What are mortgage-backed securities?
What happens to your mortgage after you’ve closed on a new house or refinance your home loan? It’s a question most homeowners probably aren’t too concerned about. After all, as long as you're building equity and inching closer to owning your house outright, who cares, right?
But your mortgage’s fate — including who owns it and why they wanted to buy your home loan in the first place — keeps the lending machine running. Much of the lending industry as we know it today is built on mortgage-backed securities (MBS).
Fair warning, we’re about to delve into the wild world of bonds, investors and financial markets, so buckle up. Here’s what you need to know about the all-important MBS and what it means for the mortgage.
What is a mortgage-backed security?
This should probably come as no surprise, but money makes the world go round. Mortgage lenders don’t dish out home loans out of the goodness of their heart — you have to pay interest to compensate them for the use of their money.
But where do lenders get the money to fund home loans in the first place? Mostly, by selling mortgage-backed securities on the secondary market. For those who don’t know, the secondary market is where investors buy stocks, bonds and other financial instruments.
Mortgage-backed security definition
A mortgage-backed security is an investment instrument, in this case a security bond, consisting of consumer home loans and commercial real estate loans. After issuing home loans to borrowers, lenders often bundle multiple mortgages together into an MBS and sell it to investors, providing more capital to fund additional loans.
How mortgage-backed securities work
An MBS is what’s known as an asset-backed security. A cornerstone of investment banking, asset-backed securities typically pool together debt from different sources to turn assets that would otherwise hold no clear financial value into investment vehicles.
That debt could be basically anything: auto loans, student loans, credit card debt — you name it. In the case of an MBS, only real estate loans are included. Like all asset-backed securities, an MBS is appealing to investors because they stand to make money off both the principal and interest of the loan. Traditional bonds only deliver interest.
The nuts and bolts of mortgage-backed securities are inherently complex, but here’s a simplified breakdown of the process:
- Your lender extends you a mortgage.
- Your lender then adds your home loan to a pool of mortgages to create an MBS.
- The MBS is sold to investors on the secondary market.
- Your lender makes back the original loan amount and gains new capital to fund more home loans.
- Your monthly mortgage payments “pass through” to those investors.
From your perspective as the borrower, nothing changes. Your housing costs stay the same, your amortization schedule stays on track and you continue making payments each month. But rather than have your mortgage payments go to your original lender, that money is often directed toward investors on the secondary market. In other cases, your mortgage payment will still be made to your original lender if they retain servicing responsibilities even after selling your loan.
How do mortgage-backed securities impact mortgage lending?
Mortgage-backed securities are sometimes viewed with skepticism — if not outright distrust. Why is your lender so eager to sell off your home loan? Who are these mysterious investors profiting off of your housing costs?
The MBS ecosystem plays a vital role in today’s lending industry, however, and actually helps make it easier for more people to get the financing needed to buy a home. Let’s take a quick look back at the history of the U.S. financial system to see how mortgage-backed securities rose to prominence.
At one point in time — read: before the Great Depression — banks and other financial institutions funded mortgages using their own money. Often, those funds included the deposits and savings held by the financial institution. If you think home loan qualifications are restrictive now, just imagine how difficult it would be to get a mortgage when all the bank’s money is tied up in a select group of home loans.
This lending environment essentially made mortgages a zero-sum game for banks and borrowers. If a lender financed your home loan, then it wouldn’t have the funds available to extend a mortgage to your neighbor. As such, banks were understandably much more selective about loan applicants and simply could not afford to issue mortgages to more people.
The Great Depression led to a number of radical changes to the U.S. lending industry, including the creation of both the Federal Housing Administration and Fannie Mae. In addition to creating liquidity in the financial markets, many of these developments focused on helping more people qualify for financing and buy a home of their own.
Jump ahead 30 or so years, and we see another dramatic shift in the mortgage lending world: The government establishes additional government-sponsored enterprises, Freddie Mac and Ginnie Mae. Fannie, Freddie and Ginnie were all authorized to issue what was then known as a mortgage pass-through. By the time Fannie Mae issued its first pass-through in the early ‘80s, mortgage-backed security became the preferred term for this type of security bond.
Allowing lenders to package and sell mortgages in this fashion has given them far more financial flexibility and liquidity. And that, in turn, has enabled mortgage lenders to extend more home loans because they can both recoup their initial investment and earn profit more quickly from MBS transactions. In short: Thanks to the MBS market, mortgage lending is no longer a zero-sum game for borrowers.
Does MBS pricing affect mortgage rates?
While some folks may hold onto the common misconception that the Federal Reserve sets interest rates, the truth is that mortgage-backed securities impact rates more than the Fed ever has.
