| Major Types of MBS | ||||
|---|---|---|---|---|
| MBS Type/Acronyms | Description | Issuer | Risk Profile | Investor Suitability |
| Pass-Through Securities | Pool of mortgages where principal and interest payments are passed through to investors pro-rata. | Government Sponsored Enterprises (GSEs) like Fannie Mae and Freddie Mac | Lower risk due to GSE backing. | Investors seeking consistent income and moderate risk. |
| Collateralized Mortgage Obligations (CMOs) | A type of collateralized debt obligation (CDO) is an MBS divided into tranches with varying maturities and risk profiles, offering different expected returns. | Private financial institutions | Varying risk levels depending on the tranche. | Investors with different risk tolerances and income preferences. |
| Agency MBS | Issued or guaranteed by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. | Fannie Mae, Freddie Mac | Lower risk due to implicit government backing. | Investors seeking relatively safe investments with moderate yields. |
| Non-Agency MBS | Issued by private entities, not backed by government guarantees. | Private financial institutions | Higher risk due to lack of government backing. | Investors with higher risk tolerance seeking potentially higher yields. |
| Commercial Mortgage-Backed Securities (CMBS) | Commercial properties like office buildings, shopping centers, and hotels back them. | Private financial institutions | Moderate to high risk depending on property types and economic conditions. | Institutional investors and high-net-worth individuals seeking exposure to commercial real estate. |
| Residential Mortgage-Backed Securities (RMBS) | Backed by residential mortgage loans, typically for single-family homes or condos. | GSEs or private financial institutions | Risk varies depending on the underlying mortgages and issuer. | Investors seeking exposure to the residential housing market with varying risk appetites. |
| Stripped Mortgage-Backed Securities (SMBS) | Separates the principal and interest payments into separate securities. | Investment banks | Higher risk due to prepayment and interest rate risks. | Sophisticated investors who understand the complexities of mortgage-backed securities. |
History of Mortgage-Backed Securities
Mortgage-backed securities were introduced after the passage of the Housing and Urban Development Act in 1968. The act created the Government National Mortgage Association, known as Ginnie Mae, which split off from Fannie Mae.
The new entity allowed banks to sell their mortgages to third parties so that they would have more capital to lend out and originate new loans. This, in turn, made it possible for institutional funds to buy up and package many loans into an MBS.
Ginnie Mae introduced the first mortgage-backed securities for the retail housing market in 1970. The first private MBS was introduced by Bank of America in 1977.
Mortgage-Backed Securities and the Financial Crisis of 2007 to 2008
Mortgage-backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth, bring down Lehman Brothers, and roil the world financial markets.
In retrospect, it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost.
The Crisis
That was the beginning of the subprime MBS. With Freddie Mac and Fannie Mae supporting the mortgage market, the quality of all mortgage-backed securities declined, and their ratings became meaningless. Then, in 2006, housing prices peaked.
Subprime borrowers started to default, which is the failure to repay a loan. As a result, the housing market began its prolonged collapse. More people began walking away from their mortgages because their homes were worth less than their loans. Even the conventional mortgages underpinning the MBS market had steep declines in value. The avalanche of nonpayments meant that many MBSs and collateralized debt obligations (CDOs) based on pools of mortgages were soon vastly overvalued.
The losses piled up as institutional investors and banks tried and failed to unload their bad MBS investments. Credit tightened, causing many banks and financial institutions to teeter on the brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of collapse.
The Bailout
The U.S. Congress authorized a $700 billion financial system bailout to ease the credit crunch. Also, the U.S. Federal Reserve bought $4.5 trillion in MBS over several years while the Troubled Asset Relief Program (TARP) injected capital directly into banks.
Some of the measures of the bailout included the following:
- Almost $250 billion to stabilize the banking industry
- $27 billion to stabilize the credit markets
- $80 billion to support the U.S. auto industry
- Almost $70 billion to bail out insurance giant American International Group
- $46 billion was allocated to help struggling families avoid home foreclosure, which is when a mortgage lender or bank seizes a borrower’s home because of nonpayment of the loan
In 2010, TARP ended. Also that year, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed. The Dodd-Frank law reduced the initial $700 billion authorized for TARP to $475 billion.
Advantages and Disadvantages of Mortgage-Backed Securities
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Fixed interest rates and monthly payouts
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More diversification than single loans
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Relatively low correlation with corporate bonds or the stock market
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Returns may be affected by borrowers refinancing or paying off their loans early.
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If interest rates increase, the price of an MBS may drop.
Advantages
Attractive Yield
For investors, mortgage-backed securities have some advantages over other securities. They pay a fixed interest rate that is usually higher than U.S. government bonds. Moreover, they typically offer monthly payouts, while bonds offer a single lump-sum payout at maturity.
Safe Investment
Mortgage-backed securities are also considered relatively low-risk, given the government backing for most of them. If an MBS is guaranteed by the federal government, investors do not have to absorb the costs of a borrower’s default. Moreover, they offer diversification from the markets of corporate and government securities.
