What Is a Mortgage-Backed Security Guarantee?
Whether a mortgage-backed security (MBS) is backed by a guarantee depends on who issues the security. An MBS is a security created through securitization. Through securitization, underlying assets are loans made to individuals and companies who use the funds to purchase buildings and homes. Mortgages are secured by the lender for the properties purchased by borrowers, and the mortgages are often backed by some form of homeowners' insurance. However, this insurance will only protect the issuer of the mortgage (mortgagee) and not the owners of an MBS that is issued for the same underlying mortgage. This explains some of the risk to MBS investors.
- An MBS is a security created through securitization whereby underlying assets are loans used to purchase buildings and homes.
- The loans, or mortgages, are secured by the lender and are often backed by homeowners' insurance. However, this insurance only protects the mortgagee not the owners of the underlying MBS.
- An MBS may or may not be guaranteed; it depends on the issuer.
- The four main issuers are Fannie Mae, Freddie Mac, Ginnie Mae, and private issuers.
How a Mortgage-Backed Security Guarantee Works
If a large number of mortgagors begin to default on their mortgages, the lender will have a difficult time passing through mortgage payments to MBS owners. Depending on how diversified the underlying pool of mortgages is across demographic and geographic regions, the risk of a mortgagor defaulting may be mitigated. However, if a significant number of mortgagors begin to default on their loans, the mortgagee may default on their MBS. This level of default will cause investors to suffer, demonstrating the need for some form of insurance or a guarantee.
Depending on the issuer, an MBS may or may not be guaranteed. There are four main MBS issuers:
- Fannie Mae (the Federal National Mortgage Association) is sponsored by the U.S. government and can issue and guarantee MBS issues. It is a publicly traded company and was established to maintain capital liquidity and to ensure that low- to middle-income individuals can purchase homes. Note that Fannie Mae's guarantee is based on its own corporate health and is not backed by the government.
- Freddie Mac (the Federal Home Loan Mortgage Corporation), is similar to Fannie Mae in that it is also sponsored by the U.S. government and is owned by stockholders. It was created to provide competition in the secondary mortgage market, which Fannie Mae originally monopolized. Like Fannie Mae, Freddie Mac can issue and guarantee MBSs, but its guarantee is not backed by the government.
- Ginnie Mae (the Government National Mortgage Association) differs from Fannie Mae and Freddie Mac in that it operates as a government agency. It does not issue MBSs, and its guarantees are backed by the full faith and credit of the U.S. government. Furthermore, Ginnie Mae guarantees MBS issues from qualified private institutions. Ginnie Mae also has a more stringent guarantee policy in that it mainly guarantees loans that are insured by the Federal Housing Administration (FHA) or other qualified insurers.
- Private issuers also issue MBSs. If a private issuer is qualified by Ginnie Mae, its issue is guaranteed by that government agency. If, on the other hand, it is not qualified by Ginnie Mae, then the MBS issue is not guaranteed.