What is a mortgage-backed security? Mortgage-backed securities (MBS) are a way to invest in mortgages. Today’s blog post will explain mortgage-backed securities and how they work. Ultimately, please decide whether this investment is right for you. Before we start, let’s get back to basics and cover some common definitions of investing. Today, we’re going to start with financial securities.
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What Are Mortgage-Backed Securities?
Mortgage-backed securities are bonds backed by the value of a pool of mortgages. The bond pays interest to investors and the principal back to the investors when the bond matures.
A mortgage-backed security is only as sound as the mortgages that back it up. If you invest in this type of security, ensure you understand its structure and how much risk exposure your money has before purchasing it.
The idea behind a MBS is simple: it allows investors to buy pieces of mortgages instead of buying entire mortgages themselves. Investors can then sell these pieces as part of an MBS or keep them until maturity if they want their money back sooner than expected.
Buying whole loans would restrict options, but mortgage-backed security gives investors more flexibility. MBS enables the bank to be an intermediary between the homebuyer and the investment industry.
When you sign up for a mortgage, your lender receives your money and then turns around and sells it at a discount for inclusion in an MBS. The bank records this sale as a plus on its balance sheet and loses nothing if you default sometime down the road.
History of a Mortgage-Backed Security
The first mortgage-backed security was created in 1968 when Congress passed the Housing and Urban Development Act. This act split Ginnie Mae (Government National Mortgage Association) from Fannie Mae (Federal National Mortgage Association).
In the peak years of subprime mortgages in 2005 and 2006, mortgage-backed securities comprised more than 50 percent of all corporate bonds. But since then, their popularity has waned.
Today, only about 5 percent of corporate bonds are MBSs. The market for MBSs is much smaller than it was at its peak but still exists today; you may even have some in your portfolio!
From 2007 to 2008, the subprime mortgage meltdown occurred. The prime cause of the crisis was the high default rate on subprime mortgages. Banks issued to borrowers who lacked the income or down payments to qualify for conventional loans.
In other words, regardless of credit score, anyone with a pulse got a mortgage. I highly recommend you check out the movie “The Big Short” on Netflix; it portrays the meltdown with shocking accuracy.
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Problem With Mortgage-Backed Securities
The most obvious risk was that the government did not guarantee mortgage-backed securities. As a result, many investors lost money when buying a mortgage-backed security without understanding this fact and assumed they were guaranteed safe investments.
Many people bought MBSs because they thought it would be easier to make money in real estate than investing in stocks or bonds (which are also risky). They felt that if they could get into a house before prices went up, they’d make all their money back and more–but this only happened for some who bought these securities.
Since then, however, significant changes have been made within this industry so that mistakes like these cannot happen again.
What Is a Financial Security?
A financial security is a fungible, negotiable financial asset with some monetary value. The term often refers to stocks, bonds, and exchange-traded funds (ETFs). We’ll see how that includes mortgage-backed security as we go on.
What Is a Bond?
A bond is a debt security that pays the holder interest until maturity. The issuer of the bond is usually a corporation or government. Investors buy the bonds because they think they will make money when they reach maturity. Maturity is the point at which you no longer owe anything. In case you didn’t know, bonds trade on exchanges like stocks.
As interest rates go up, bond prices rise. Therefore, this makes sense because if you have to pay more for your loan, it will cost more for someone else to borrow from you.
And finally, what is a mortgage-backed security?
What Is a Mortgage?
A mortgage is a legal contract between you and your lender. You agree to pay back the loan amount plus interest, and if you default on your payments, the bank can foreclose on your home. Ultimately, a mortgage secures the repayment of the loan by using real property (your house) as collateral. Finally, this assures lenders they can recover their money if you fail to repay the loan.
All of this brings us to the whole purpose of this blog: to explain the concept of mortgage-backed security.
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Mortgage-Backed Security Today
Today, mortgage-backed security is essential to the global financial system. An MBS allows investors to enter the real estate market without having to buy houses themselves and provides lenders with a way to raise capital for mortgages.
MBS are created by pooling thousands of mortgages and selling shares in that pool; these shares represent the loans made with the money raised from their sale. The borrower pays interest on their loan each month, and then the interest is paid out as dividends to investors who own those shares.
Advantages of a Mortgage-Backed Security
Set Interest Rates & Terms
A mortgage-backed security has a set term and interest rate. MBSs also have an interest rate that goes up or down depending on market conditions and other factors, such as inflation and economic growth rates.
Safety
Home loan receivables back the mortgage-backed securities. As a result, they’re considered a safer investment than many other bonds because they are secured by real estate rather than an individual company or government entity.
As such, mortgage-backed securities are often used as an investment vehicle for retirement accounts. Essentially, they get to mitigate their risk while still earning a higher return than they could with treasuries.
Liquidity
They have long maturities and low interest rates, and investors can easily sell their shares when needed. This liquidity makes them attractive to investors who need cash quickly.
Low correlation with other asset classes
MBSs tend to move independently from other asset classes like stocks and commodities so that investors don’t lose money if one sector crashes while another rises sharply. Ultimately, this makes them good choices for diversifying their portfolios and hedging against market volatility.
Final Thoughts
The reason for this is simple: there is already a secondary market for trading mortgages back and forth between buyers and sellers! This means that if you don’t want your mortgage anymore, someone else might want it.
And that’s the appeal of a mortgage-backed security.
Mortgage-backed securities are a type of investment that offers a way to diversify your assets. As mentioned above, their value depends on the underlying loans’ value. Mortgage-backed securities are a great investment for those who want to diversify their portfolio.
Frequently Asked Questions
It's an asset security traded on a secondary market. Investors can make money in the housing market without buying and selling real estate.
These typically have higher yields than government bonds.
The two most common MBSs are pass-throughs and collateralized mortgage obligations.
There is a risk that the person with the mortgage pays it off faster than anticipated and makes higher monthly payments and refinances, allowing a faster payoff.