Disadvantages
Prepayment Risk
Prepayments can be either voluntary, such as when borrowers refinance or relocate, or involuntary from defaults. Refinancing is the most significant source of prepayment, as borrowers can pay off their remaining balance at par without penalty when market interest rates decline. This makes MBS callable securities, limiting their price appreciation potential and resulting in negative convexity. The weighted average coupon (WAC) can estimate the prepayment characteristics of a pool of underlying mortgages. The WAC will change periodically as mortgages are paid off.
This is related to duration risk, which arises from the sensitivity of MBS prices to changes in interest rates. MBS typically have extended maturities and pay fixed coupons, resulting in high duration and significant price sensitivity to interest rate movements. However, unlike traditional fixed-income securities, the duration of MBS is not fixed but remains uncertain because of the potential for borrowers to prepay their loans at any time.
Interest Rate Risk
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.
Liquidity Risk
Liquidity varies significantly across different types of MBS, with agency MBS benefiting from the highly liquid to-be-announced or TBA forward market and the ability to execute dollar rolls for funding. In contrast, private-label MBS have much more limited liquidity.
Mortgage-Backed Securities Today
In the U.S., the MBS market is massive, with over $11 trillion in outstanding securities and almost $300 billion in average daily trading volume, according to the Federal Reserve Bank of New York. The market is divided into two main categories: agency MBS, which are issued by government-sponsored entities like the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), and non-agency MBS, which are issued by private financial institutions.
Agency MBS are considered less risky because they are backed by Fannie Mae and Freddie Mac guarantees, which promise to pay investors even if homeowners default on their loans. This guarantee is ultimately backed by the U.S. government, making agency MBS attractive to investors looking for stable, fixed-income returns. In May 2024, agency MBS’s average daily trading volume reached $292.9 billion, a 19.4% increase over May 2023.
Non-agency MBS, meanwhile, do not have explicit government guarantees and typically carry higher credit risk. Investors in non-agency MBS face potential losses if homeowners default on their mortgages. Non-agency MBS often have higher yields than agency MBS to compensate for this increased risk. In May 2024, non-agency MBS’s average daily trading volume was around $1.62 billion, a 6.8% increase over May 2023, but only a tiny fraction of agency MBS.
The growth of the MBS market can be attributed to increasing demand for these securities, global economic expansion, and ongoing efforts to stimulate economic growth through monetary policy—these are not the only assets the U.S. Federal Reserve has been working to get off its balance sheet. However, the market also faces challenges, such as interest rate risk.
When residential mortgage-backed securities fall, residential mortgages tend to rise. The reverse is also true.
MBS prices are inversely related to interest rates, meaning that existing MBS become less valuable when rates rise. Also, when homeowners refinance their mortgages at lower rates, they pay off their existing loans early, which can cut the cash flows that investors expect to receive from MBS. Economic downturns can also lead to increased mortgage defaults, resulting in losses for MBS investors.
Despite these challenges, the MBS market remains highly active, with massive liquidity. The Federal Reserve, which bought large amounts of MBS during and after the financial crisis, has slowly sold off its holdings. As such, the market has shifted from traditional bank and Fed holdings to money managers and other institutional investors. This change is partly because of new regulations and the Fed’s quantitative tightening program.
MBS spreads—the difference between interest rates sellers must pay investors and 10-year Treasurys—grew to almost double their pre-pandemic levels in 2022 to 2023, though in the mid-2020s, those spreads began to narrow. This means investors have wanted less compensation for taking them on, suggesting more confidence in the quality of these securities. However, there’s also been a more limited supply of MBS, given the high interest rates.
What’s the Relationship Between MBS and a Bank?
Essentially, the mortgage-backed security turns the bank into an intermediary between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then sell them at a discount for inclusion in an MBS.
The bank records the sale as a plus on its balance sheet and loses nothing if the homebuyer defaults sometime down the road. This process works for all concerned as long as everyone does what they’re supposed to do: The bank keeps to reasonable standards for granting mortgages; the homeowner keeps paying on time; and the credit rating agencies that review MBS perform due diligence.
What Is an Asset-Backed Security (ABS)?
An ABS is a type of financial investment collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time until maturity.
For income-seeking investors, ABSs can be an alternative to other debt instruments, like corporate bonds or bond funds. ABSs allow issuers to raise cash that can be used for lending or other investment purposes.
What Role Do Mortgage Servicers Play in the MBS Market?
Mortgage servicers have a major role in the MBS market by managing the day-to-day administration of the mortgage loans within the pool. They are responsible for collecting monthly mortgage payments from borrowers, managing escrow accounts, handling delinquencies, and ensuring that investors receive their scheduled payments.
The Bottom Line
An MBS is an investment, essentially a share in a large basket of mortgages. As each homeowner pays off their loans, the loan payments provide a steady income stream for investors who hold MBS.
The growth in the MBS market, particularly in agency MBS, has been substantial, but it is crucial to monitor risks and imbalances that could lead to market instability. As the market evolves, participants must stay informed about the latest trends, risks, and prospects to make sound investment decisions.
