Mortgage-backed securities are investment products that consist of groups of mortgage loans. These pooled mortgages are sold on the secondary market and provide investors with regular monthly income. Below, we’ll cover what you should know about mortgage-backed securities, including how they affect mortgage rates and the overall economy.
Banks may not hold onto mortgage loans for their entire 15 or 30-year terms. Instead, they may sell the mortgages to government agencies or private institutions, which will then pool the loans together and turn them into a financial product that can be sold on the secondary mortgage market. This product is called a mortgage-backed security (MBS).
MBSs consist of mortgages that have been bundled together and split into sellable shares through the securitization process. When investors buy an MBS, they are essentially buying a partial claim on the mortgage payments from the borrowers of the underlying loans. MBS investors receive regular distributions of the principal and interest payments from these mortgages, similar to the way one would receive income from a bond or bond fund.
MBSs fall under two main categories: agency and non-agency.
→ Agency MBSs are issued by Ginnie Mae — a U.S. government agency, and Fannie Mae or Freddie Mac — U.S. government-sponsored enterprises. The U.S. government guarantees the MBSs sold by Ginnie Mae.
→ Non-agency MBSs are issued by private entities.
Let’s compare MBSs to a more common investment — mutual funds — to deepen our understanding. Owning a share of a mutual fund represents partial ownership of many companies, while owning a share of an MBS represents a partial claim on the cash flows generated by many mortgages. Similarly, mutual funds allow investors to spread risk across many companies, while MBSs allow investors to spread risk across many mortgages.
Mortgage-backed securities and banks
The relationship between mortgage-backed securities and banks is closely intertwined. Here’s how this relationship unfolds step-by-step:
- Banks lend money to homebuyers in the form of a mortgage.
- Each bank can decide to keep their loans “in house” or sell them to a government-sponsored entity, such as Fannie Mae, or a private financial institution.
- Banks use the sale proceeds to lend out more money in the economy.
- The government agency or private entity turns the loans into MBSs through the process of securitization.
- MBSs are sold to individuals, institutional investors, government agencies and banks in the secondary market.
How mortgage-backed securities affect mortgage rates
Mortgage-backed securities and mortgage rates have an inverse relationship, meaning when mortgage rates go up, MBS prices tend to go down. The opposite is also true — when mortgage rates drop, MBS prices tend to rise. This also means that existing MBSs lose value when rates go up, since investors can earn higher yields from newly issued securities.
History of mortgage-backed securities
The modern U.S. MBS market began in 1970, when Ginnie Mae created the first agency MBS pool. Bank of America created the first private MBS in 1977. The market began to grow significantly in the 1980s, partly driven by high interest rates and as a way for banks to boost their lending power so more people could afford to buy homes.
However, during the 2008 housing crisis, MBSs played a part in many people losing their homes, along with subprime mortgage lending. In the years leading up to the crisis, mortgage lenders relaxed their lending standards, leaving many people with mortgages they couldn’t afford.
When home values dropped, MBS investors were left with pools of loans secured by underwater homes, meaning people owed more on their mortgages than their homes were worth. When the homeowners were unable to make their payments, mortgage defaults surged, causing a massive financial crisis.
The Consumer Financial Protection Bureau (CFPB) has since set strict “ability to repay” rules that improve the chances of borrower repayment — and therefore reducing the odds that MBS investors will be stuck with pools of risky loans.
Mortgage-backed securities today
While mortgage-backed securities contributed to the 2008 housing crisis, they’re still a big part of the economy today — though they are more heavily regulated. As of 2022, the U.S. MBS market has more than $11 trillion of securities outstanding and nearly $300 billion in average daily trading volume.
Types of mortgage-backed securities
→ Pass-through mortgage-backed securities. As the name suggests, all cash flows, including principal and interest payments, are collected by the issuer and then “passed through” to investors on a pro-rata basis. Pass-through MBSs generate cash flow through scheduled principal and interest payments — which are usually fixed — and prepaid principal payments.
→ Collateral mortgage obligations (CMOs). CMOs are more complex than standard pass-through MBSs, separating mortgage pools into different classes or “tranches.” Each tranche has its own risk level and duration to appeal to different investor needs and risk tolerances.
→ Stripped mortgage-backed securities. With this type of MBS, the principal and interest payments from the underlying mortgages are “stripped” apart and turned into separate securities. This differs from standard MBSs that combine cash flow from both sources.
→ Commercial mortgage-backed securities (CMBS). These investment instruments function similarly to other MBSs, except they’re backed by commercial mortgages instead of residential mortgages. The underlying loans in CMBSs may include mortgages for office buildings, warehouses and hotels.
You can purchase mortgage-backed securities through most investment brokerages. Some funds may require a minimum investment. One of the easiest ways to invest in MBSs is through an exchange-traded fund (ETF). Since ETFs are traded on stock exchanges, they’re easier to buy and sell and usually require a smaller upfront investment.
Some ETFs that invest in the mortgage-backed security market are Vanguard’s Mortgage-Backed Securities Index Fund and the iShares MBS Bond ETF. Both of these funds primarily invest in agency MBSs.
Pros and cons of mortgage-backed securities
Pros
Consistent income. One of the main draws of investing in mortgage-backed securities is that they offer periodic payments, which are typically paid out on a monthly basis.
Diversification. Because mortgage-backed securities are a pool of many different mortgage loans, you’re spreading risk across many mortgages, so you’re not as impacted by a single default or prepayment.
Some MBSs are backed by the U.S. government. Certain types of mortgage-backed securities carry essentially zero default risk. MBSs issued through Ginnie Mae are backed by the full faith and credit of the U.S. government.
Cons
Prepayment risk. Homeowners may pay off their mortgage early or refinance, exposing MBS investors to prepayment risk. As prepayments occur, it reduces the principal faster than expected and may lower overall returns — especially if you have to reinvest at a lower interest rate.
Default risk. MBSs are tied to the mortgage payments of the underlying borrowers. If borrowers fail to make their mortgage payments, it poses default risk for investors — though the level of risk varies by MBS type. Ginnie Mae MBSs have no default risk, since they’re guaranteed by the U.S. government. For non-agency MBSs, investors bear the losses.
Complexity. MBSs aren’t as straightforward as other types of investments, and minimum investment requirements can be challenging to meet for many investors. It’s crucial to do your due diligence and understand the risks before investing in MBSs.
One of the biggest risks of investing in mortgage-backed securities is prepayment risk. Prepayment risk occurs when the underlying mortgage borrowers pay off their loan early or refinance. Prepayment risk is typically highest when interest rates drop, causing many borrowers to refinance their loans.
Whether mortgage-backed securities are a good investment depends on your financial situation, goals and risk tolerance. MBSs typically offer higher yields than U.S. government bonds and can add diversification to your portfolio. However, care should be taken to understand the risks before investing.
An asset-based security derives its value from underlying assets that generate income, including credit card debt and student loans. An MBS is a type of asset-based security, with its underlying assets being mortgage debt.
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