What Are Mortgage-Backed Securities (MBS)?

Many homeowners are surprised to learn that lenders can sell their mortgages. One of the most common ways this happens is by bundling many mortgages together into a package for investors. This bundle of mortgages is called a mortgage-backed security (MBS).

With MBS, investors benefit from the mortgage business without needing to buy or sell home loans themselves. We’ll help you learn more about what mortgage-backed securities are and how these investments work. As with any investment, we recommend reaching out to a financial advisor to build the best investment strategy for you.

What Is A Mortgage-Backed Security?

A mortgage-backed security is a type of bond investors can purchase through the bond market. You can invest as an individual, but large companies and commercial banks are some of the biggest buyers. The U.S. government can also invest in MBS.

Each mortgage-backed security is made up of and secured by hundreds or thousands of underlying mortgages. As individual borrowers make their principal and interest payments each month, that money goes to the investors, creating consistent cash flow. By pooling so many mortgages, there’s less investment risk with MBS if someone defaults on their mortgage.

How Do Mortgage-Backed Securities Work?

The basic idea is that mortgage-backed securities provide liquidity to the real estate market while providing reliable returns for investors.

The process begins with individual borrowers taking out mortgage loans from lenders. To clear credit for new borrowers and to turn an immediate profit, most lenders will look to sell the mortgage loan on the secondary mortgage market.

Nothing should change for the borrower when their loan gets sold. They’ll still continue to make their principal and interest payments each month. In fact, it’s common for mortgages to be resold multiple times over the loan term.

Mortgage Aggregation

When lenders look to sell the mortgages they’ve issued, government-backed Fannie Mae and Freddie Mac are two of the biggest buyers. However, they can only purchase loans that meet certain criteria, known as conventional loans.

Ginnie Mae is also government-backed and purchases mortgages, but their focus is on making homeownership more accessible. That means they can purchase loans with different underwriting requirements than Fannie Mae and Freddie Mac.

Fannie Mae, Freddie Mac and Ginnie Mae buy mortgages from all types of lenders, including online lenders, banks and credit unions. They then bundle hundreds or thousands of these loans into mortgage-backed securities. Because of this, they’re sometimes referred to as loan aggregators.

MBS issued from Fannie Mae, Freddie Mac or Ginnie Mae are called agency MBS, and they carry a government-backed credit guarantee.

Other companies can and do aggregate loans to create mortgage-backed securities called nonagency MBS. They’re not guaranteed by the government.

The Bond Market

Loan aggregators sell MBS on the bond market. Banks and the U.S. government are two of the biggest investor classes, but individuals can also invest. Exchange-traded funds and mutual funds are the two primary ways to invest as an individual.

Types Of Mortgage-Backed Securities

There are two main types of mortgage-backed securities: pass-throughs and collateral mortgage obligations (CMO). Let’s look at an overview of both.

Pass-Throughs

A mortgage pass-through is the most basic MBS form. When homeowners make their monthly mortgage payments, the principal and interest received are passed on to the investors. The payment individual investors receive is proportional to their investment.

This means investors receive monthly payments from interest and a partial return on the principal. A mortgage pass-through doesn’t change any aspect of homeowners’ payments.

Collateral Mortgage Obligations

Collateralized mortgage obligations (CMOs) are more complex than mortgage pass-throughs. In a CMO, the mortgages are organized into tranches, or segments, based on rates, risk, and maturity dates. The different tranches are given credit ratings, which determine the mortgage-backed securities rates.

History Of Mortgage-Backed Securities

The goal behind MBS was to allow lenders to sell off mortgages so they’d have more money available to lend to consumers. The addition of mortgage-backed securities paved the way for financial institutions other than banks to enter the mortgage business. Creating bonds backed by principal and interest payments on mortgages helped them take off with a new class of investors.

The problem was that while banks and financial institutions were regulated, MBS were not. To remain competitive, many lenders began lowering their standards for who they’d give mortgages to. This contributed to the financial crisis of 2008. After the housing crisis subsided, the government tightened regulations on the financial industry.

MBS are now regulated, and investors must receive certain information and disclosures. The financial crisis also emphasized the importance of filling mortgage-backed securities with sound assets.

The Pros And Cons Of Investing In Mortgage-Backed Securities

Investing in MBS comes with advantages and disadvantages, which will vary depending on the security and entity you invest in.

Before investing in mortgage-backed securities, you should ensure the investment asset fits your specific needs and risk levels. Here’s an overview of some pros and cons of investing in these securities:

Pros Of Mortgage-Backed Securities

• Safe investment: MBS tend to be fairly safe investments since they’re usually fixed-rate loans with prepayment penalties.
• Attractive yields: MBS come with yields that tend to be higher than what you’d get by investing in U.S. government bonds. Securities with higher coupons offer the greatest potential rewards.
• Minimal credit risk: The credit risk is considered minimal for MBS backed by government-sponsored entities.

Cons Of Mortgage-Backed Securities

• Prepayment risk: There’s always a risk that borrowers will make higher-than-expected monthly payments or pay their mortgage off early. They could also pay off the mortgage by refinancing, which is more common when interest rates go down.
• Credit and default risk: If borrowers fail to make their interest and principal payments, investors will experience losses. The risk level depends on the market’s strength and when the loan was issued.
• Extension risk: There’s the risk that borrowers will decide not to make prepayments on their mortgages as initially expected. When this happens, the security may come with a lower-than-expected coupon since the principal is lower. This typically happens when Treasury rates begin going up.

Mortgage-Backed Securities FAQs

Here are some common questions that come up when discussing MBS.

Is there any risk to me as a homeowner if my home loan is bundled into a mortgage-backed security and sold?

Your loan terms should stay the same whether the lender keeps your mortgage or it gets sold and bundled as part of a mortgage-backed security. If you fail to make payments on your loan, you risk foreclosure regardless of who currently owns your loan.

How do I invest in mortgage-backed securities?

Exchange-traded funds and mutual funds are the primary ways to invest in MBS as an individual. You can either purchase a fund through the company that created it or open your own brokerage account. (This will also allow you to purchase stocks.) Opening a brokerage account is similar to opening a bank account.

Do MBS affect mortgage rates?

Yes, the MBS market does impact mortgage rates. When the price of MBS are higher, mortgage rates tend to decrease. When the cost of MBS is low, mortgage rates tend to increase. MBS also increase the liquidity in the marketplace, allowing for more mortgages to be issued.

Does the Federal Reserve buy mortgage-backed securities?

Yes. They’re one of the largest investors in MBS. Recently, however, the Fed has made the decision to slowly exit the MBS market by halting its continual purchasing of bonds.

The purchase of these MBS helped keep mortgage rates low, which provided an economic boost because housing accounts for a significant share of the money pumped into the economy. However, cheaper financing meant higher home prices – something that is, at this point, actually detrimental. By halting its purchase of MBS, the Fed hopes to combat inflation.

The Bottom Line

Mortgage-backed securities have evolved quite a bit over the years. Thanks to increased regulation of the financial industry, MBS are a much safer investment today than they were in the past. However, no investment is risk-free. Before investing in any asset, you should always familiarize yourself with the potential risks and rewards.

If you’re ready to become a homeowner, start the mortgage process today with our friends at Rocket Mortgage^®.