What Is a Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.

The MBS is a type of asset-backed security. As became glaringly obvious in the subprime mortgage meltdown of 2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up.

An MBS may also be called a mortgage-related security or a mortgage pass-through.

How a Mortgage-Backed Security Works

Essentially, the mortgage-backed security turns the bank into a middleman between the homebuyer and the investment industry. A bank can grant mortgages to its customers and then sell them on 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.

The investor who buys a mortgage-backed security is essentially lending money to home buyers. An MBS can be bought and sold through a broker. The minimum investment varies between issuers.

Mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth.

This process works for all concerned as everyone does what they're supposed to do. That is, 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.

In order to be sold on the markets today, an MBS must be issued by a government-sponsored enterprise (GSE) or a private financial company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings issued by an accredited credit rating agency.

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Understanding Mortgage-Backed Securities

Types of Mortgage-Backed Securities

There are two common types of MBSs: pass-throughs and collateralized mortgage obligations (CMO).

Pass-Throughs

Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors. They typically have stated maturities of five, 15, or 30 years. The life of a pass-through may be less than the stated maturity depending on the principal payments on the mortgages that make up the pass-through.

Collateralized Mortgage Obligations

CMOs consist of multiple pools of securities which are known as slices, or tranches. The tranches are given credit ratings which determine the rates that are returned to investors.

The Role of MBSs in the Financial Crisis

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.

That was the beginning of the subprime MBS. With Freddie Mac and Fannie Mae aggressively 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 and the housing market began its long collapse. More people began walking away from their mortgages because their homes were worth less than their debts. Even the conventional mortgages underpinning the MBS market saw steep declines in value. The avalanche of non-payments meant that many MBSs and collateralized debt obligations (CDO) based off of pools of mortgages were vastly overvalued.

The losses piled up as institutional investors and banks tried and failed to unload 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.

In the end, the U.S. Treasury stepped in with a $700 billion financial system bailout intended to ease the credit crunch. The Federal Reserve bought $4.5 trillion in MBS over a period of years while the Troubled Asset Relief Program (TARP) injected capital directly into banks.

The financial crisis eventually passed, but the total government commitment was much larger than the $700 billion figure often cited.

Key Takeaways

  • The MBS turns a bank into a middleman between the homebuyer and the investment industry.
  • The bank handles the loans and then sells them at a discount to be packaged as MBSs to investors as a type of collateralized bond.
  • For the investor, an MBS is as safe as the mortgage loans that back it up.

Mortgage-Backed Securities Today

MBSs are still bought and sold today. There is a market for them again simply because people generally pay their mortgages if they can.

The Fed still owns a huge chunk of the market for MBSs, but it is gradually selling off its holdings. Even CDOs have returned after falling out of favor for a few years post-crisis.

The assumption is that Wall Street has learned its lesson and will question the value of MBSs rather than blindly buying them. Time will tell.