How do mortgage-backed securities work?
To understand how mortgage-backed securities work, it's crucial to have a foundational knowledge of the way in which the mortgage market functions: When you are ready to buy a home, you go to a bank or lender to get a mortgage. Then, you pay back the mortgage over a period of many years.
However, your bank or lender doesn't have to wait until the end of your loan term to recoup their investment. Instead, they can sell your mortgage loan to a financial institution like Fannie Mae, Freddie Mac, or Ginnie Mae for a profit. (Although we should also point out that some MBSes may also be issued by private firms like investment banks. Also, they are a riskier investment.) However, in either case, the profit from selling the loan allows the mortgage lender to generate more cash flow to fund more loans.
From there, Ginnie Mae and the government-sponsored enterprises (GSEs) bundle your mortgage with other, similar loans to create a mortgage security. Once it's created, each mortgage security is divided and sold to investors.
Today, both an institutional investor and an individual investor can invest in the MBS market. Yet, it's important to note that wasn't always the case. Mortgage-backed securities are a relatively recent type of asset-backed security. In fact, President Lyndon B. Johnson was instrumental in their creation when he authorized the 1968 Housing and Urban Development Act, which gave banks and lenders the freedom to sell mortgage loans and created Ginnie Mae.
What are the different types of MBS?
Now that you have a better idea of what mortgage-backed securities are and how they work, we'll go over the different types of MBSes.
The most basic type of mortgage-backed security is known simply as a "pass-through." In this case, the mortgage payments are collected in a trust and then a share of the profits is distributed to each MBS investor.
Notably, this type of mortgage security is typically made up of residential mortgages with either a 30-year or 15-year loan term and a fixed or adjustable interest rate. (Basically, you generally won't see CMBS loans used in this type of security.)
Collateralized mortgage obligation (CMO)
A collateralized mortgage obligation (CMO) is a bit more complex. Here, instead of collecting funds from a single pool of mortgages and simply passing the mortgage payments along to each MBS investor as cash flow, CMOs are made up of many different pools of securities.
These separate pools of mortgages are called "tranches." In each CMO, there are many tranches, and each one gets to decide how it distributes its payments. Since CMOs are far more complex than pass-throughs, they are generally reserved for more experienced investors, such as an institutional investor. However, many bond funds invest in CMOs on behalf of their clients.
What are the benefits of investing in a mortgage-backed security?
There are many reasons why real estate investors may want to consider adding mortgage-backed securities to their portfolios. Here are a few of them:
- Passive income: Mortgage-backed securities are attractive to many investors because, once you invest, they create passive income. It's a way to invest in mortgages without having to go through the hassle of buying an investment property.
- Monthly payments: Unlike a fixed-income security, investors receive a monthly payment as opposed to the traditional semiannual payment.
- Attractive yields: Mortgage securities have attractive yields, especially compared to other types of bonds, like corporate bonds or Treasury bonds.
What are the risks of investing in a mortgage-backed security?
That said, mortgage-backed securities come with their fair share of risk. In fact, the 2008 financial crisis can be largely attributed to mortgage-backed securities that were largely made up of subprime loans. When the subprime borrowers began to default on their loans, there was no way to pay the MBS investors, which created a domino effect that shook the entire economy.
With that in mind, if you're thinking of investing in the MBS market, it's crucial to make sure that you understand the risks first, such as:
- Credit risk: First and foremost, credit risk occurs when one party does not meet their financial obligations. From an MBS perspective, there's always a risk that a borrower will default on their loan. In that case, the investor may lose out on that money.
- Prepayment risk: There's also a risk that a borrower will pay off their mortgage prematurely or refinance. When that happens, the investor misses out on a portion of the interest income that they would have received over the life of the loan.
The Millionacres bottom line
Investing in mortgage-backed securities can be a solid option to generate passive income. Still, like any other financial move, the decision to invest in mortgage securities should not be made lightly. If you're thinking of investing, do your own research first. Additionally, if you have specific questions, it's a good idea to reach out to a financial advisor.