MBS: What Are Mortgage-Backed Securities?

6-Minute Read
Published on February 5, 2020
Share:

Houses can be an expensive investment. Because of this, they’re generally funded by large mortgages with terms as long as 30 years. In the beginning, lenders would give a loan to those looking to buy a home and hold onto the loans until they were paid off. This led to a couple of problems. For starters, terms back then tended to be much shorter, around 5 years. This led to higher monthly payments, which presented a higher hurdle even if you could afford a down payment that needed to be as high as 50% at times.

The evolution of the mortgage-backed security, along with government-sponsored entities like mortgage investors Fannie Mae and Freddie Mac and governments agencies such as the FHA and VA, have helped to provide liquidity in the housing finance market. This liquidity helps stabilize the lending market and make homeownership a more attainable goal.

What Are Mortgage-Backed Securities?

Mortgage-backed securities are a type of investment backed by a homeowners’ monthly mortgage payments. The return is a percentage of all the principal and interest payments associated with that particular security, with the individual investor return based on the size of their stake in the MBS. These securities allow investors to participate in the housing finance market without having to buy and sell individual mortgages.

The first mortgage-backed security was issued by Fannie Mae in 1968. However, they didn’t come into widespread use in the financial markets until 1977 when Lewis Ranieri, a bond trader at Salomon Brothers, was looking for a way to respond to the fact that operators of local savings-and-loan banks had stopped originating as many mortgages. At the time, the long payoff period and lower interest made it hard for these banks to use that money to pay a higher interest rates on the shorter-term deposits of their clients.

Banks didn’t want to hold as many mortgages. This made it more difficult to get one, keeping a lid on the housing market. In response, Ranieri came up with the idea to create 5- and 10-year bonds funded by principal and interest payments on mortgages. Mortgage investors like Fannie Mae, Freddie Mac, the FHA and VA had already created the mechanism for MBS, but the new class allowed for people to invest in mortgages and get the return over a shorter time frame. This attracted more investors and really helped the market take off.

Mortgage-backed securities provided liquidity that ultimately made the home loan process easier. As a result, mortgage financing became more widely available. This has generally helped push prices up over time, but the amount of monthly income that borrowers were spending didn’t increase dramatically because the survival of the long-term mortgages they were used to was helped by the liquidity.

How Do Mortgage-Backed Securities Work?

Mortgage-backed securities are bought and sold on the bond market. Many investors are large mutual funds and other large institutions charged with protecting and investing people’s money. One of the major investors in MBS is actually the U.S. government. The Treasury Department began buying loads of MBS during the last financial crisis in order to lower mortgage rates and stimulate the economy. In general, bonds are considered safer assets, so when people want money to be protected, they put it in the bond market – including in mortgage-backed securities. People trade MBS with the assistance of a broker, who places orders on behalf of their clients.

Let’s take a step back for a minute and look at how a mortgage-backed security works. Let’s say you’re getting a 30-year conventional mortgage for a one-unit primary residence with a 20% down payment (80% loan-to-value ratio) and further assume that you have a 760 median FICO®Score.

Once your loan is closed, it can be sold to either Fannie Mae or Freddie Mac as a conventional loan. When Fannie Mae buys your loan, they’ll take it and put it in a pool of other mortgages with similar characteristics. The pool could include 1,000 loans or more. Once packaged, Fannie Mae will offer the MBS for trading on the bond market.

The requirements for inclusion in specific pools is dependent on individual loan characteristics and risk profiles. Every mortgage investor also has minimum standards for the loans they will buy. For example, conventional loans require a DTI of 50% or less and a minimum median FICO®Score of 620 or higher.

It’s this trading of MBS that plays a big role in determining what mortgage rates are for individuals. Investor appetites for MBS that feature your mortgage characteristics and credit profile drives bond yields up or down, which has a direct impact on mortgage rates.

Different Types Of Mortgage-Backed Securities

Now that you understand the basics of mortgage-backed security, let’s dig a little bit further into the investment mechanics. There are a couple of different types of mortgage-backed securities: pass-through and collateral mortgage obligations.

Pass-Throughs: In a pass-through, investors get a percentage of the principal and interest payments equal to their investment in the trust. It has a given maturity period, although this may be shortened if enough people prepay their mortgages before the maturity dates and there’s no more principal left to pay on.

Collateralized Mortgage Obligations: CMOs are made up of several different tranches with different maturity dates as well as different levels of risk. Investors are able to pick exactly what they want based on their risk tolerance and hope for return.

Are Mortgage-Backed Securities A Good Investment?

For a couple of reasons, mortgage-backed securities are safe investments. The likelihood of actually losing money is significantly lower than it would be if you invested in the stock market, for example. However, the investment isn’t without its downsides. Let’s run through some of this.

MBS tend to be fairly safe investments. Securities bought through Ginnie Mae (FHA, USDA and VA loans) are directly backed by the U.S. government. Fannie Mae and Freddie Mac are privatized enterprises, but because they’ve been in government conservatorship since late 2008 and have a deal to be backed in certain circumstances by the Federal Housing Finance Agency, they have a somewhat implied government guarantee. If properties are foreclosed upon, it’s the responsibility of the bond backer to make mortgage investors whole.

If you do invest in a mortgage-backed security offered by an entity without any kind of government backing, that’s a little bit riskier. If the housing market takes a downturn and people start walking away from homes on which they owe more than the homes are worth, that’s asking for trouble if enough people default. On the flip side, people will give up a lot of other things to make sure they have a roof over their head, so investing in mortgages is still fairly safe, even in this scenario. You just have to have confidence in the overall housing market.

The downside to investing in mortgages is that there’s an inverse relationship between the level of safety and the reward. You’ll gain a higher rate of growth out of a stock if it’s successful, but there is also more potential for a loss. Because the growth rate is lower for mortgage-backed securities, one thing you have to worry about is outpacing inflation. If you have investment in an MBS that paid a 4% return at the end of a 30-year term, and inflation rises at 6% over the same timeframe, your money is worth less now than when you invested it, even if you haven’t technically lost a single penny. Inflation risk is definitely something to think about.

There’s also a prepayment risk. It’s advantageous for a client to pay off the mortgage as soon as possible in order to save on interest. However, those invested in MBS don’t like prepayment because it means you’re getting less interest, which has a direct effect on the amount of return you can expect to receive.

Before considering any investment, know your comfort level and feel free to consult a financial advisor about the best options for your individual circumstances.

Summary

Mortgage-backed securities represent an investment in a pool of mortgages for which an investor is paid back in the form of principal and interest for a period up to the maturity date on the security. Mortgage-backed securities are bought and sold through a broker. A typical MBS might consist of 1,000 or more mortgages with similar financial characteristics and risk profiles.

There are two different types of mortgage-backed securities. Pass-throughs give you interest and principal payments proportional to your investment. Meanwhile, collateral mortgage obligations combine several different mortgage pools to let the investor pick a maturity date and credit rating that matches their appetite for return balanced against risk. While MBS are considered a safe investment, you do have to worry about the bond yield potentially not keeping up with inflation and the possibility for prepayment, which would mean the investor collects less interest.

Now that you know more about MBS and maybe even some of how that applies to your loan, maybe you’re ready to buy or refinance. You can apply online with Rocket Mortgage®by Quicken Loans®or give one of our Home Loan Experts a call at (800) 785-4788.

Apply for a Mortgage with Quicken Loans®

Call our Home Loans Experts at (800) 251-9080 to begin your mortgage application, or apply online to review your loan options.

Start Your Application