Mortgage-backed securities (MBS) are a pool of mortgages purchased from the banks that issued them. These mortgages are then sold to investors. While you’d need to be a sophisticated investor to buy into these mortgages, mortgage-based securities are geared toward investors looking to profit from the mortgage business without the need to purchase, sell, or rent properties themselves.
Here is how they work — and what you need to know about the potential risks of investing.
What are mortgage-backed securities?
When someone buys a home, they typically take out a home loan from a bank or a credit union, aka the lending bank. Larger banks or financial institutions may now buy these mortgages from the issuing banks and group or bundle them to form a financial instrument called a mortgage-backed security.
Mortgage-backed securities are asset-backed securities that get their value from the assets contained within them, in this case, the collection of home loans or mortgages. These securities can be traded in the secondary market. Typically, mortgage-backed securities issuers are government agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae, as well as central and private investment banks. MBSs are bought by individual investors, corporations, and institutional investors.
The importance of MBS in the U.S. economy
You may have heard of mortgage-backed securities in the context of the global financial crisis and subprime mortgage crisis in 2008 and 2009 and the $700 billion bailout by the U.S. Treasury. The Federal Reserve bought MBS at the time to ease the credit crunch.
But MBS aren’t new. They were issued for the first time in 1970 after the Housing and Urban Development Act in 1968 created Ginnie Mae, the Government National Mortgage Association. The securities were backed by the U.S. government and offered as a way of bringing in extra funds and expanding affordable housing. Federal housing agencies Fannie Mae and Freddie Mac also issued MBSs soon after. As of 2023, financial institutions had issued $991.3 billion in mortgage-backed securities.
How do mortgage-backed securities work?
To understand how mortgage-backed securities work, it’s helpful to understand the life cycle of a home loan and how it becomes a security.
Step 1: The borrower takes out a mortgage
When you purchase a home, unless you’re buying with cash, you’ll take out a mortgage with a financial institution, typically a bank or a credit union. In exchange for the loan, the issuing bank charges interest. At this point, the bank can do nothing and keep earning interest through the payments until you eventually pay off the loan — or sell the loan.
Step 2: The bank sells the loan
The bank could choose to pass the loan on to another bigger financial institution or government agency, let’s say, Fannie Mae. The bank will then continue to close mortgages with individual borrowers and sell the loans to Fannie Mae. What this does is give the bank both liquidity as well as take away the risk. While Fannie Mae now owns the principal and interest on the mortgages, the bank still earns money from origination and other fees but is not at risk if you default. Plus, with the money now available from the sale of the loan, it can service new individual borrowers. Banks can bundle up thousands of these mortgage loans and sell them to financial institutions or federal agencies such as Fannie Mae.
Step 3: The loans are bundled and sold
Fannie Mae now sells these mortgage-based securities to the secondary market, where private or institutional investors can pick them up. A government-sponsored enterprise (GSE) or a private financial company must issue an MBS. Fannie Mae Issues both mortgage-backed securities and standard corporate coupon bonds.
Types of mortgage-backed securities
There are two main types of mortgage-backed securities:
1. Pass-through securities
This is the simplest type of mortgage-backed security. A mortgage pass-through security is structured as a trust that receives the principal and interest payments from borrowers and then passes them to the investors. These mortgage-backed securities have a stated maturity term, typically 15 or 30 years, though their lifespan can be shorter. For investors, income from pass-through securities comes in three ways:
- Partial principal payments on the loan
- Interest payments
- Prepaid principal payments
2. Collateralized mortgage obligation (CMO)
Collateralized Mortgage Obligations, or CMOs, are much more complex than pass-through securities. With a CMO, the pass-through cash flow is divided into three different bond classes or tranches based on rates, risk, and maturity dates. These three tranches are then given credit ratings, which will determine the mortgage-backed securities rate. The riskiest tranches are given the highest interest rates, and those with the lowest interest rates are generally more secure.
A CMO gives investors payment predictability by distributing the principal payments among various classes and creating a predictable schedule for principal pay-downs for residential mortgage-backed securities and commercial MBSs.
Advantages of MBS
Investing in MBSs can be beneficial for investors in a variety of ways. These include:
Mortgage-based securities pay a fixed rate, which is typically higher than government bonds. CMOs offer even more significant returns but with higher risk. Further, mortgage-based securities offer monthly payouts, which means there’s cash flow, which is not the case with bonds, which offer bondholders a single lump sum payout at maturity.
Since MBSs are typically fixed-rate mortgages with prepayment penalties, they’re considered safe investments. The federal government may also guarantee an MBS, in which case a borrower’s default would not be an investor’s loss.
Lower credit risk
A mortgage-based security is only as good as the underlying mortgages held inside it, and so the creditworthiness of an MBS is impacted by the number of home buyers in it who default on their loans. The same is true for commercial mortgages. The credit risk is considered minimal for mortgages backed by federal agencies or government-sponsored enterprises. Therefore, these MBSs have higher credit quality.
Risks of MBS
There are also a few risks that come with investing in mortgage-backed securities. These include:
An investor makes money on a mortgage-backed security through the interest earned on the loan. When a borrower pays off a mortgage early, either through refinancing or early payment, it means lost money for the investor and reduces the dependable cash flow. Since a refinance or prepayment is unpredictable, it can reduce investors’ expected returns from fixed-income securities.
Interest rates can impact price
Mortgage-based securities pose a higher interest rate risk since the price of the security can drop when interest rates for mortgages rise. When interest rates rise, fewer people will take out mortgages, and this will cause the overall mortgage market to decline, including the price of the MBS.
Payment default risk
If a borrower fails to make monthly mortgage payments or meet their debt obligations, the loan could default, and the investor, not the bank, assumes this risk. If federal agencies back the mortgages, the investor may be covered if timely payments aren’t made and repayment is affected.
The bottom line
If you’re a sophisticated real estate investor, mortgage-backed securities might be the perfect way to take advantage of the mortgage business without needing to get involved in the day-to-day purchase or management of properties.
For investors who prefer a more hands-off form of investing, REITS are also an excellent option. Arrived properties are structured as REITs or real estate investment trusts, which means that when you invest in a rental property through Arrived, not only are you able to take advantage of the lower barrier to entry, but you may also get a completely hands-off way to make passive income through rental properties.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The views reflected in the commentary are subject to change at any time without notice. View Arrived’s disclaimers.