A mortgage-backed security (MBS) is a financial asset, similar to bonds or shares, backed by one or more mortgages. When you buy mortgage-backed security, what you are doing is buying the rights to the interests and principal accruable to one or more mortgage loans. In essence, you have just lent money to one or more home buyers and therefore are entitled to the interests and principles payable on the mortgage.
How Does Mortgage-Backed Security Work?
There are three steps involved in the mortgage-backed security acquisition process.
A bank first grants a mortgage loan to an intending home buyer. Then the bank packages the loan and then sells them to an investment bank or a federal institution. This allows them to make profits instantly, then proceed to grant more mortgages.
The Financial Institutions
Financial institutions such as investment banks or some other government institutions buy mortgage loans from banks, combine them with other similarly-valued mortgages, and then offer them as securities to interested investors.
Interested buyers approach the investment banks to purchase the offered MBS as a security type. These investors can choose to buy the value of part of a whole or many mortgages. All the interests and capital are tied to the mortgage. Thus, they become a mortgage lender without actually getting involved in the process of lending money to home buyers.
Who Are the Buyers?
Even though anyone can acquire MBSs, only private investors with deep pockets have acquired them because of how expensive they are.
Cooperate investors are businesses that typically buy shares of other companies intending to make profits or take over those companies. Sometimes, they invest in MBSs if the terms are favorable.
Investment firms are created solely for profit-making. This is why MBSs are the perfect investment opportunities, making them the commonest investors in the securities. Hedge funds and mutual funds are examples of financial institutions that routinely buy up mortgage-backed securities.
Types of Mortgage-backed Security
There are two types of MBS; they are ‘Pass-through Mortgage-backed Security’ and ‘Collateralized Mortgage Obligations.’
Pass-through Mortgage-backed Security
A pass-through MBS is a type where the security issuer (investment bank) serves as an intermediary between the lender (investor) and the homeowner (mortgagor). It is called pass-through because the interests and principal are paid to the investor through the investment bank, thereby serving as an intermediary. Depending on the mortgage term, pass-through MBS can have varying maturity periods. Although, mortgagors may choose a payment plan that allows them to pay up the loan before the maturity date.
Collateralized Mortgage Obligations (CMO)
The second type of MBS is the Collateralized Mortgage Obligations; this is when different securities are pooled together in packages known as tranches, given ratings, and then sold to investors. Unlike the pass-through MBSs, CMOs typically are packaged together based on interest and principal similarities, then rated and offered to investors. Interest rates usually reflect the risk level associated with the different tranches. Thus, investors are rewarded directly based on risks taken.
How you can benefit from MBS
Mortgage-backed Securities have a controversial history because of their roles in the 2008 financial crisis. However, subsequent and recent regulations have returned trust to the market, making it high in demand. If you are an investor, the following are ways you can benefit from MBSs if you choose to invest in them.
One of the most attractive features of MBSs is that they offer handsome returns to investors. Compared to other investment portfolios such as treasuries, returns from investing in MBSs can be very high, especially for high-risk tranches.
MBSs offer some of the benefits of securities like bonds without some of the risks that accompany them. A good example is the transfer of interests that help to stem the financial sector influence, which increases the homeowners’ chances of repayment.
Default risk transfer
While the transfer of interest may increase the returns accruable by an investor, this can also end badly if a borrower defaults in their payments.
On many occasions, mortgagors pay off their mortgage loans before the maturity date, thereby reducing the interest payable. While this is good for the mortgagor, it is not suitable for the investor.
Interest reduction over time
As the principal reduces for mortgage loans, so does the interest payable. As an investment option, this can be considered a demerit of MBS as reduced interest means there will be a corresponding reduction in returns as the mortgage nears total repayment.
Like other asset-backed securities, mortgage-backed securities can be a very fruitful investment choice for those who can afford to. Despite its controversial past, MBS is now correctly regulated, making it easier for intending home buyers to secure funds while providing good investment returns to investors.