If you have questions about mortgage backed securities, you’re not alone. For this blog, we thought we’d take some time to briefly answer some of the more commonly asked questions.
What is a mortgage backed security?
Also known as an MBS, a mortgage backed security is a security that’s backed by assets, and as the name implies, it’s most commonly backed by a collection of mortgages.
Ultimately, this type of security allows for two things. One, it allows smaller, regional banks, the ability to lend money to home buyers—without needing to worry about whether the borrowers have sufficient assets to cover the loan.
The reason that banks can do this, is because the loans are funded by participants of the investment market.
When people invest money in a mortgage backed securitiy, they are lending money to people who are wanting to use that money to buy a home. When the borrower pays interest, the interest is divided between the pool of investors (also known as shareholders.)
Are there different types of mortgage backed securities?
The quick answer to this question is “yes.” As a general rule of thumb, there are two distinct types of MBS. The first is known as a “pass through” and the second is known as a “collateralized mortgage obligation.”
Pass-Through MBS In this type of MBS, the security is structured as a trust. Borrowers make their monthly mortgage payments and the investors receive their return once the pass-through matures. In most cases, these types of securities mature at 5, 15 or 30 years.
Collateralized mortgage obligation (CMO) In a nutshell, in this type of MBS, multiple pools of securities are combined together and each one is referred to as a tranche. Each tranche (which is sometimes referred to as a slice) is assigned a credit rating, and the ROI that investors receive will depend on the credit rating of the tranche. A secured (or collateralized) tranche will have a lower ROI for investors than an unsecured tranche, because it comes with a lower risk.
MBS and the 2007 financial crisis
In the months leading up to the financial crisis, large pools of mortgages were overvalued, and when buyers stopped making their loan payments, the losses to borrowers was catastrophic.
As you likely remember the losses were so catastrophic that the US Treasury needed to step in with a $700 billion bailout.
Although mortgage back securities are still being traded today, Wall Street has taken a more cautious approach when it comes to assigning value to an MBS, because the prior practice of inflating value, without cause, proved to be disastrous.
If you have further questions about the intricacies of mortgage backed securities, how they work and whether you could benefit by adding this type of security to your investment portfolio, be sure to speak to your financial advisor.
Not only can they help you understand the pros and cons of MBS, they can help you determine whether this type of investment strategy is right for you.