mortgage-backed securities. They involve passing mortgage payments from the lender (through servicers) to the investors of the MBS. Each investor receives a pro-rata share of the cash flows from the underlying mortgage pool.
Collateralized Mortgage Obligations (CMOs)
CMOs are complex MBS products that divide the pool of mortgage loans into tranches, each with different maturity dates and levels of risk. This structure is designed to address different investors’ risk appetites and investment horizons.
Special Considerations
Credit Risk
The risk that borrowers will default on their mortgage payments. This risk can vary greatly based on the credit quality of the underlying borrowers.
Prepayment Risk
The risk that the underlying mortgages will be prepaid due to refinancing or sale of the property, which can affect the returns to MBS investors.
Interest Rate Risk
The risk that changes in interest rates will affect the value of the MBS. Rising interest rates can lead to slower prepayments, prolonging the duration of the MBS, while falling interest rates can lead to higher prepayments.
Historical Context
The Origins of MBS
The concept of mortgage-backed securities can be traced back to the United States in the 1960s when the Government National Mortgage Association (Ginnie Mae) created the first MBS. This move was intended to provide liquidity to the mortgage market and support homeownership.
The 2008 Financial Crisis
MBS played a significant role in the 2008 financial crisis. The creation and spread of subprime mortgage-backed securities contributed to the housing market collapse and the subsequent financial implosion, leading to global economic turmoil.
Applicability
Investment Portfolio Diversification
MBS can help diversify an investment portfolio since they typically have low correlations with other asset classes, such as stocks and corporate bonds.
Income Generation
Due to the periodic payments from underlying mortgage loans, MBS are often used by investors looking for regular income.
Comparisons
MBS vs. ABS (Asset-backed Securities)
While both MBS and ABS are types of asset-backed securities, MBS are specifically backed by mortgage loans, whereas ABS can be backed by a variety of other loans such as auto loans, credit card receivables, and personal loans.
Related Terms
- Tranche: A portion or slice of an MBS or CMO, each with different risk levels, interest rates, and maturity dates.
- Securitization: The process of pooling various types of contractual debt such as mortgages, car loans, or credit card debt obligations, and selling them as securities to investors.
FAQs
What are the benefits of investing in MBS?
Are MBS safe investments?
How do interest rates affect MBS?
References
- “Mortgage-backed Security (MBS) Definition” by Investopedia
- “The 2008 Financial Crisis: Causes and Consequences” by the Federal Reserve Bank
- “Understanding Securitization” by the Securities Industry and Financial Markets Association (SIFMA)
Summary
Mortgage-backed Securities (MBS) are a fundamental financial instrument that has played a crucial role in real estate financing and investment markets. Understanding the mechanics, risks, and historical context of MBS can provide investors with the insights needed to make informed decisions and assess the potential impacts on broader financial markets. By securing investments with pooled mortgage loans, MBS offer a structured financial product aimed at balancing risk and return.
