Mortgagerateslocal.com – Are you looking for a way to diversify your portfolio and earn some passive income? Do you want to learn more about one of the most popular and influential financial instruments in the world? If so, you might be interested in mortgage-backed securities (MBS).
Mortgage-backed securities are a type of asset-backed security that is backed by a pool of mortgages. They allow investors to invest in the housing market without buying or selling properties. They also offer higher returns than other fixed-income securities, such as Treasury bonds or corporate bonds.
However, mortgage-backed securities are not as simple as they sound. They involve various types of risks, such as credit risk, prepayment risk, and interest rate risk. They also require a high level of expertise, as they are based on complex and dynamic factors, such as the economic conditions, the inflation expectations, and the supply and demand of the MBS.
We will explain what mortgage-backed securities are, how they are created, what are their benefits and risks, and how you can invest in them. By the end of this article, you will have a better understanding of this complex but potentially lucrative financial instrument.
What is a Mortgage-Backed Security?
A mortgage-backed security is a type of asset-backed security that is backed by a pool of mortgages. A mortgage is a loan that a borrower takes out to buy a property, such as a house or an apartment. The borrower agrees to pay back the loan with interest over a period of time, usually 15 or 30 years.
The lender, which can be a bank or a financial institution, has the right to foreclose on the property if the borrower fails to make the payments. A mortgage-backed security is created when a lender sells a group of mortgages to a third party, such as a government agency or a private company.
The third party then bundles the mortgages into a security and sells it to investors. The investors receive regular payments from the interest and principal of the mortgages, similar to a bond. The third party acts as a middleman between the lenders and the investors, and collects a fee for its service.
How are Mortgage-Backed Securities Created?
There are two main types of mortgage-backed securities: agency MBS and non-agency MBS. Agency MBS are issued by government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie Mac, and Ginnie Mae.
These are entities that are chartered by the federal government to support the housing market by buying mortgages from lenders and securitizing them. Agency MBS are guaranteed by the GSEs or the government, which means that the investors will receive their payments even if the borrowers default on their mortgages.
Agency MBS are considered to be very safe and liquid investments, and they are often used by institutional investors, such as banks, pension funds, and insurance companies. Non-agency MBS are issued by private entities, such as banks, hedge funds, and mortgage companies.
These are entities that are not backed by the government, and they have more flexibility in choosing the mortgages they securitize. Non-agency MBS are not guaranteed by anyone, which means that the investors bear the risk of default by the borrowers.
Non-agency MBS are considered to be more risky and less liquid than agency MBS, but they also offer higher returns. They are often used by sophisticated investors, such as hedge funds, private equity firms, and wealthy individuals.
Mortgage-Backed Securities Examples
To illustrate how mortgage-backed securities work, let’s look at some examples of different types of MBS.
Pass-Throughs
A pass-through is a type of MBS that passes through the cash flows from the underlying mortgages to the investors. For example, suppose a bank sells a pool of 100 mortgages with a total face value of $10 million and an average interest rate of 4% to a GSE, such as Fannie Mae.
Fannie Mae then creates a pass-through security and sells it to investors. The investors pay $10 million to buy the pass-through and receive monthly payments from Fannie Mae based on the interest and principal payments of the mortgages.
Assuming that the mortgages have a 30-year term and no prepayments, the investors will receive a monthly payment of $47,715, which is equal to the total payment of the mortgages minus a 0.5% servicing fee paid to Fannie Mae. The investors will receive this payment until the mortgages are fully paid off or until they sell the pass-through to another investor.
Collateralized Mortgage Obligations
A collateralized mortgage obligation (CMO) is a type of MBS that divides the cash flows from the underlying mortgages into different tranches, or slices, that have different characteristics and risks.
For example, suppose a bank sells a pool of 100 mortgages with a total face value of $10 million and an average interest rate of 4% to a private entity, such as a hedge fund. The hedge fund then creates a CMO and sells it to investors.
The CMO has four tranches: A, B, C, and Z. Each tranche has a different face value, coupon rate, maturity, and priority of payment. The table below shows the details of each tranche:
| Tranche | Face Value | Coupon Rate | Maturity | Priority |
|---|---|---|---|---|
| A | $5 million | 3.5% | 5 years | 1 |
| B | $2 million | 4% | 10 years | 2 |
| C | $2 million | 4.5% | 15 years | 3 |
| Z | $1 million | 0% | 30 years | 4 |
The investors who buy the CMO will receive monthly payments from the hedge fund based on the interest and principal payments of the mortgages. However, the payments will be distributed according to the priority of each tranche.
The tranche A investors will receive their payments first, followed by the tranche B investors, and so on. The tranche Z investors will receive their payments last, after all the other tranches are paid off.
The tranche Z investors will also receive no interest payments until then, but their principal will accrue interest at 4%. The CMO structure allows the hedge fund to create different tranches that appeal to different investors with different risk preferences and return expectations.
What are the Benefits and Risks of Mortgage-Backed Securities?
