What Are Mortgage-Backed Securities (MBS)?

What Are Mortgage-Backed Securities (MBS)?

Mortgage-backed securities (MBS) are investments like bonds, each consisting of a bundle of home loans and other real estate debt bought from the banks that issued them. They represent claims on the cash flows from pooled home loans, offering you periodic income similar to bond payments. The MBS market has evolved a lot since the 2007-2008 financial crisis, and it plays a crucial role in today's financial system. I'll explain their structure, benefits, and risks so you can decide if MBS fit into your investment strategy. As an investor in MBS, you receive periodic payments like bond coupon payments.

The MBS market changed significantly after the crisis caused by the collapse of subprime mortgages and complex MBS derivatives. Today, it's still a major part of the global financial system, with new regulations and more scrutiny from investors and policymakers. Over three in five U.S. mortgages are repackaged as MBS by total value. As investments in them grow again to pre-crisis levels, you might wonder if the next recession could trigger mortgage defaults that havoc the world economy. In what follows, I'll take you through what these investments are, why they exist, and their place in the 2020s markets. Then you'll be better equipped to decide if they belong in your portfolio.

Key Takeaways

Mortgage-backed securities (MBS) are investments backed by pools of mortgages and offer periodic payments similar to bond coupon payments. Agency MBS are considered the highest credit quality due to backing by government-sponsored enterprises, while non-agency MBS carry higher risk and potentially higher yields. MBS were central to the financial crisis of 2007-2008 due to their links to subprime mortgages, leading to significant economic repercussions. MBS provide a stream of income to investors but are sensitive to interest rate changes and prepayment risks, impacting their value. The U.S. MBS market remains substantial, with agency MBS considered less risky due to government guarantees, attracting investors seeking stable fixed-income returns.

How Mortgage-Backed Securities (MBS) Work

MBS are asset-backed securities formed by pooling together mortgages. When you buy a mortgage-backed security, you're essentially lending money to homebuyers. You can buy and sell an MBS through a broker, and the minimum investment varies between issuers. As we saw in the subprime mortgage meltdown of 2007 to 2008, an MBS is only as sound as the mortgages that back it up. In the 2020s, most MBS have the backing of the U.S. government; these are called agency MBS.

To be sold on the markets today, an MBS must be issued by a GSE or a private financial company, and it must have received one of the top two ratings from an accredited credit rating agency. Non-agency MBS are issued by private financial institutions and are not guaranteed. Instead, securities are grouped by seniority and sold to investors with different appetites for risk. Remember, mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth.

The Formation Process of Mortgage-Backed Securities

The best way to understand MBS is to see how they are formed. Let me walk you through the steps. First, origination: A financial institution, such as a bank, provides mortgages to homebuyers, secured by the properties being bought. Then, pooling: The bank pools many of these mortgage loans with similar characteristics like interest rates and maturity dates. Next, securitization: The pooled mortgages are sold to a trust, GSE, or private financial institution, which structures them into MBS.

After that, issuance: The MBS are issued and sold to investors, backed by the mortgage loans in the pool. Servicing comes next: A mortgage servicer collects monthly payments from borrowers and distributes these to MBS investors. Finally, investment: You buy MBS and receive periodic interest and principal repayments.

Key Types of Mortgage-Backed Securities Explained

There are two broadest types of MBS: pass-throughs and collateralized mortgage obligations (CMOs). Pass-throughs are structured as trusts where mortgage payments are collected and passed to investors, typically with stated maturities of five, 15, or 30 years. The life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that make up the pass-through. CMOs consist of multiple pools of securities known as slices or tranches, given credit ratings that determine the rates returned to investors. Tranches within an MBS can have different credit risk profiles.

The Evolution of Mortgage-Backed Securities

Mortgage-backed securities were introduced after the passage of the Housing and Urban Development Act in 1968, which created Ginnie Mae, separating it from Fannie Mae. This new entity allowed banks to sell their mortgages to third parties, giving them more capital to lend out and originate new loans. This made it possible for institutional funds to buy up and package many loans into an MBS. Ginnie Mae introduced the first mortgage-backed securities for the retail housing market in 1970, and the first private MBS was introduced by Bank of America in 1977.

Impact of Mortgage-Backed Securities on the 2007-2008 Financial Crisis

Mortgage-backed securities played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth, bringing down Lehman Brothers and roiling world financial markets. In retrospect, it seems inevitable that the rapid increase in home prices and growing demand for MBS encouraged banks to lower lending standards and drove consumers to jump into the market at any cost. That was the beginning of the subprime MBS. With Freddie Mac and Fannie Mae supporting the mortgage market, the quality of all MBS declined, and their ratings became meaningless. Then, in 2006, housing prices peaked.

