What Are Mortgage-Backed Security (MBS)?
A mortgage-backed security is a type of investment security backed by a mortgage loan’s principal and interest payments. In other words, investors purchase certificates or notes that are collateralized by these mortgages instead of directly investing in a single mortgage. A mortgage-backed security is any financial instrument based on a fixed pool of mortgages. The main types of MBS are Agency MBS and Non-Agency MBS. You can learn more about them in this article.
Agency MBS
An agency MBS is a type of mortgage-backed security issued by a government institution, mainly the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Fannie Mae and Freddie Mac. The Federal Housing Finance Agency (FHFA) oversees Fannie Mae’s and Freddie Mac’s operations. Fannie Mae and Freddie Mac buy mortgages from banks, mortgage companies, and other entities that lend money for home purchases. They then package these mortgages together into MBSs and sell them to investors. The securities are called agency MBSs because the issuer is a federal government agency. The acronyms FNMA and FHLMC are the entities’ full names: Federal National Mortgage Association and Federal Home Loan Mortgage Corporation.
Non-Agency MBS
A non-agency MBS is a type of mortgage-backed security not issued by a government agency but by a private financial institution. To issue non-agency MBS, the institution must meet certain requirements and be approved by the Securities and Exchange Commission (SEC). Non-agency MBSs are mainly issued by institutions not subject to the same regulatory oversight as government agencies. However, they also include private institutions that cannot issue mortgage-backed securities.
What is the MBS Structure?
A mortgage-backed security is a security or financial asset, and the cash flow of a pool of mortgages backs that. An MBS works mainly as a pass-through security, which means that the interest and principal payments of the mortgages are deposited into a trust and are then passed on to the holders of the MBS. The trust is a holding company for holding and managing mortgages; it also issues notes or certificates representing shares of the mortgages held in the trust. This structure makes it easy for investors to diversify their holdings and gain exposure to the housing market by investing in a single security.
Types of Mortgage-Backed Securities
MBSs are grouped into a few categories based on their underlying collateral and the type of investors that purchase them. Agency MBSs – These MBSs are issued by Fannie Mae and Freddie Mac, government-sponsored entities (GSEs). Agency MBSs are also referred to as Government-Sponsored Enterprises (GSEs) because the government sponsors them. Non-Agency MBSs – Non-agency MBSs are not issued by GSEs but by private institutions. Residential mortgages with low loan-to-value ratios mainly collateralize these MBSs. Investment Grade MBSs – These are MBSs rated as investment grades by credit rating agencies. Investment grade MBSs are relatively safe investments because they are highly liquid and have a low risk of default. Jumbo MBSs – These are MBSs with a high dollar amount of the total mortgage loan balance. Jumbo MBSs are issued for mortgages with a loan amount of more than $417,000 for a single-family residence in areas where the average home price is below $417,000.
Advantages of MBS
Easy to Invest – Investors can easily invest in MBSs because the process is similar to buying shares of a stock on a stock exchange. Importantly, MBSs are highly liquid, so they can be quickly bought and sold without losing value. As a result, investors can choose to invest as little as $1,000 in MBSs. In addition, MBSs provide diversification which can lower risk because many mortgages back them. MBSs can also be used to create synthetic derivatives that are used for trading derivatives.
Disadvantages of MBS
Default Risk – MBSs are debt securities backed by a mortgage loan’s principal and interest payments. If the borrower of a mortgage defaults, the MBS holder might not be paid back. Investors can reduce default risk by diversifying their holdings through MBS funds. These funds invest in a portfolio of MBSs that different mortgage lenders issue. MBSs are priced based on the interest rate of the underlying mortgage and the risk associated with the borrower of the mortgage loan. Therefore, the price of the MBS will change as interest rates and risk levels change. In addition, investors should be aware that they are not entitled to the cash flows of the underlying mortgages. Finally, MBSs are relatively illiquid, so it may take time to sell them.
How to Buy and Sell MBS?
Investors buy MBSs through a broker and will receive a confirmation statement from a clearing house after the transaction has been executed. To sell MBSs, investors must first find a buyer. Selling MBSs can be challenging because there is a relatively low volume of trading in MBSs.
Conclusion
Mortgage-backed securities are financial devices backed by a mortgage loan’s principal and interest payments. Investors can buy MBSs to gain exposure to the housing market and earn a return on their investment. There are different types of MBSs, the most common being agency, and non-agency MBSs.