Mortgage-backed securities offer several benefits to investors, such as:
- Diversification: MBS allow investors to diversify their portfolio by investing in a different asset class that is not correlated with the stock market or the bond market.
- Income: MBS provide investors with a steady stream of income from the interest and principal payments of the mortgages. The income is usually higher than that of other fixed-income securities, such as Treasury bonds or corporate bonds.
- Liquidity: MBS are traded in a large and active secondary market, which means that investors can buy and sell them easily and quickly. Agency MBS are especially liquid, as they are supported by the government and the GSEs.
However, MBS also entail some risks, such as:
- Credit risk: This is the risk that the borrowers will default on their mortgages, which will reduce the cash flow and the value of the MBS. Non-agency MBS are more exposed to this risk than agency MBS, as they are not guaranteed by anyone. Credit risk can be affected by various factors, such as the economic conditions, the quality of the mortgages, and the creditworthiness of the borrowers.
- Prepayment risk: This is the risk that the borrowers will pay off their mortgages earlier than expected, which will reduce the cash flow and the value of the MBS. Prepayment risk can be affected by various factors, such as the interest rate environment, the refinancing activity, and the housing market. When interest rates fall, borrowers are more likely to refinance their mortgages at lower rates, which will increase the prepayment rate. When interest rates rise, borrowers are less likely to refinance their mortgages, which will decrease the prepayment rate.
- Interest rate risk: This is the risk that the value of the MBS will fluctuate due to changes in the interest rates. Interest rate risk can be affected by various factors, such as the monetary policy, the inflation expectations, and the supply and demand of the MBS. When interest rates rise, the value of the MBS will fall, as the investors will demand a higher yield to invest in them. When interest rates fall, the value of the MBS will rise, as the investors will accept a lower yield to invest in them.
Interest Rates and Mortgage-Backed Securities
Interest rates are one of the most important factors that affect the performance and valuation of mortgage-backed securities. Interest rates influence the cash flows, the prepayment behavior, and the discount rate of the MBS. In general, there are two types of interest rates that are relevant for MBS: the policy rate and the market rate.
The policy rate is the interest rate that the Federal Reserve (Fed) sets and controls to influence the economy and the inflation. The Fed adjusts the policy rate by conducting open market operations, which involve buying and selling Treasury securities and other assets.
The policy rate affects the borrowing and lending costs of banks and other financial institutions, as well as the consumer and business spending and saving decisions. The policy rate also influences the market rate, which is the interest rate that is determined by the supply and demand of money and credit in the market.
The market rate is the interest rate that reflects the prevailing conditions and expectations of the economy and the inflation. The market rate affects the yield and the price of various fixed-income securities, such as Treasury bonds, corporate bonds, and mortgage-backed securities. The market rate also affects the mortgage rate, which is the interest rate that lenders charge borrowers for taking out mortgages.
How to Buy Mortgage-Backed Securities
There are several ways to buy mortgage-backed securities, depending on your investment goals, risk tolerance, and budget. Here are some of the most common methods:
- Buying individual MBS: You can buy individual MBS through a broker or a dealer, either in the primary market or the secondary market. The primary market is where the MBS are issued for the first time, and the secondary market is where the MBS are traded among investors. Buying individual MBS requires a large amount of capital, as the minimum investment is usually $25,000 or more. It also requires a high level of expertise, as you need to analyze the characteristics and the performance of the underlying mortgages, such as the interest rate, the maturity, the loan-to-value ratio, the credit score, and the delinquency rate.
- Buying MBS funds: You can buy MBS funds, which are mutual funds or exchange-traded funds (ETFs) that invest in a portfolio of MBS. Buying MBS funds requires a lower amount of capital, as the minimum investment is usually $1,000 or less. It also requires a lower level of expertise, as you rely on the fund managers to select and manage the MBS. However, buying MBS funds also involves paying fees to the fund managers, which can reduce the returns. Some examples of MBS funds are the Vanguard Mortgage-Backed Securities ETF (VMBS), the iShares MBS ETF (MBB), and the PIMCO Mortgage-Backed Securities Fund (PMRAX).
- Buying MBS derivatives: You can buy MBS derivatives, which are financial contracts that derive their value from the performance of the MBS. Buying MBS derivatives requires a high level of expertise, as you need to understand the complex and volatile nature of the derivatives. It also involves a high level of risk, as you can lose more than your initial investment. Some examples of MBS derivatives are the mortgage-backed securities index (MBSI), the interest-only security (IO), and the principal-only security (PO).
Before you buy any MBS, you should do your research and understand the benefits and risks of each option. You should also consult a financial advisor or a broker who can help you find the best MBS for your portfolio.
Conclusion
Mortgage-backed securities are a type of asset-backed security that is backed by a pool of mortgages. They offer investors a way to diversify their portfolio and earn some passive income, but they also involve some risks, such as credit risk, prepayment risk, and interest rate risk. Investors can invest in MBS by buying individual MBS, buying MBS funds, or buying MBS derivatives, depending on their capital, expertise, and risk tolerance.
