What Are Mortgage-Backed Securities? How Do They Work?

Updated: 28th Dec 2021 Written by Samantha Cathey
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Have you ever wondered how banks come up with the money they lend to borrowers?

According to the National Association of Realtors, 5.64 million existing homes were sold in 2020, and though some consumers can afford to pay cash for their dwellings, most homeowners have a mortgage.

That’s a lot of home loans! Where does this money come from?

What Are Mortgage-Backed Securities?

One-way mortgage lenders generate funding for all those home and real estate loans is through mortgage-backed securities (MBS).

These are a pool of home loans, grouped together by similar characteristics that investors purchase to make money from the underlying principal and interest payments made by borrowers. A mortgage-backed security is essentially a bond secured by multiple mortgages.

An MBS is a type of asset-backed security, or an investment collateralized by an underlying group of assets, like loans, credit card balances, or leases, which generate a cash flow from debt. It pays a fixed rate of income for a set amount of time to the investor.

In the late 1970s, banks needed a way to free up finances to loan more money to more potential homeowners.

A bond trader by the name of Lewis Ranieri is credited with popularizing securitization, which is the creation of a financial instrument by grouping various assets into one group.

Hence, the mortgage-backed security was born when Ranieri conceptualized 5- and 10-year bonds funded by principal and interest payments on mortgages.

The creation of the MBSs and government-sponsored enterprises like Freddie Mac and Fannie Mae, helped create much needed liquidity in the housing finance market.

That in turn stabilized the mortgage market and enabled more people to get a home loan. Eventually, the housing market took off.

>> More: Freddie Mac vs. Fannie Mae

How Do Mortgage-Backed Securities Work?

You now know what mortgage-backed security is, but how do they work?

Bought and sold on the bond market, sometimes called the “secondary mortgage market,” a typical MBS may consist of up to 1,000 home loans with similar risk profiles and characteristics, usually interest rate and term.

Investors include insurance companies, mutual funds and other institutions charged with investing their client’s money.

Given their complexity, MBSs aren’t suitable for most individual investors, but a major player in the bond market is the U.S. government. We’ll touch more on the government’s role later.

The investor pays an upfront price to acquire the security, and as homeowners pay down their mortgages the investor makes money.

Mortgage-backed securities are safe investment since most home loans are backed by the U.S. government through the VA or FHA.

>> More: How the Federal Reserve Affects Mortgage Rates

How a Mortgage-Backed Security is Created

When an applicant tries to get a home loan, the lender vets the individual, making sure certain qualifications are met like credit score and debt-to-income ratio.

Based on these personal qualifications as well as market factors, an applicant is offered a certain interest rate, term, and loan dollar amount. Their loan is sold and then grouped with other similar mortgages to create an MBS.

Before the MBS is marketed to investors, a private issuer must earn one of the top two ratings from an accredited credit rating agency.

However, most MBSs are guaranteed by one of these government-sponsored enterprises and don’t need to acquire a certain rating: Ginnie Mae, Fannie Mae, and Freddie Mac.

Here is a basic breakdown of how mortgage-backed securities are originated:

1. Lender produces a home loan for a consumer.
2. Lender sells the loan to an investment bank or government-sponsored enterprise (GSE).
3. Investment bank/GSE adds the loan to other mortgages like it and creates MBS.
4. MBS is put in Special Purpose Vehicles (SPV) or Special Investment Vehicles (SIV) to separate it
from bank’s other services.
5. SPV markets MBS to investors.

Example of Mortgage-Backed Securities in Action

Mortgage-backed securities came under intense public scrutiny after their key role in the 2008 financial crisis. Their role in this is perhaps their best example.

In the few years leading up to 2008, Freddie Mac and Fannie Mae aggressively supported the MBS market.

Lenders more frequently were offering loans to high-risk borrowers with little regard to whether they could repay their mortgage.

Home prices peaked and the housing bubble bust. Borrowers struggled and eventually defaulted on their loans as their homes became less valuable than their actual mortgages.

Without underlying payments, mortgage-backed securities, and collateralized debt obligations (CDO) were overvalued, leaving financial institutions with trillions of practically worthless investments in subprime mortgages.

Since so many types of investors from pension funds to banks to insurance companies were involved, a lot of players took a loss. Ordinary citizens lost their jobs, savings, homes, or even all three.

The entire U.S. economy nearly collapsed until Congress authorized a $700 billion financial system bailout.

