What is A Mortgage-Backed Security (MBS)

Mortgage-backed securities (MBS) act as a bridge between the housing market and investors. These pseudo-bonds play a crucial role in financial markets and represent a form of secure investment supported by the value of the real estate.

In a MBS, a bank approves loans for people purchasing property, then sells a collection of those loans to investors for a lump sum. The banks assume little risk because they receive an upfront payment, allowing them to issue loans more freely.

The investors benefit through a steady cash return from capable homeowners and always have the option to recoup losses due to non-payment by foreclosing on the real estate. This is why MBS are considered "safe" investments.

However, anyone who's lived through the 2007 housing crisis will know that no investment is ever 100 percent safe.

Types of Mortgage-Backed Securities

MBS comes in two forms, each with unique advantages.

These are:

• Pass-through Securities
• Collateralized Mortgage Obligations (CMOs).

Pass-throughs are the most basic type of MBS. Cash flows are directly passed to investors through principal and interest payments. These payments typically take decades to mature, but the exact length depends on the owner's capabilities. This type of MBS has issues with uncertain cash flow due to changing interest rates, refinancing rates, and defaulting borrowers.

CMOs get around this problem by collecting payments from multiple pass-through securities and dividing them into classes called tranches. These tranches are assigned ratings by the government or a private financial company based on risk and priced accordingly.

By consolidating the cash flow from multiple MBS, a CMO can offer varying levels of security and payment predictability. This allows investors of all means to buy in depending on the class of the tranche.

How to Create an MBS

Designing an MBS involves multiple parties moving the trust and payments around. The responsibilities of each party are outlined in a "Pooling and Servicing Agreement," and the entire process is known as mortgage securitization.

Mortgage securitization includes all the steps required to repackage mortgages into protected, interest-bearing assets. At the top is the "Seller," the mortgage lender or bank that initially creates the loan.

Sellers decide which assets to mark off from their balance sheets, allowing them to report loans as a positive action and avoid repercussions from defaults. These marked-off assets are sold to investors so the bank can increase liquidity and continue financing new loans.

However, the Sellers don't completely leave the picture after selling to investors. They continue acting as an intermediary for the borrowers. Property owners pay the banks who pass along the earned cash flow or a predetermined amount to the investors in the case of a Collateralized Mortgage Obligation.

The separation of mortgages into tranches is what allows banks to promise investors a certain return schedule. Tranches are created from a group of loans with similar risks. The ones with better likelihoods of repayment are sold at a premium, while riskier options are unloaded at a lower price.

The riskiness of tranches is calculated by government agencies or independent financial companies using a Monte Carlo Simulation.

In many cases, CDOs are securitized through other banks. Rather than sell to independent investors, the original Seller creates an MBS and pays a second bank a fee to carry some of the risk. If the borrower defaults, the Seller will receive some percentage of the MBS's value from the second bank.

This trade is called a credit default swap or a credit derivative contract and isn't exclusive to MBSs.

Unpacking MBS's Role in the 2008 Housing Crash

The 2007-2008 housing crash, often called the subprime mortgage crisis, was an incredibly complicated financial event that damaged the global economy. The overvaluation of tranches within mortgage-backed securities played a significant role in its development.

In the years leading up to the crash, subprime lending became an acceptable industry standard in banking. This means that financial institutions were expected to provide mortgages to applicants whose creditworthiness didn't meet the loan requirements. These are called "subprime" mortgages.

MBSs got around this by bundling subprime mortgages and using the total cash flow to hide the weaknesses of individual loans through securitization. Alone, this would not have snowballed into such a massive problem because rating agencies were supposed to value these MBSs accurately.

However, the credit rating agencies often ignored the faults of MBSs and CDOs and arbitrarily assigned stellar ratings to high-risk assets. Investors trusted the ratings and bought these incorrectly rated assets, which funded the bank's problematic lending practices.

Inevitably, millions of homeowners with subprime mortgages failed to meet their obligations, leading to widespread defaults. This destroyed the value of the underlying assets, which was the bedrock of every MBS.

The dramatic drop in property value triggered a freeze in credit markets because banks were afraid to back each other. They couldn't refer to each other's balance sheets for trust since those numbers were tarnished by mismanaged MBSs.

Since banks couldn't back each other, only borrowers with unshakeable credit could secure a loan, further depressing housing prices.

Types of MBS and Their Influence on Different Housing Segments

There are commercial MBSs designed to finance large-scale real estate projects which are significant business assets. These are structured similarly to residential MBS but are created by pools of high-value commercial mortgages.

The value of CMBS is closely related to business cycles and the economy's health. The banks do not have the liquidity to fund commercial projects during a recession.

Investors must also consider factors specific to commercial property types backing the securities. These considerations include location, tenants, and demand for each borrower's services.

How to Analyze an MBS as an Investor

Considering an MBS involves looking at multiple independent factors to make informed decisions. It's not enough to trust the rating. MBS are complex financial instruments, and comprehending the underlying risks is crucial.

Understand the Type of MBS

Pass-through securities offer returns based on borrower's repayment rates. This means investors are carrying much more risk if there are mass defaults. However, some may prefer this method over trusting tranche ratings on CMOs.

Evaluate Credit Quality

Assess the credit quality of the mortgages within the MBS. Look at the credit scores, loan-to-value ratios, and other relevant contributors to creditworthiness. A rating might be an easy way to filter options immediately, but it shouldn't be the deciding factor.

Diversification

Assess how an MBS fits in your investment portfolio and existing risks. It may be a good choice as a standalone investment but may also tilt your overall risk potential into the red.

Consider Prepayment Risks

There are risks outside of default when investing in an MBS. Responsible property owners may pay off their mortgages early, particularly if there's a period of low interest rates or refinancing. These factors will significantly affect an investor's cash returns in pass-through security because the repayment period will shorten.

Consult with Financial Professionals

Before taking the plunge, seek advice from financial advisors with expertise in fixed-income securities. They may catch something you miss by looking through property records and can steer you away from dangerous investments.

Government Role in Regulating MBSs

After the 2007-2008 housing crash, the government took a much heavier-handed role in regulating the creation and ratings of MBSs. American policy generally aims to encourage homeownership and stabilize the housing market as much as possible. This period also saw a decline in the use of instruments like bearer bonds, which are unregistered and thus carry higher risks and less regulatory oversight compared to registered securities.

The creation of Government-Sponsored Entities (GSEs), such as the Federal National Mortgage Association, played a central role in uprooting the MBS market. These entities buy mortgages from lenders with the backing of the government to significantly enhance the credit quality of an MBS,contrasting with the less regulated nature of bearer bonds.

Many standards and regulations were also created to ensure the transparency and reliability of marketed MBS. Strict guidelines state the criteria for mortgage eligibility, disclosure requirements, and risk management. These components prohibit most subprime mortgages.

Conclusion

Mortgage-backed securities play a crucial role in financial markets despite their destructive history. They're an access point for investors to support homeowners without going through the trouble of sourcing and managing loan repayment plans.

However, taking an active and personal role in evaluating MBSs and CDOs is crucial for all investors. To make an intelligent decision, you must understand the underlying assets, default risks, and homebuying conditions.