Fixed Income Investments - Mortgage-Backed Securities (MBS)

An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay investors' principal and interest on the MBS.

When you invest in a mortgage-backed security you are lending money to a homebuyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry if the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the homebuyer and the investment markets.

A mortgage-backed security (MBS) is secured by the collateral of mortgages on real estate for which the borrower has agreed to make a predetermined series of payments. The mortgage gives the lender the right to take a property in case the borrower fails to make the payments on his loan, thus ensuring that the debt is paid off. These securities are amortizing, meaning they will decrease to zero as the payments are made. The cash flows consist of a principal payment and an interest payment that can be paid in full at anytime by the borrower. The investor in an MBS does not receive the full payment made by the borrower because the issuer charges servicing fees for doing the administrative work and prepayments.

Let's look at a $150,000 mortgage with a mortgage rate of 6%, a monthly payment of $1,000 and a term of 30 years or 360 months.

Month Beginning Month
Mortgage Bal
Interest Scheduled Principle Repayment End of Month Mortgage Balance
1 $150,000 $1,000 $750 $250 $149,750
2 $149,750 $1,000 $748.75 $251 $149,498.75
3 $149,498.75 $1,000 $747.49 $252.51 $149,246.62

This process continues until the mortgage balance reaches zero, either by the scheduled payments or through any sort of prepayment. As you can see the interest decreases through the term of the loan as the mortgage balance decreases. This also means that that as the loan matures, more of the scheduled mortgage payment is applied to the mortgage balance.

Prepayment occurs when a bond's payments to its holders incorporates both interest and principal. Typically, in asset-backed securities (ABS) and Mortgage-backed securities (MBS) there is always a chance for a prepayment. To go back to an old example, a homeowner may only have to pay $500 a month on his mortgage, but decide to pay $700 a month. This additional amount is an example of prepayment. It can occur in chunks like this or it may be paid off in one lump sum.

Risk of Prepayment
The risk of prepayment is that they typically occur in declining rate environments. When this happens, individuals tend to refinance their mortgages or credit cards at lower rates, causing the securities that were made of these obligations to be prepaid before their stated maturity date. This causes the investors in these securities to have to reinvest their proceeds at a lower market rate.

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