Additionally, the Federal Reserve purchased $4.5 trillion in MBSs for a period of a few years, and slowly the economy regained its footing.

Who Issues Mortgage-Backed Securities?

Now, most mortgage-backed securities are issued by government-sponsored enterprises, but some do stem from private financial institutions and investment banks.

Leading up to the 2008 financial crisis, private-label MBSs made up more than 50% of the mortgage finance market, originally a very small niche part of the market.

The issuing organization, whether government-sponsored or private, has the responsibility to guarantee investors receive their monthly payouts, even if homeowners’ default on their underlying loans.

Let’s talk about who Ginnie, Fannie, and Freddie are. No, they’re not people, but they are closely related.

Ginnie Mae

Officially known as the Government National Mortgage Association (GNMA) and informally referred to as Ginnie Mae, this government agency was created in 1968 when President Lyndon Johnson authorized the Housing and Urban Development Act, which gave banks the ability to sell mortgages and thereby free up funding for more lending to homeowners.

Ginnie Mae doesn’t purchase, package, or sell mortgages, but it does guarantee principal and interest payments for mortgage-backed securities created by government home loans from the FHA, VA, and USDA. These bonds are backed by the full faith and credit of the U.S. government.

Fannie Mae

Chartered by Congress in 1938, the Federal National Mortgage Association (FNMA), does not originate loans or lend money directly to consumers, but rather purchases mortgages to help facilitate the flow of capital in the housing market.

Fannie Mae is the leader of mortgage financing, and it guarantees its bonds sold to investors.

Freddie Mac

Like Fannie Mae, the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac, also purchases mortgages to pack into bonds and sell to investors.

These MBSs are guaranteed by Freddie Mac, not the government.

Types of Mortgage-Backed Securities

Pass-Throughs

The simplest of mortgage-backed securities are pass-throughs, where a percentage of the underlying home loan payments are gathered and passed through to investors, proportional to their initial investment. They have maturities of 5, 10 or 30 years, and are structured as a trust.

Collateralized Mortgage Obligations (CMOs)

Comprised of multiple pools of securities, collateralized mortgage obligations (CMOs) are complex investments that should be reserved for sophisticated investors.

These pools are called “tranches” and each one abides by its own rules dictating when and how principal and interest payments are disbursed.

Each tranche has its own credit rating and risk tolerance. A less risky tranche has more certain cash flow and a lower possibility for default, while more risky tranches have unpredictable cash flow and a greater exposure to default risk. An elevated level of risk is compensated with higher interest rates, however.

Collateralized Debt Obligation

A collateralized debt obligation is like a CMO but is composed of all types of loans, not strictly mortgages.

This derivative fell out of favor after playing a role in the Great Recession, but slowly they are becoming popular again.

How do Mortgage-Backed Securities affect Mortgage Rates?

You can read specifics about the Federal Reserve here but know for now that it is a major player in the bond market.

Fixed-rate mortgage-backed securities are purchased in droves by the Fed from Fannie Mae, Freddie Mac, and Ginnie Mae, which helps stabilize national mortgage rates and keeps financing flowing.

The trading of MBSs on the bond market drives bond yields up or down depending on investor appetite. This has a direct impact on national mortgage rates, which generally move in step with bond rates.

Are Mortgage-Backed Securities a Good Investment?

Mortgage-backed securities are considered a safe investment, though all investments are subject to risk.

The likelihood of losing money with a mortgage-backed security is lower than if you invested in the stock market.

But that lower risk carries a lower return since the bond market is so conservative. Additionally, a smaller return on your investment may not outpace inflation.

MBSs have many of the same risks as fixed-income securities. Interest rate changes, credit, liquidity, default, and market events are all associated risks.

Finally, if your MBS is privately sponsored, it carries higher risk than were it sponsored directly or indirectly by the government.

Bottom Line: What Are Mortgage-Backed Securities?

A typical MBS could be worth millions of dollars, comprised of thousands of mortgages with similar risk profiles and characteristics.

They are an important aspect of the national mortgage market and help normal consumers like us acquire competitive rates for our home loans.

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Samantha Cathey
Samantha Cathey

Samantha Cathey is a Senior Personal Finance Writer & Product Analyst with years of financial training and industry knowledge. She is a former banker, loan officer and investment advisor before dedicating her energy to helping individuals more creatively, through her writing. Samantha studied at the University of Idaho where she majored in Journalism and Writing. Her areas of expertise are mortgages, credit cards, loans, and investing.