Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them. Mortgage-backed securities, or MBS, are investments that take mortgages, pool them, and then sell the pools of loans to investors as a single investment. As a basic example, if a mortgage lender originates 100 loans that meet the standards of a government-sponsored enterprise such as Fannie Mae, the lender might mortgage backed securities meaning package the loans as mortgage-backed securities to sell to investors.

1. Mortgage-backed securities were introduced after the passage of the Housing and Urban Development Act in 1968.
2. MBS typically have extended maturities and pay fixed coupons, resulting in high duration and significant price sensitivity to interest rate movements.
3. They package them together into a single pool of loans and essentially sell bonds backed by this pool of loans.
4. More people began walking away from their mortgages because their homes were worth less than their loans.
5. But the bulk of new homeowners just couldn’t afford their payments, which didn’t seem to disturb lenders.

Q. How do MBS generate income?

The principal and interest payments are then redirected to the investors in the pool. If the underlying loans fail, the banks transfer most of the risk to the investor, typically a large hedge fund or a pension fund. Collateralized mortgage obligations are organized by slicing a pool of mortgages into similar risk profiles known as tranches. Tranches are given different credit ratings and generally have different principal balances, interest rates, maturity dates, and the potential for repayment defaults.

Interest rate risk and prepayment risk

The cash flows from the underlying mortgages are then passed on to investors. Commercial mortgage-backed securities (CMBS) are a type of fixed-income investment product. They are secured by mortgages on commercial properties rather than residential real estate. These securities are created by pooling various commercial mortgage loans and selling them to investors in the form of bonds.

MBSs are also sensitive to changes in interest rates on loans and mortgages. If interest rates rise, fewer people will take out mortgages, causing the housing market to decline. With Freddie Mac and Fannie Mae supporting the mortgage market, the quality of all mortgage-backed securities declined, and their ratings became meaningless. 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. 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.

Is there any risk to me as a homeowner if my home loan is bundled into a mortgage-backed security and sold?

CMOs are repackaged pass-through mortgage-backed securities with the cash flows directed in a prioritized order based on the structure of the bond. A CMO’s objective is to provide some protection against prepayment risk—above and beyond the protection offered by pass-throughs—while still offering credit quality and high yields. Mortgage-backed securities enable lenders to sell mortgages to investors, regardless if it’s an agency or non-agency MBS. Once a loan has been placed in an MBS, the original lender may collect payments, but investors receive the cash flow. MBSs help provide liquidity to the mortgage market, creating greater efficiency and lowering the costs of financing for many borrowers. For example, a certain community may have only one or two local banks interested in lending to their area.

Banks and the U.S. government are two of the biggest investor classes, but individuals can also invest. Exchange-traded funds and mutual funds are the two primary ways to invest as an individual. They’ll still continue to make their principal and interest payments each month.

Which of these is most important for your financial advisor to have?

However, the average life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that assemble the pass-through. Pass-throughs are constructed as trusts in which mortgage payments are received and passed through as principal and interest payments to bondholders. The investors then buy the MBSs (similar to a bond) and collect monthly income (principal and interest) while holding them. So, in principle, if the customer pays off their mortgage, the MBS investor profits. The federal government regulated banks to protect their depositors, but those rules didn’t apply to MBSs and mortgage brokers.