Typical buyers of these securities include institutional, corporate, and individual investors. However, if the homeowner defaults, the investor who paid for the mortgage-backed security won’t get paid, which means they could lose money.
Acronym: MBS
How a Mortgage-Backed Security Works
President Lyndon Johnson paved the way for modern-day mortgage-backed securities when he authorized the 1968 Housing and Urban Development Act, which also created Ginnie Mae. Johnson wanted to give banks the ability to sell off mortgages, which would free up funds to lend to more homeowners. Mortgage-backed securities allowed non-bank financial institutions to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. They had the deep pockets to wait until these loans were repaid 15 or 30 years later. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. The number of lenders increased. Some offered mortgages that didn’t look at a borrower’s job or assets. This created more competition for traditional banks. They had to lower their standards to compete. Worst of all, MBSs were not regulated. The federal government regulated banks to make sure their depositors were protected, but those rules didn’t apply to MBSs and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all.
How an MBS Is Created
The MBS process starts when a bank or mortgage company makes a home loan. That lender then sells that loan to an investment bank. It uses the money received from the investment bank to make new loans. While the lender starts the process over with a new mortgage for a new customer, the investment bank takes the original loan and adds it to a bundle of mortgages with similar interest rates. After the investment bank creates a bundle of similar mortgages, it puts the bundle in a special company designed to create an MBS. These companies are called Special Purpose Vehicles (SPVs) or Special Investment Vehicles (SIVs). That keeps the mortgage-backed securities separate from the bank’s other services. The SPV markets these mortgage-backed securities to investors. For the investor buying the MBS, it’s similar to any other bond. The investor pays a price to acquire the bond and receives income while holding the bond. In theory, the customer pays off their mortgage, and the MBS investor profits.
Types of Mortgage-Backed Securities
While all mortgage-backed securities are essentially the same product—a bond—there are some variations on the product that investors can choose from.
Pass-Through Participation Certificate
The simplest MBS is the pass-through participation certificate. It pays the holders their fair share of both principal and interest payments made on the mortgage bundle.
Collateralized Debt Obligation
In the early 2000s, the structured securities market grew very competitive. Investment banks created more complicated investment products to attract customers. For example, they developed collateralized debt obligations (CDOs) which could include any type of loan. To the investor, these products function like an MBS, even though they may or may not contain mortgages.
Collateralized Mortgage Obligation
Around the time CDOs were created, investment banks also developed a more complex version of the mortgage-backed security, the collateralized mortgage obligation (CMOs). These complicated investments are constructed by slicing a pool of mortgages into similar risk categories, known as tranches. The least risky tranches have more certain cash flows and a lower degree of exposure to default risk, while riskier tranches have more uncertain cash flows and greater exposure to default risk. However, the elevated level of risk is compensated with higher interest rates, which are attractive to some investors.
What It Means for Individual Investors
The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage businesses. At first, mortgage-backed securities created more demand to lend out money, which allowed more people to buy homes. However, this got out of hand during the real estate boom, when some lenders didn’t take the time to confirm that borrowers could repay their mortgages. That allowed people to get into mortgages they couldn’t afford. These subprime mortgages were bundled into private-label MBSs. These subprime mortgages created an asset bubble that burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds, and financial institutions owned mortgage-backed securities, everyone took losses. That’s what created the 2008 financial crisis.
