Mortgage-Backed Securities Demystified: A Clear Explanation
Mortgage-backed securities (MBS) are financial instruments that pool together mortgage loans and then issue securities backed by these pools. These securities are typically purchased by investors, providing them with a steady income stream through interest payments from homeowners and the potential for capital gains from principal payments as mortgages are paid off [1][3].
Two Types of MBS: Agency and Private-label
There are two main types of MBS: agency MBS and private-label MBS. The key difference between these two lies in the issuer and credit guarantee.
Agency MBS
Agency MBS are issued or guaranteed by government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, or government agencies. These entities buy mortgages from lenders, pool them, and issue MBS with a guarantee of timely principal and interest payments, which reduces credit risk for investors. Fannie Mae, for example, charges a guaranty fee for providing this credit risk protection [2][3].
Private-label MBS
Private-label MBS, on the other hand, are issued by private institutions such as banks or mortgage companies and do not have a government guarantee. These MBS carry credit risk directly borne by investors. They are sometimes called non-agency MBS and often include loans that don’t meet agency standards, such as subprime or non-conforming loans [1][4].
Risks and Rewards
MBS can be complex financial instruments, requiring careful research and analysis for informed investment decisions. While they offer diversification, income generation, and potential capital gains, they also come with certain risks.
Prepayment Risk
Prepayment risk can reduce the overall return on investment and disrupt cash flow due to early mortgage payments. This risk can be mitigated in fixed-income investments, although the specific methods are beyond the scope of this article [1].
Interest Rate Risk
Interest rate risk can cause MBS values to decline if interest rates rise. This is because when interest rates rise, new mortgages are issued at higher rates, causing the value of existing MBS to become less attractive [1].
Credit Risk
Credit risk exists, as borrower defaults can lead to investor losses, particularly during economic downturns [1].
Structured MBS
MBS structures may feature layers (tranches) with different claims on cash flows and risks, similar to collateralized loan obligations (CLOs), although this is more common in complex MBS varieties like collateralized mortgage obligations (CMOs) [5].
Trading MBS
MBS can be traded in the secondary market, offering investors liquidity [1]. This means that investors can buy and sell MBS even after the initial issuance, providing flexibility for those looking to adjust their investment portfolios.
Further Learning Opportunities
Understanding prepayment risk on MBS and its impact on fixed-income investments is a valuable skill for any investor. Additionally, learning about the various types of mortgages backing MBS, such as prime, subprime, Alt-A, buy-to-let, and single-family rental loans, can help investors make informed decisions [1].
In conclusion, MBS are a unique investment opportunity that offers diversification, income generation, and potential capital gains. However, they also come with certain risks, such as prepayment risk, interest rate risk, and credit risk. By understanding these risks and the various types of MBS, investors can make informed decisions and potentially reap the benefits of this investment.
[1] Investopedia. (2021). Mortgage-backed securities (MBS). [Online]. Available: https://www.investopedia.com/terms/m/mortgagebackedsecurities.asp [2] Fannie Mae. (2021). What are mortgage-backed securities? [Online]. Available: https://www.fanniemae.com/content/guide/selling/selling-guide/b3-2-02.pdf [3] Freddie Mac. (2021). What are mortgage-backed securities? [Online]. Available: https://www.freddiemac.com/learning/glossary/mortgage-backed-securities/ [4] The Balance. (2021). Non-agency mortgage-backed securities (non-Agency MBS). [Online]. Available: https://www.thebalance.com/non-agency-mortgage-backed-securities-2995147 [5] Investopedia. (2021). Collateralized mortgage obligation (CMO). [Online]. Available: https://www.investopedia.com/terms/c/cmo.asp
- Agency MBS, such as those guaranteed by Fannie Mae and Freddie Mac, offer a lower credit risk for investors due to the guarantee of timely principal and interest payments provided by government-sponsored enterprises.
- Private-label MBS, issued by private institutions, come with greater credit risk borne directly by investors, as they do not have a government guarantee and often include non-conforming loans.
