Mortgage-Backed Security (MBS)

Definition

A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a collection, or pool, of mortgage loans. Investors in MBS receive periodic payments similar to bond coupon payments. These payments come from the interest and principal repayment of the underlying mortgage loans. MBS can be seen as a way to convert illiquid individual mortgages into a liquid and tradable financial product.

MBS can broadly be categorized into two main types:

Pass-Throughs: These securities pass through the mortgage payments to the MBS holders on a pro-rata basis.
Collateralized Mortgage Obligations (CMOs): These divide pools of mortgage loans into different tranches that vary based on risk levels and returns.

Examples

Residential MBS:
- Sachs Mortgage Broker Company purchases $100 million worth of home mortgages.
- They then pool these mortgages to form a MBS, which they subsequently sell to investors.
- As homeowners make their monthly payments, Sachs uses these funds to pay investors who hold the MBS.
Commercial MBS (CMBS):
- A commercial bank bundles together a pool of mortgages on commercial real estate properties.
- A CMBS is then created and sold to institutional investors. These investments often come with varying levels of risk and returns.

Frequently Asked Questions

Q1: What is the primary benefit of investing in a Mortgage-Backed Security?

A1: The key benefit is the potential for steady income streams generated from the mortgage payments. Additionally, MBS often diversify the portfolio since they are tied to real estate.

Q2: What risks are associated with investing in MBS?

A2: Risks include prepayment risk, credit risk, and interest rate risk. For instance, if homeowners pay off their mortgages earlier than expected, investors might receive lower returns.

Q3: How do MBS differ from traditional bonds?

A3: Traditional bonds are issued by entities (corporates or governments) for raising capital and promise regular interest payments, whereas MBS revenues come from mortgage payments made by borrowers.

Q4: What is a REMIC?

A4: A Real Estate Mortgage Investment Conduit (REMIC) is a special type of entity used to pool mortgage loans and issue MBS, offering tax advantages.

Q5: Who regulates mortgage-backed securities?

A5: In the U.S., entities such as the Securities and Exchange Commission (SEC) and the Federal Housing Finance Agency (FHFA) oversee MBS markets.

Collateralized Mortgage Obligation (CMO): A type of MBS that reflects a pool of mortgages structured into different tranches.
Pass-Through Security: A type of MBS where mortgage repayments are passed through directly to investors.
Real Estate Mortgage Investment Conduit (REMIC): An entity to pool mortgage loans and issue MBS.
Tranche: A portion or slice of the MBS, which comes with different risks and returns.
Prepayment Risk: The risk that mortgage borrowers will repay their loans early, affecting the MBS returns.

Online Resources

References

Gorton, G. B. (2009). Slapped by the Invisible Hand: The Panic of 2007. Oxford University Press.
Fabozzi, F. J. (2012). The Handbook of Mortgage-Backed Securities. Oxford University Press.

Suggested Books for Further Studies

Fabozzi, F. J. & T. N. Dunlevy. (2001). Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. Wiley.
Fabozzi, F. J. (2015). The Handbook of Mortgage-Backed Securities, 7th Edition. Oxford University Press.

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

### What is a mortgage-backed security (MBS)? - [ ] A bond issued solely by the government. - [ ] A stock backed by real estate companies. - [x] A financial instrument secured by a pool of mortgage loans. - [ ] A mutual fund that invests in real estate. > **Explanation:** A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a collection of mortgages. Investors in MBS earn income from the pooled mortgage payments. ### Which of the following is **NOT** a classification of MBS? - [ ] Pass-Throughs - [ ] Collateralized Mortgage Obligations (CMOs) - [x] Real Estate Bonds (REBs) - [ ] Tranches > **Explanation:** Pass-Throughs and CMOs are types of MBS. Tranches are segments within CMOs. Real Estate Bonds are not a type of MBS classification. ### What is the primary source of income for investors in MBS? - [ ] Dividends from real estate operations. - [ ] Direct loans from mortgage borrowers. - [x] Mortgage payments from the underlying pool of mortgages. - [ ] Government subsidies. > **Explanation:** Investors earn income primarily from the mortgage payments made by borrowers in the pooled mortgages that back the MBS. ### What is prepayment risk in MBS? - [x] The risk of mortgage borrowers repaying their loans earlier than expected. - [ ] The risk of borrowers defaulting on their mortgage payments. - [ ] The risk of receiving reduced interest payments. - [ ] The risk of changes in government regulation affecting MBS. > **Explanation:** Prepayment risk arises when borrowers pay off their mortgages ahead of schedule, affecting the expected returns on the MBS for investors. ### Who oversees the trading and regulation of MBS in the United States? - [x] Securities and Exchange Commission (SEC) - [ ] National Association of Realtors (NAR) - [ ] Department of Housing and Urban Development (HUD) - [ ] U.S. Treasury > **Explanation:** The Securities and Exchange Commission (SEC) is one of the main regulatory bodies overseeing the trading and regulation of MBS in the United States. ### How does an MBS differ from a traditional bond? - [x] MBS income derives from pooled mortgage payments, while bonds derive from issuer’s revenue. - [ ] MBS are government-issued while bonds are corporate-issued. - [ ] MBS are backed by stocks, whereas bonds are backed by property. - [ ] Bonds have fixed interest rates but MBS have floating rates. > **Explanation:** The primary distinction is that MBS derive income from mortgage payments made by borrowers within a pool, whereas traditional bonds derive income from the issuer’s revenue and creditworthiness. ### Which of the following can be classified as a related term to MBS? - [ ] Rent-to-own agreement - [ ] Hard-money loan - [x] Collateralized Mortgage Obligation (CMO) - [ ] Deed in lieu of foreclosure > **Explanation:** A Collateralized Mortgage Obligation (CMO) is a type of MBS with varied tranches of risk and return, making it a related term. ### Why might investors be interested in MBS? - [ ] To take outright control of the properties. - [ ] To earn dividends from the underlying real estate companies. - [ ] For government-backed guarantees providing implicit risk. - [x] To receive income streams from homeowner mortgage payments. > **Explanation:** Investors seek MBS mainly to receive income streams generated from mortgage payments made by homeowners. ### What is a tranche in MBS? - [x] A segment within CMOs with different levels of risk and returns. - [ ] A contract to buy mortgage loans at a future date. - [ ] A bond issued straight to the public market. - [ ] A type of property deed involving mortgages. > **Explanation:** Tranches are segments within CMOs, each having different levels of risk, duration, and returns for investors. ### Which entity uses a pool of mortgages to issue MBS? - [ ] U.S Tax Courts - [ ] Small Business Administration (SBA) - [ ] Internal Revenue Service (IRS) - [x] Real Estate Mortgage Investment Conduit (REMIC) > **Explanation:** A Real Estate Mortgage Investment Conduit (REMIC) is an entity set up to pool mortgage loans and issue MBS, commonly providing tax benefits for them.