Mortgage-Backed Securities: A Perennial Investment Vehicle

In 1968, the first mortgage-backed security, abbreviated MBS, was put on the market. Since then, the MBS market has expanded at a rapid pace, with existing issues currently exceeding $11 trillion in outstanding securities and a daily trading volume that averages close to almost $300 billion.

In this article, we will discuss MBSs, their characteristics, different structures, and risks.

Mortgage-Backed Securities, the Definition

Mortgage-backed securities, or MBS, are defined as debt obligations backed by mortgages and other loans. While residential properties are typically utilized as the underlying assets for mortgage-backed securities, certain types of MBSs also make use of commercial assets.

The mortgages are bundled and sold to a federal government agency, such as Ginnie Mae, Fannie Mae or Freddie Mac, or an investment bank, which then securitizes the loans into a security that can be purchased by investors.

There is also a third kind of MBSs that are issued by private companies. The creditworthiness and rating of the companies that issue these “private label” mortgage-backed securities (MBS) may not be as high as that of government agencies and GSEs. These MBS are issued by subsidiaries of investment banks, financial institutions, and homebuilders.

In other words, MBSs can be distinguished as follows:

• Agency MBS – Supported by a government-backed credit guarantee from one of Fannie Mae, Freddie Mac, or Ginnie Mae.
• Non-agency MBS – Mortgage-backed securities issued by private financial institutions are not guaranteed. Instead, assets are tranched based on seniority to accommodate investors with varying tolerances for credit risk.
• Residential-backed – The majority of MBS are secured by mortgages on residential residences, referred to as RMBS.
• Commercial-backed – There is, however, a robust market for commercial mortgage-backed securities (CMBS), which are backed by a wide variety of commercial real estate, including office spaces, industrial facilities, hotels, etc. (CMBS are larger, more complicated, and more diverse than RMBS)

Mortgage-Backed Securities: The Different Structures

There are many different structures that mortgage-backed securities can take.

The most fundamental varieties are referred to as “pass-through”. They entitle the bearer to a proportional share of all principal and interest payments made on a pool of mortgage loans. The bulk of pass-through securities have stated maturities of 30, 15, and 5 years. Most of these securities are backed by fixed-rate mortgage loans, although adjustable-rate mortgage loans (ARMs) and other loan combinations are also commonly utilized. Due to their characteristics, these securities' average life is significantly less than the stated maturity period and fluctuates based on the paydown history of the underlying pool of mortgages.

More complex structures are often referred to as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (REMICs). These mortgage-backed securities are comprised of multiple classes of securities that are intended to attract to investors who have varying investment goals and levels of risk tolerance. The principal and interest payments that are paid on the pool of mortgage loans are dispersed among the various classes of securities, also known as “tranches”. There might be dozens of tranches, and each tranche has its own set of distribution regulations.

Investing in CMOs is often reserved for seasoned investors, as revenue forecasting requires substantial research and due diligence.

How Does a Mortgage-Backed Security Function

Most investors of mortgage-backed securities (MBS) receive interest payments on a monthly basis as opposed to on a semi-annual basis, in contrast to standard fixed-income bonds. This is because homeowners, the mortgages of which constitute the underlying collateral for MBS, pay their mortgages monthly – Mortgage payments are what, in the end, drive to investors in mortgage-backed securities.

One more distinction may be noted between the returns that investors get from mortgage-backed securities (MBS) and, for instance, a Treasury note. Treasury notes only pay interest, but mortgage-backed securities (MBS) pay both interest and principal. As a result, the majority of the cash flow that investors receive from MBSs at the beginning comes from the interest, but with time, an increasing proportion of their earnings come from the principal.

Because the original “pass-through” structure reflects the fact that the owners themselves do not pay the same amount each month, there is a possibility that the cash flow from MBSs will not be the same amount each and every month. Because of this, investors who seek the security provided by a dependable and predictable payment twice a year may find the unpredictability of MBS to be unsettling.

Indeed, mortgage-backed securities, such as pass-throughs and CMOs, differ from conventional fixed-income bonds in a number of fundamental respects. These distinctions can be summarized as follows:

Risks of Mortgage-Backed Security Investments

Investments in mortgage-backed securities involve certain risks that investors should be aware of.

Prepayments, for instance, are a substantial risk associated with residential mortgage-backed securities (RMBS), caused by homeowners refinancing their mortgages when interest rates drop. These prepayments have a tendency to repay principal to investors at exactly the moment when the choices available to those investors for reinvesting those monies may be somewhat unfavorable.

Moreover, investors in mortgage-backed securities might potentially be subject to severe market and liquidity risks in addition to the prepayment risk that they already face.

The Bottom Line

Mortgage-backed securities have been around for as long as anyone can remember. They are among the most resilient and timeless investment vehicles – Despite recent market turmoil, numerous analysts presently view MBSs as an opportunity.

Nonetheless, before making any investment decision, prospective investors should thoroughly research their characteristics and risks.