Mortgage-Backed Security (MBS)

Definition

A Mortgage-Backed Security (MBS) is a financial instrument backed by a collection of home loans bought from the original lenders (typically banks or mortgage companies) and aggregated into pools by a quasi-governmental agency like Fannie Mae, Freddie Mac, or Ginnie Mae. These agencies either guarantee the payment of interest and principal or offer a means for private issuers to sell these securities to investors. The primary attractiveness of MBS is that they offer a stream of income which is derived from the mortgage payments made by borrowers.

Examples

GNMA (Ginnie Mae) Guarantee MBS:
- These are securities backed by the Government National Mortgage Association and tend to be composed of FHA-insured loans and Veterans Administration (VA) loans. For example, you might invest in a pool primarily consisting of 30-year mortgage loans.
Conventional MBS:
- Typically issued by private institutions like banks or investment funds, these might include a variety of mortgage types with different risk levels and maturities. An example could be an MBS consisting of adjustable-rate mortgages (ARMs) that vary in risk but are expected to yield higher returns.

Frequently Asked Questions

What is the main benefit of investing in MBS?

The main benefit of investing in MBS is the opportunity for relatively stable income, generated from the pooled mortgage payments.

Are there risks associated with MBS investments?

Yes, MBS carry several risks including prepayment risk, credit risk, and interest rate risk. Because repayment comes from the borrowers’ mortgage payments, changes in interest rates or borrowers’ defaulting on loans can affect returns.

What are collateralized mortgage obligations (CMOs)?

CMOs are a type of MBS where mortgage loans are divided into parts (tranches) to direct cash flow in varying priorities, helping to reduce risk and suit different investor appetites.

How do MBS differ from regular bonds?

Unlike regular bonds that typically have fixed payments structured over time, MBS payments can vary as they depend on mortgage repayments which can fluctuate with prepayments or refinancings.

Can MBS be sold on secondary markets?

Yes, MBS are traded on the secondary mortgage market, allowing investors to buy and sell these securities before they mature fully.

Securitization: The process of pooling various types of debt (including mortgages) and selling its resultant cash flow streams to investors as securities.
Tranches: Portions or slices of a pool of securities that are subdivided based on differing risk profiles or payment structures.
Prepayment Risk: The risk that a borrower might pay off their mortgage early, thus affecting the amount and timing of the expected cash flows from the MBS.
Credit Risk: The risk of loss associated with the borrower failing to make required payments.
Primary Mortgage Market: The original loan issuance marketplace where borrowers directly receive loans from lenders.
Secondary Mortgage Market: The marketplace where mortgage loans and servicing rights are bought and sold between lenders and investors.

Online Resources

Federal Reserve: Mortgage-Backed Securities
Investopedia: Mortgage-Backed Security (MBS)
Securities and Exchange Commission (SEC): SEC’s Overview on Asset-Backed Securities

References

Fabozzi, F. J. (2005). The Handbook of Mortgage-Backed Securities. McGraw-Hill Education.
Hayre, L. (2001). Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities. John Wiley & Sons.
Gangel, M. H. (2012). MBS Basics: Why and How to Invest in Mortgage-Backed Securities. CreateSpace Independent Publishing Platform.

Suggested Books for Further Studies

“The Handbook of Mortgage-Backed Securities” by Frank J. Fabozzi: Comprehensive resource for understanding MBS, covering subjects like valuation, structure, and analysis.
“Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques” by Anand K. Bhattacharya and Frank J. Fabozzi: Detailed guide on structuring MBS products and the analytical techniques used in the market.
“Fixed Income Markets and Their Derivatives” by Suresh M. Sundaresan: This book provides insight into the broader fixed-income market, including a thorough discussion on MBS.

Real Estate Basics: Mortgage-Backed Security (MBS) Fundamentals Quiz

### What is a Mortgage-Backed Security (MBS)? - [x] A financial instrument backed by pooled mortgage loans. - [ ] A direct loan offered to individuals. - [ ] A type of individual retirement account. - [ ] An equity investment in real estate. > **Explanation:** A Mortgage-Backed Security (MBS) is an asset-backed security that is backed by a collection of home loans. Investors receive periodic payments derived from the underlying mortgage payments made by borrowers. ### What is a key risk associated with MBS investments? - [ ] Land depreciation risk. - [x] Prepayment risk. - [ ] Inflation risk only. - [ ] Non-existence risk. > **Explanation:** One of the main risks associated with MBS is prepayment risk, where the repayment of the principal occurs sooner than expected, potentially affecting the income stream from the investment. ### How does a Collateralized Mortgage Obligation (CMO) differ from an MBS? - [ ] CMOs are riskier. - [ ] CMOs pay a fixed income. - [ ] CMOs can only be issued by government agencies. - [x] CMOs divide pools into tranches. > **Explanation:** CMOs are a type of MBS that divides the mortgage pool into tranches with varying levels of risk and payment structures. This allows investors to choose tranches that best fit their risk appetite and investment timeline. ### Who typically guarantees Government-guaranteed MBS? - [x] Agencies like Ginnie Mae (GNMA). - [ ] Private hedge funds. - [ ] Commercial banks. - [ ] Credit unions. > **Explanation:** Government-guaranteed MBS are often backed by agencies like Ginnie Mae (GNMA), which ensures the timely payment of principal and interest to investors. ### Which of the following is NOT a type of risk related to MBS? - [ ] Credit risk. - [ ] Interest rate risk. - [ ] Prepayment risk. - [x] Geographic risk. > **Explanation:** MBS are related to multiple types of risks such as credit risk, interest rate risk, and prepayment risk, but geographic risk is not typically associated with mortgage-backed securities. ### What distinguishes a mortgage in an MBS pool? - [x] Diversification of various mortgage loans. - [ ] Each mortgage is individually managed. - [ ] Only mortgages from one region are grouped. - [ ] Banks manage payments directly to investors. > **Explanation:** Mortgages in an MBS pool are diversified, aggregating different home loans to distribute risk across various borrowers, providing safer investment from an income generation standpoint. ### How might interest rate changes impact an MBS? - [ ] They have no impact. - [x] They can affect borrower refinancing behavior. - [ ] They only impact the servicing agent. - [ ] They stabilize the cash flow stream. > **Explanation:** Changes in interest rates can affect borrower refinancing behavior, which in turn, can lead to early mortgage repayments, affecting the anticipated cash flows from the MBS. ### Are MBS only backed by residential mortgages? - [ ] Yes, always. - [x] No, there are commercial MBS (CMBS) as well. - [ ] They also include auto loans. - [ ] Only credit card debts back them. > **Explanation:** While many MBS are backed by residential mortgages, there are also commercial mortgage-backed securities (CMBS) that are backed by commercial property loans. ### Can MBS be affected by borrower default? - [x] Yes, it increases credit risk. - [ ] No, defaults don't impact MBS. - [ ] Only in government-backed MBS. - [ ] Defaults are managed separately. > **Explanation:** Borrower defaults can increase the credit risk associated with MBS by reducing the expected cash flows from mortgage repayments, impacting investors' returns. ### In which market do investors typically trade MBS? - [x] Secondary mortgage market. - [ ] Stock exchange market. - [ ] Primary mortgage market. - [ ] Derivatives market only. > **Explanation:** MBS are typically traded on the secondary mortgage market, where investors buy and sell these securities before they reach maturity.