What is a 'Mortgage-Backed Security (MBS)'
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. This security must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pays periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.
BREAKING DOWN 'Mortgage-Backed Security (MBS)'
An MBS is also known as a "mortgage-related security" or a "mortgage pass through." An MBS can be bought and sold through a broker, and the minimum investment amount is usually $10,000, but varies between issuers. It is issued by either a federal government agency company, government-sponsored enterprise (GSE) or private financial company. Although an MBS issued by a government-sponsored enterprise may appear to carry a lower degree of risk, credit and default risks are prevalent, and the federal government is not obligated to bail out a GSE from default.
Mortgage-Backed Security Mechanics
When an investor invests in a mortgage-backed security, he is essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.
This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS.
Types of Mortgage-Backed Securities
There are two common types of MBSs: pass-throughs and collateralized mortgage obligations, also known as CMOs. Pass-throughs are structured as a trust in which mortgage payments are collected and passed through to investors. Pass-throughs typically have stated maturities of five, 15 and 30 years. Adjustable-rate mortgages, fixed-rate mortgages and other types of loans are pooled to create pass-throughs. The average life of pass-throughs may be less than the stated maturity, depending on the principal payments of the pool of mortgages.
Collateralized mortgage obligations consist of multiple pools of securities, which are known as slices, or tranches. The tranches are given credit ratings, and the rates that are returned to investors depend on the tranches. For example, pools of securities in the senior secured tranche typically have lower interest rates than those in the unsecured tranche, due to the low degree of risk assumed in the senior secured tranche.