Mortgage-Backed Security (MBS)

Definition

A Mortgage-Backed Security (MBS) is a type of asset-backed security that’s collateralized by a collection of mortgages. These mortgages are bundled together into a pool, thereby generating cash flows for investors from the mortgage payments. MBS are bought and sold by institutional investors in financial markets.

Phonetic

The phonetic pronunciation of “Mortgage-Backed Security (MBS)” would be: “Mawr-gij Bakd Si-kew-ri-tee (ehm-be-ess)”.

Key Takeaways

<ol><li>Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a collection of mortgages. It allows investors to benefit from the mortgage business without having to directly buy or sell a home loan.</li><li>MBSs carry certain risks such as prepayment risk, where borrowers could pay back their loan sooner than expected, potentially affecting the investor’s return. Moreover, MBSs rely heavily on the creditworthiness of the underlying assets, meaning if borrowers default on their loans, investors may experience losses.</li><li>Investors usually receive periodic payments from MBS, similar to bond coupon payments. These payments include both the principal and interest payments received from the underlying mortgages.</li></ol>

Importance

Mortgage-backed securities (MBS) are important because they represent a cornerstone of the finance industry. MBSs are a type of asset-backed security backed by mortgages as collateral. They work by pooling together multiple mortgages into a product that investors can buy shares in, which provides banks and lenders a method of turning relatively illiquid individual home loans into liquid assets. This process increases the overall liquidity in the market, allowing financial institutions to issue more loans and stimulate economic growth. Additionally, MBSs provide investors with a way to earn income through mortgage interest payments, diversifying their portfolio. However, they also come with risks associated with potential default on mortgages, as experienced during the 2008 financial crisis.

Explanation

Mortgage-Backed Securities (MBS) primarily serve as an investment vehicle. Financial institutions, primarily banks, initiate the process by packaging their home loans into securities and then selling them to investors, much like shares in a company. By doing so, banks offload the loan risk from their books and also get immediate liquidity which they can use to issue more home loans. So, part of the purpose of MBS is to provide lending institutions with a system to get more liquidity, allowing them to originate more loans and overall stimulating the housing market.For investors, MBS offer a viable option to broaden and diversify their investment portfolio beyond traditional securities, while providing steady income streams derived from the underlying mortgage payments. Investors of MBS assume the role of a bank, where they can earn the interest on the mortgage. This kind of investment typically attracts institutional investors, mutual funds, and pension funds. It’s important to note, however, that while MBS can be lucrative, they also carry specific risks such as prepayment risk and credit risk.

Examples

1. Freddie Mac: Freddie Mac (Federal Home Loan Mortgage Corporation) is a public government-sponsored enterprise that operates in the secondary mortgage market. They purchase mortgages on the secondary market, pool them, and sell them as a mortgage-backed security to investors on the open market.2. Ginnie Mae: Ginnie Mae (Government National Mortgage Association) is a government-owned corporation within the U.S. Department of Housing and Urban Development (HUD). Ginnie Mae guarantees investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans — mainly loans insured by the Federal Housing Administration (FHA) or guaranteed by the Veterans Administration (VA). This creates liquidity in the mortgage market and promotes affordable housing.3. Private Banks or Financial Institutions: Large private financial institutions such as Bank of America, Wells Fargo, or JP Morgan Chase also deal with Mortgage-Backed Securities. These institutions may issue MBS which are not guaranteed by a government agency, these are known as private-label, or non-agency, MBS and are considered higher risk. During the 2008 financial crisis, many of these types of MBS became “toxic assets” due to rising mortgage delinquencies and falling home prices, which negatively affected the global financial sector.

Frequently Asked Questions(FAQ)

What is a Mortgage-Backed Security (MBS)?

A Mortgage-Backed Security (MBS) is a type of investment product that is secured by a mortgage or a collection of mortgages. Investors buy these securities for the potential interest and principal payments that are generated from the underlying mortgages.

How do Mortgage-Backed Securities (MBS) work?

Mortgage lenders, banks, and other financial institutions typically sell mortgages to entities like investment banks, who then package these loans into MBS. These MBS are then sold to investors, who earn interest from the mortgage payments made by borrowers.

What are the risks associated with investing in MBS?

Risks include interest rate risk (the risk that fluctuating interest rates will affect the value of the MBS), prepayment risk (the risk that the underlying mortgages will be paid off early, reducing anticipated interest), and default risk (the risk that borrowers might default on their mortgage).

What are the benefits of investing in MBS?

MBS may offer an attractive payoff of regular income, often at higher rates than government or corporate debt. Also, because MBS are made up of a bundle of mortgages, they can diversify the risk that would come with investing in a single mortgage.

How often do MBS pay returns to investors?

Usually, MBS pay investors on a monthly basis, whereas most bonds pay semi-annual interest.

How can I buy Mortgage-Backed Securities (MBS)?

MBS can be purchased through brokers, mutual funds, or other investment vehicles. They can also be purchased indirectly through a Real Estate Investment Trust (REIT).

Who are the main issuers of MBS?

The main issuers of MBS are typically government-sponsored entities like Ginnie Mae, Fannie Mae, and Freddie Mac, but private financial institutions can also issue MBS.

How does the value of an MBS fluctuate?

Like any bond, the value of an MBS can fluctuate with changes in interest rates. When rates decrease, the value of an MBS may increase. Conversely, when rates increase, the value of an MBS may decrease.

Related Finance Terms

Collateralized Mortgage Obligation (CMO)
Principal and Interest Payments (P&I)
Pass-Through Rate
Tranches
Prepayment Risk

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