Mortgage-Backed Security (MBS)

What Is a Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.

Understanding Mortgage-Backed Security (MBS)

Mortgage-backed securities (MBS) are variations of asset-backed securities that are formed by pooling together mortgages exclusively. The investor who buys a mortgage-backed security is essentially lending money to home buyers. An MBS can be bought and sold through a broker. The minimum investment varies between issuers.

As became glaringly obvious in the subprime mortgage meltdown of 2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up. An MBS may also be called a mortgage-related security or a mortgage pass-through.

Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then 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 sometime down the road.

This process works for all concerned as everyone does what they're supposed to do. That is, the bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time, and the credit rating agencies that review MBS perform due diligence.

In order to be sold on the markets today, an MBS must be issued by a government-sponsored enterprise (GSE) or a private financial company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings issued by an accredited credit rating agency.

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.

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations (CMO).

1. Pass-throughs: Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors. They typically have 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.
2. Collateralized mortgage obligations (CMO): CMOs consist of multiple pools of securities which are known as slices, or tranches. The tranches are given credit ratings which determine the rates that are returned to investors.

MBS and the Financial Crisis

Mortgage-backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth, bring down Lehman Brothers, and roil the world financial markets.

In retrospect, it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost.

The Crisis

That was the beginning of the subprime MBS. With Freddie Mac and Fannie Mae aggressively supporting the mortgage market, the quality of all mortgage-backed securities declined, and their ratings became meaningless. Then, in 2006, housing prices peaked.

Subprime borrowers started to default, which is the failure to repay a loan. As a result, the housing market began its long collapse. More people began walking away from their mortgages because their homes were worth less than their loans. Even the conventional mortgages underpinning the MBS market saw steep declines in value. The avalanche of non-payments meant that many MBSs and collateralized debt obligations (CDO) based on pools of mortgages were vastly overvalued.

The losses piled up as institutional investors and banks tried and failed to unload bad MBS investments. Credit tightened, causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of collapse.

The Bailout

The U.S. Treasury stepped in with Congress to authorize a $700 billion financial system bailout intended to ease the credit crunch. Also, the Federal Reserve bought $4.5 trillion in MBS over a period of years while the Troubled Asset Relief Program (TARP) injected capital directly into banks.

Some of the measures of the bailout included the following:

On October 3, 2010, the authority to initiate new financial commitments ceased, essentially ending any new bailouts under the TARP program.

Also, in 2010, Congress authorized the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act reduced the initial amount of the $700 billion authorized for the TARP program to $475 billion.

Mortgage-Backed Securities Today

Mortgage-backed securities are still bought and sold today. There is a market for them again simply because people generally pay their mortgages if they can. The Fed still owns a huge chunk of the market for MBSs, but it is gradually selling off its holdings.

Even CDOs have returned after falling out of favor for a few years post-crisis. The assumption is that Wall Street has learned its lesson and will question the value of MBSs rather than heedlessly buying them. Time will tell.

What Are the Types of Mortgage-Backed Securities (MBS)?

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations (CMO). Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors. They typically have stated maturities of five, 15, or 30 years. CMOs consist of multiple pools of securities which are known as slices, or tranches. The tranches are given credit ratings which determine the rates that are returned to investors.

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 its customers and then 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 sometime down the road.

This process works for all concerned as long as everyone does what they're supposed to do. That is, the bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time, and the credit rating agencies that review MBS perform due diligence.

What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets — usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity.

For income-oriented investors, ABSs can be an alternative to other debt instruments, like corporate bonds or bond funds. For issuers, ABSs allow them to raise cash which can be used for lending or other investment purposes.