Subprime borrowers started to default, failing to repay loans, and the housing market began its prolonged collapse. More people walked away from their mortgages because their homes were worth less than their loans. Even conventional mortgages underpinning the MBS market declined in value. The avalanche of nonpayments meant many MBS and CDOs based on pools of mortgages were vastly overvalued. Losses grew as investors and banks struggled to sell bad MBS investments. Credit tightened, causing many banks and institutions to teeter on insolvency. Lending was disrupted to the point the entire economy risked collapse.

The U.S. Congress authorized a $700 billion bailout to ease the credit crunch. The Federal Reserve bought $4.5 trillion in MBS over several years, and TARP injected capital into banks. Measures included almost $250 billion to stabilize banking, $27 billion for credit markets, $80 billion for the auto industry, almost $70 billion for AIG, and $46 billion to help families avoid foreclosure. TARP ended in 2010, the year Dodd-Frank was passed, reducing the authorized amount to $475 billion.

Pros and Cons of Investing in Mortgage-Backed Securities

Advantages include fixed interest rates and monthly payouts, more diversification than single loans, and relatively low correlation with corporate bonds or the stock market. Disadvantages are that returns may be affected by borrowers refinancing or paying off loans early, and if interest rates increase, the price of an MBS may drop.

Benefits of Mortgage-Backed Securities

For investors, MBS have advantages over other securities. They pay a fixed interest rate usually higher than U.S. government bonds, and they offer monthly payouts, unlike bonds with a single lump-sum at maturity. MBS are also considered relatively low-risk, given the government backing for most. If guaranteed by the federal government, you don't absorb the costs of a borrower's default. They offer diversification from corporate and government securities markets.

Risks Associated with Mortgage-Backed Securities

Prepayment risk comes from borrowers refinancing or paying off loans early, either voluntarily like when refinancing or relocating, or involuntarily from defaults. Refinancing is the biggest source, as borrowers pay off at par without penalty when rates decline. This makes MBS callable, limiting price appreciation and causing negative convexity. The weighted average coupon (WAC) estimates prepayment characteristics and changes as mortgages are paid off. This ties to duration risk from MBS price sensitivity to interest rates. MBS have extended maturities and fixed coupons, leading to high duration, but unlike traditional fixed-income, their duration is uncertain due to prepayment potential.

MBS are sensitive to interest rate changes on loans and mortgages. If rates rise, fewer people take out mortgages, declining the housing market. Liquidity risk varies: agency MBS benefit from liquid TBA markets and dollar rolls, while private-label MBS have limited liquidity.

Mortgage-Backed Securities Today

In the U.S., the MBS market is massive, with over $11 trillion outstanding and almost $300 billion in average daily trading volume, per the Federal Reserve Bank of New York. It's divided into agency MBS from entities like Fannie Mae and Freddie Mac, and non-agency from private institutions. Agency MBS are less risky with guarantees paying investors even on defaults, backed by the U.S. government, attracting those seeking stable returns. In May 2024, their average daily trading was $292.9 billion, up 19.4% from 2023.

Non-agency MBS lack guarantees and carry higher credit risk, with potential losses on defaults, but offer higher yields. Their trading volume was $1.62 billion in May 2024, up 6.8% but a fraction of agency. The market grew due to demand, economic growth, and policy, but faces interest rate risk. MBS prices are inversely related to rates, becoming less valuable when rates rise. Refinancing at lower rates cuts expected cash flows. Downturns increase defaults, causing losses.

Despite challenges, the market is active with massive liquidity. The Fed bought many during the crisis and sold them off, shifting holdings to money managers due to regulations and quantitative tightening. MBS spreads nearly doubled from pre-pandemic by 2023 but narrowed in the mid-2020s, showing more confidence but limited supply from high rates. When residential MBS values drop, mortgage values usually rise, and vice versa.

What’s the Relationship Between MBS and a Bank?

Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to customers and sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on its balance sheet and loses nothing if the homebuyer defaults later. This works if everyone does their part: the bank keeps reasonable lending standards, the homeowner pays on time, and credit rating agencies perform due diligence.

What Is an Asset-Backed Security (ABS)?

An ABS is a financial investment collateralized by a pool of assets that generate cash flow from debt, like loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying fixed-rate income until maturity. For income-seeking investors, ABSs are an alternative to corporate bonds or bond funds. They allow issuers to raise cash for lending or other purposes.

What Role Do Mortgage Servicers Play in the MBS Market?

Mortgage servicers manage the day-to-day administration of mortgage loans in the pool. They collect monthly payments from borrowers, handle escrow accounts, deal with delinquencies, and ensure investors receive scheduled payments.

The Bottom Line

Mortgage-backed securities represent a unique way for you to earn income from homeowners' mortgage payments. Agency MBS, with government guarantees, have grown significantly and offer low-risk returns. However, the market's volatility requires vigilance due to risks like prepayment, interest rate changes, and liquidity challenges. Stay informed about the evolving MBS landscape and understand these risks to make informed decisions about including MBS in your portfolio.