What is a Mortgage-Backed Security (MBS)?

Point of interest

Mortgage backed securities led to one of the largest financial crises in our country’s history, but these real estate-based investment vehicles are still considered viable today.

With over 4.3 million housing purchase loans totaling over $1.2 trillion dollars in 2018, it’s not surprising that banks look to mortgage lending as a core part of their business. To maximize the funds available for making new mortgage loans, banks will often offer mortgage-backed securities, or MBS, to investors as a way to free up loan funds and continue to reap the benefits of traditional mortgages.

So, what are mortgage-backed securities? In short, they’re unique investment vehicles that allow investors to financially back home loans and earn a profit on real estate transactions. This type of investment earned a bad rep during the subprime mortgage area, but these investments have changed in recent years in direct response to the housing crisis of 2008.

What are mortgage-backed securities (MBS)?

Mortgage-backed securities are a type of investment that is secured by mortgage loans issued to residential home buyers. To facilitate this investment, a bank acts as the intermediary by connecting those who want to invest in real estate with those who need funding to buy their own home.

Traditionally, people who wanted to buy a home would visit a bank to secure a mortgage loan. This loan would cover the cost of the home, and the individual who obtained the loan would pay back the amount financed with interest, usually over the next 15-30 years. With MBS’, the bank can take many of these loans and bundle them into a secured investment vehicle, much like a bond, which is then offered to financial backers. 

Those who invest in the MBS would provide funds to the bank to cover the principal balance of the mortgage loans, and they would earn interest on their investment through the mortgage payments made to the bank. Since the inception of mortgage backed securities, banks have used this financial strategy to cut down on the risk associated with offering mortgage loans while freeing up funds to generate additional capital.

How do mortgage backed securities work?

To create a mortgage backed security, three main parties must be involved: investors, banks and individuals who need a home loan. For the individuals purchasing the homes, the experience isn’t much different from any traditional mortgage. The bank offers a mortgage loan to the individual at a specific interest rate for a specified repayment term. The individual receiving the loan then makes monthly payments for the specified repayment period (usually 30 years).

The bank repeats the process of offering mortgage loans to individuals many times until it has a group of mortgage loans to bundle together. This group of mortgages is then marketed as a real estate investment vehicle to potential investors or investment companies. The most common type of MBS is a pass-through MBS, in which is money passed through the investment vehicle created by the bank. First, investors provide funds to the bank to support mortgage loans. Individuals then make their mortgage payments to the bank, the bank takes a cut for servicing and managing the loan, and the bank then passes the funds through the investment vehicle to repay the original investors with interest.

Since these investments rely on individuals who want to purchase homes, they are especially popular when the housing market is performing well. When the housing market improves, individuals see homes as a more secure investment and are more likely to buy. As more buyers purchase homes, interest rates tend to go up in turn, which also makes MBS investments more profitable for investors.

How did MBS change the housing industry?

In 1968, legislation passed by Lyndon B. Johnson created Fannie Mae and Freddie Mac. These government-sponsored entities were responsible for fueling money into the housing industry and helping mortgage lenders stay afloat. This led to the creation of the secondary mortgage market, which was a privatized market where only banks and other investors could buy and sell mortgage loans.

Banks realized they could offload mortgages to Fannie Mae and Freddie Mac in the secondary mortgage market through the use of mortgage-backed securities, freeing up funds to make additional loans and thus generating more capital for the bank. As the housing industry started booming, these mortgage-backed securities were proving extremely profitable, which fueled the demand for additional MBS opportunities.

Because Fannie Mae and Freddie Mac were government-sponsored, they were given more leeway than other financial institutions. These two organizations were allowed to take on massive amounts of mortgage debt from other banks, further fueling the housing industry.  

In order to meet the demand for additional mortgage loans and mortgage-backed securities — and since this investment vehicle allowed them to defray most of the risk — banks relaxed their loan qualification policies and began to provide mortgages to individuals with lower credit ratings. 

Eventually, these borrowers defaulted on their loans, which caused massive financial problems for companies that were heavily invested in mortgage-backed securities, including Fannie Mae and Freddie Mac. As the housing market crashed, it took many major financial institutions with it.

This housing crash led to sweeping changes designed to prevent a similar bubble from ever happening again. Now, MBS investments are much more heavily regulated, and banks are required to demonstrate due diligence in determining creditworthiness for any loans that will be resold to investors. Subprime mortgages, or mortgages offered to borrowers who pose serious credit risks, are still allowed, but the interest rates on these types of mortgages are much higher and the associated risks must be fully disclosed to investors.

Mortgage-backed securities today

Although mortgage-backed securities were a major contributor to the housing market crash of 2008, they are still in existence today. When all involved parties do their part, it is a good financial vehicle for diversifying risk. To help avoid another financial meltdown, there are now stricter regulations on MBS investments and banks are required to provide more clarity in the types of loans involved.

These additional regulations do make it harder for the riskiest borrowers to obtain mortgage loans, but MBS investments remain a viable way for banks to smooth out the risk associated with major lending and mitigate losses.

Final thoughts

While mortgage-backed securities may have earned some negative press over the years, the negative consequences experienced during the fallout from the 2008 mortgage crisis were primarily the result of investors chasing inflated and over-promised returns on real estate investments. As with any investment, it is important to conduct proper research and make sure the investments are actually sound. To avoid a repeat of the housing crisis in the future, federal lawmakers have instituted regulations that allow banks to smooth out the risks associated with offering mortgage loans while still providing safeguards for those who choose to invest in mortgage-backed securities.

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Julia Taylor

Personal Finance Contributor

Julia Taylor is a freelance writer based in Nashville, TN. She takes complex business, financial, and technical topics and makes them easy to understand. You can find her work published on a variety of business blogs, including Paychex, Kapitus, Sanford Brown, Fortis Educational Institutes, American University of Antigua and Interest.com. She also earned her Bachelor’s degree in Business from the University of Tennessee and her MBA from Tennessee Tech University. When she’s not working on her next writing piece, you can find her working in the yard or spending time with her three teenaged children.