Mortgage-Backed Securities, Their Types, and How They Work

Home equity securities (MBS) are investments that are safe. A security is an investment made with the expectation of making a profit through the efforts of another person.2 It allows investors to benefit from the mortgage business without having to buy or sell an actual mortgage loan. Typical buyers of these securities are institutional, corporate and individual investors.

When you invest in an MBS, you are buying the right to receive the value of a mortgage package. That includes the monthly mortgage payments and the principal payment. Since it is a collateral, you can buy only part of the mortgage. You receive an equivalent part of the payments. An MBS is a derivative because it derives its value from the underlying asset.

How Mortgage-Backed Security Works

First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment bank. Use the money received from the investment bank to make new loans.

The investment bank adds the loan to a package of mortgages with similar interest rates. He puts the package in a special carrier designed for that purpose. It’s called a Special Purpose Vehicle (SPV) or Special Investment Vehicle (SIV). That keeps the mortgage-backed securities separate from the bank’s other services. The SPV markets the mortgage-backed securities.4

Types of MBS

The simplest MBS is the pass participation certificate. It pays owners their fair share of the principal and interest payments made on the mortgage package.4

In the early 2000s, the MBS market became very competitive. Banks created more complicated investment products to attract clients. For example, they developed collateralized debt obligations (CDOs) for loans other than mortgages5. These are called collateralized mortgage obligations (CMO).

Investment banks divide mortgage packages into similar risk categories, known as “astranches.” The least risky tranches contain the first three years of payments. Borrowers are more likely to repay during the first three years. For adjustable rate mortgages, these years also have the lowest interest rates.

Some investors prefer riskier tranches because they have higher interest rates. Those tranches contain payments from the fourth to the seventh year. As long as interest rates remain low, the risks remain predictable. If borrowers prepay the mortgage because they refinance, investors receive their initial investment back.

CMOs are sophisticated investments. Many investors lost money to CMOs and CDOs during the 2006 mortgage crisis. Borrowers with adjustable-rate mortgages were caught off guard when their payments rose due to rising interest rates. They couldn’t refinance because interest rates were higher, which meant they were more likely to default. When borrowers defaulted, investors lost the money they had invested in the CMO or CDO.6

How Mortgage-Backed Securities Changed the Housing Industry

The invention of mortgage-backed securities completely revolutionized the housing, banking, and mortgage businesses. At first, mortgage-backed securities allowed more people to buy houses. During the housing boom, some lenders did not take the time to confirm that borrowers could pay their mortgages. That allowed people to get into mortgages they couldn’t pay. These subprime mortgages were grouped into private label MBS.

That created an asset bubble. Itbst erupted in 2006 with the subprime mortgage crisis. Because so many investors, pension funds, and financial institutions owned mortgage-backed securities, they all suffered losses. That is what created the financial crisis of 2008.7

Private label MBS

Private label MBSs were more than 50% of the mortgage finance market in 2006.

Mortgage-backed securities and the housing crisis

President Lyndon Johnson created mortgage-backed securities when he authorized the Housing and Urban Development Act of 1968. He also created Ginnie Mae.8 Johnson wanted to give banks the ability to sell mortgages, which would free up funds to lend to more homeowners.

Mortgage-backed securities allowed non-bank financial institutions to get into the mortgage business. Before MBS, only banks had enough deposits to make long-term loans. Their pockets were full to wait until these loans were paid back 15 or 30 years later. The invention of MBS meant that lenders got their money back from secondary market investors. The number of lenders increased. Some offered mortgages that did not take into account the work or assets of the borrower.9 This created more competition for traditional banks. They had to lower their standards in order to compete.

Worst of all, MBS were unregulated. The federal government regulated banks to make sure their depositors were protected, but those rules did not apply to MBSs and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all.