Like any other financial market, MBS prices go up when demand is high. And when lenders are in a position to charge more to investors for an MBS, they may be flexible when it comes to setting interest rates.
hOW mbs PRICES IMPACT INTEREST RATES
In general, higher demand for mortgage-backed securities is a good thing for borrowers. You’re more likely to get a lower interest rate under those conditions. Of course, the reverse is true as well: When MBS prices drop, mortgage rates often go up.
Are mortgage-backed securities good or bad?
Mortgage-backed securities have gained something of a bad reputation over the last decade or so, due to their role in the 2008 financial crisis. The prevailing narrative often casts MBS trading as one of — if not the — primary causes of the Great Recession. Although risky trading behavior from both lenders and investors certainly played a part, there were many factors that needed to come together to precipitate such a massive economic disaster on a global scale.
In 2018, University of Chicago researchers found that the role of MBS in that crisis may actually be a bit overstated. For one thing, their analysis of the MBS market concluded that roughly 65% of mortgage-backed securities lost less than 5% of their value.
Whatever amount of blame can be assigned to MBS traders for that particular event, the fundamentals of MBS remain sound. There are certainly many benefits that come from mortgage-backed securities — most notably, making it possible for more people to receive home loans. Weighing the positives and negatives of MBS, one could argue that benefit alone, being as monumental as it is, outweighs whatever potential drawbacks this system presents.
How mortgage-backed securities pricing works
Mortgage-backed securities are usually priced in such a way that both parties — the lender and investor — benefit from the transaction. To make the numbers work, the individual mortgages that make up an MBS are sold at a price that’s higher than the loan amount but less than the total amount due on the mortgage.
Let’s say your lender extends you a $200,000 mortgage that will yield another $50,000 in interest over the life of the loan. At this point, the lender has invested $200,000 with the potential to make $50,000 if the loan is repaid in full. Depending on the length of the loan, it could take 15 to 30 years to realize the full value of the mortgage — in this case, $250,000.
Now, your lender turns around and sells your mortgage as part of an MBS. It needs to be priced higher than $200,000 to make a profit, while coming in under the loan’s $250,000 maximum potential value. Otherwise, who would buy it?
Splitting the difference, the lender settles on a $225,000 price point and sells the mortgage to investors as part of an MBS. By doing so, both sides come out ahead:
- Your lender gets back its original $200,000 investment, plus $25,000.
- The investors stand to make $25,000 (plus whatever potential profit the other bundled mortgages offer) over the long run.
- Alternatively, the investors could sell the asset off themselves before the security fully matures.*
Types of mortgage-backed securities you should know
For all of the complexity that an MBS entails, there are only two common types you really need to familiarize yourself with:
- Collateralized mortgage obligation
A pass-through MBS functions in roughly the way we’ve described above. That is, it’s structured so the mortgage’s principal and interest payments are collected and then sent directly to the investors. In many — but not all — cases, pass-through securities will comprise the same type of mortgage — for instance, 30-year fixed rate loans. They may even exclusively use mortgages with the same interest rate or property type. Every pass-through MBS has a maturity of 5, 15 or 30 years, but the actual life of the security could wind up being less, depending on the specific pool of mortgages it contains.
Collateralized mortgage obligation
A collateralized mortgage obligation — usually referred to as a “CMO” — is a bit more complex than a pass-through. While a pass-through uses a single bundle of mortgages, a CMO will contain multiple pools of securities called tranches. Those tranches could vary significantly in terms of loan type, interest rate, maturity period, yield projection and level of risk, creating a much more complicated financial picture for investors.
To help clarify the risk-reward potential with these types of investments, every tranche is given a credit rating. Depending on what investment strategy one uses — long-term holds vs. quick wins, for instance — investors may seek out CMOs with one credit rating over another.
Lenders often bundle consumer and commercial mortgages into mortgage-backed securities, which are then sold on the secondary market. It’s not just private lenders getting in on this action, either: Ginnie Mae, Fannie Mae and Freddie Mac may all issue MBS investment instruments.
Mortgage-backed securities play an enormous role in the lending industry, enabling mortgage providers to turn a profit much more quickly than they otherwise would over the life of a home loan. Despite the cloud of negativity that tends to follow the MBS market, mortgage-backed securities are frequently a net positive for borrowers. MBS investments lead to more lending activity, which means more people could receive the financing needed to buy a house.
*All sample loan scenarios are not advertised loan options and are provided only for illustration purposes and are not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. Guaranteed Rate, Inc. cannot predict where rates will be in the future.
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