MORTGAGE-BACKED SECURITIES

Mortgage-Backed Securities (MBS)

Mortgage-Backed Securities (MBS)

Introduction

In its earliest form, home mortgage loans were written by local banks, which held these loans in their portfolios of interest-earning assets. Over the years, better suitors emerged for these loans. The purpose of banks became to match them with potential investors or risk-takers. Eventually, to avoid the inconvenience of dealing with each mortgage loan individually, they were pooled with backing from the government, essentially creating mortgage-backed securities.

The creation of MBS comes through a process of standardization called securitization, which facilitated investing. It resolved the lack of available, consistently priced capital, which had previously put a ceiling on the number of new mortgages that could be issued. With the backing of the government and other secure agencies and furthermore backed by the underlying mortgages, these loans were pooled together. These loans can characterize a number of different set of features. Pooling them together cleared up any confusion that investors might have had in what they were investing in. The three most main issuers of MBS are Ginnie Mae, Fannie Mae, and Freddie Mac. Even though, only Ginnie Maes is fully backed by the US government, Fannie Maes and Freddie Macs are viewed as just as secure, taking out all default risk that existed before (Liebowitz, 2008, pp.6-10).

The two main reasons for MBS securitization were the long maturities of most mortgage loans and the fact that mortgage lending is backed by charge over real estate, which is a strong asset-backing. Consequently, an important implication of the creation of MBS was to make mortgage funds available to more Americans by protecting lenders from the risk of default, enabling them to take a separate exposure.

The structure of a fixed-rate MBS is similar to that of an ordinary debt instrument. It carries a monthly payment made up of the amortization of principal and the interest payment. In the beginning of the loan, most of the payment consists of interest, but as the end nears, the principal will make up most of the monthly payment. However, the difference between a MBS and a bond is the option of prepayment on a MBS. This is the risk that the mortgages in the pool will be prepaid, would immediately pay out the rest of the principal and produce a reduced rate of return for the entire MBS. Some common examples of prepayment include home sales, refinancing, and highest payoffs.

The MBS market has been growing ever since its inception. More recently, the MBS market has been expanding extremely rapidly. In 2002, the issuance of MBS nearly quadrupled from the amount issued in 1994. Right now, with rising interest rates in the past year and promising further growth, refinancing is slowing down and mortgage-backed securities look more attractive than ever. This trend will most likely translate into increased trading in MBS (Capone, 2007, pp.314-25).

Mortgage-Backed Securities and Financial Crisis 2008

A popular bond category since the 1980s, mortgage-backed securities (MBS) can be a highly profitable, extremely complicated, and highly risky investment ...