Mortgage-Backed Securities (MBS): What Are They And Should You Invest In Them?
If you don’t follow the mortgage market every day, it may seem like the rates change out of nowhere of their own accord. However, in addition to personal financial factors, there’s one type of financial instrument above all that determines market movements in mortgage rates. Today, we’ll discuss the ins and outs of mortgage-backed securities.
What Are Mortgage-Backed Securities (MBS)?
Mortgage-backed securities (MBS) are investments secured by a group of mortgages. They are categorized based on security issuer, repayment terms and interest rates.
The interest rate you get bucketed into and the price you pay for it is based on a combination of market appetite for that particular MBS and your personal financial factors like credit score, loan-to-value ratio and the way you occupy the property.
The return on an MBS 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.
When an individual originates a mortgage, the vast majority of the time, it’s sold shortly thereafter to a mortgage investor, which provides immediate capital to the lender so they can make more loans without having to wait years for the full pay off.
The initial interaction between lenders and originators is referred to as the primary mortgage market. Interactions between lenders and mortgage investors take place on the secondary market.
The biggest investors are Fannie Mae and Freddie Mac, which buy conforming conventional mortgages. Ginnie Mae buys government loans like those from the FHA and VA. Regardless of who the investor is, they’ll package loans with similar attributes together (credit score, down payment/equity amount, primary or vacation home, etc.) into an MBS.
These MBS are then sold to investors on the bond market with the yield on these securities playing a key role in determining mortgage rates.
What Are The Current MBS Rates?
The underlying rates for MBS change daily just as mortgage rates to, so it’s impossible to say what the rate is at any given moment in an article. Adding to the complication, they vary heavily depending on who the mortgage investor is.
However, there is some shorthand you can use to look up the prices of MBS. Most of the trading right now is happening on 5.5% – 6% coupons. The prices on these bonds are always quoted relative to $100. If you buy a 5.5% bond for $100, you can expect a 5.5% rate of return at the end of the term.
When the price on any given day is higher or lower than $100, you’ll earn slightly more or slightly less than the 5.5% return. We’ll have a little more later on, but this movement off the 100 (or par) rate is what moves mortgage rates up and down.
There are many places you can track MBS prices. MBS from Fannie Mae or Freddie Mac are typically listed as UMBS while government bonds from Ginnie Mae are listed as GNMA.
When the underlying mortgages are based on a 30-year term, the next thing listed will be the coupon rate (for example, UMBS 5.5). When the term is different, that’s listed between the bond type and the rate (UMBS-15 5.0). So in that example, it’s a 15-year term with a 5% coupon rate.
How Do Mortgage-Backed Securities Work?
Lenders, like Rocket Mortgage®, and mortgage investors, like Fannie Mae, serve as intermediaries between consumers and the bond market investors who will ultimately determine what interest rates are for a given mortgage. Let’s go a bit deeper on how that works.
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 – including mortgage-backed securities – are considered safer assets, so when people want money to be protected, they put it in the bond market.
There’s an interplay between stocks and bonds. When people are feeling better about the economy, they tend to invest in stocks because of the potential for higher returns. If people are more risk-averse, money goes back into bonds and rates fall because the yield doesn’t have to be as high to attract investors.
Additionally, the investor has choices of other bonds besides MBS as well, so appetite within and outside of the bond market influences rates.
People trade MBS with the assistance of a broker, who places orders on behalf of their clients. MBS can be bought through a physical brokerage or purchased online.
Mortgage rates are about a mix of bond market demand and your personal qualifying factors. That’s a bit hard to wrap your head around without an example, so let’s give this a shot.
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 usually require a DTI of 50% or less and a minimum median FICO® Score of 620 or higher.
This determines the mortgage-backed security you would be placed into based on coupon rate. So how does the market factor into this? We wrote a second ago about how to read bond prices.
Depending on the way investors are feeling on any given day, they might be willing to pay more or less than 100. When prices are higher, investors earn less return and rates are lower. If investors are more bullish on the economy, they’d be willing to pay less for bonds relative to other investments. If that’s the case, the price goes down and mortgage rates go up.
Types Of MBS
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 collateralized mortgage obligations.
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.
For an investor, you don’t want mortgages prepaid in high numbers because it means you earn less interest.
Collateralized Mortgage Obligations (CMO)
A collateralized mortgage obligation (CMO) is a different type of MBS where mortgages have different maturity dates and levels of risk. These are separated into tranches, basically a fancy word for different risk tolerance levels, an investor can choose from.
There are a couple of different advantages to this. Having different maturity dates gives an income stream over all different time periods, which helps with prepayment risk not being as high. Additionally choosing the level of risk you’re comfortable with can help you also gain a higher rate of return.
Investing In Mortgage-Backed Securities: The Pros And Cons
There are both upsides and downsides of investing in MBS. Let’s use the next couple of sections to touch on them.
The Pros Of MBS
- MBS can be a relatively safe investment. Even if people get into financial trouble, they tend to prioritize their house payment. Moreover, some who offer these investments guarantee the rate of return even in the event of foreclosure.
- Pick yield based on risk tolerance. You can get a higher or lower yield by looking at the prices you’re willing to pay and the types of mortgages underlying the MBS. You can find ones based on fixed or adjustable rates with various terms.
The Cons Of MBS
- Prepayment risks are real. If too many people pay their mortgage prior to the scheduled expiration of the term, you will end up earning less interest than you would expect based on the coupon and the term of the bond.
- The return may not always keep up with inflation. Bonds are generally low risk investments, but that can also mean a low return. If inflation is high enough and bond rates are low enough, you could end up with less money in terms of real spending power.
The Bottom Line
Mortgage-backed securities are financial instruments backed by the monthly mortgage payments of homeowners. If you’re considering investing in MBS, you should make sure you have a thorough understanding of how cash flow would work and interest rate you’d be getting along with the risk factors. For more info, check out our article on agency MBS.