Mortgage-Backed Securities

by Ellis Reilly

“A mortgage-backed security or MBS is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.”[1] This simply means that a MBS is a type of security (like a bond) that is backed by the payments that people or businesses make to pay off their mortgages. For example John goes to a bank to take out a $200,000 mortgage to buy his house. The bank gives him the $200,000 and John pays the bank monthly installments with interest until he has paid off the $200,000. From here Fannie Mae and Freddie Mac would buy John’s mortgage (and many others) from the bank so that banks could lend out more mortgages allowing more Americans to buy homes. Fannie and Freddie would then sell these mortgages to investment banks as mortgage-backed securities so that they (Frannie and Freddie) could get more money to buy more mortgages from more commercial banks. So now when John makes his monthly payment for his mortgage the money goes to the investment bank which is holding John’s mortgage. Normally when MBSs are created and sold they are made up of many different mortgages (for example: 20% of John’s mortgage, 10% of Sally’s mortgage, etc.) which makes the MBSs less of a risk for investment banks (that way if one person does not pay their mortgage the investment bank still gets money from the other mortgages that make up their MBS).
There are many risks to holding MBSs however. MBSs are not backed by the Federal government (which is a reliable government), but by common people. The MBS’s value is not certain either. The only way the owner of the MBS receives their money is if the people who took out the mortgages pay them. When people are unable to pay their mortgage the investors get no money and are stuck with a worthless security. MBSs get more risky when it is made up of mortgages of people who have trouble paying them or are not qualified to take out large mortgages. Other problems are: people can refinance their mortgage at a lower rate which makes the MBS worth less; if a person begins to pay off their mortgage early the mortgage is gaining less interest which also can potentially lower the value of the MBS.

Mortgage-backed security sub-types include:[2]
-Pass-through mortgage-backed security is essentially a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
-Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property
-Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property
-Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
-Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
-Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
-Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
[1] En.wikipedia.org/wiki/mortgage_backed_securities
[2] En.wikipedia.org/wiki/mortgage_backed_securities