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Introduction to Mortgage Backed Securities

By Arvin Sahakian · Aug 12, 2015 · Mortgage

Introduction to Mortgage Backed Securities

Image courtesy of Flickr, woodleywonderworks

Mortgage-backed securities are bonds backed by payments on mortgages and other real estate loans. Although complex, some investors find them to be an attractive investment.

Mortgage-backed securities were at the heart of the 2008 global financial crisis. Now, they're making a comeback. Learn how these investments work, what role they played in the worst recession since the Great Depression, and why you might want to consider investing in them now.

What are Securities?

You often hear or read about securities in financial reports, but what are they? Securities is a general term that refers to stocks, bonds, mutual funds, and other investments. Securities differ from other types of investments like gold and silver because they are intangible. You can't actually see, touch, or hold them in your hand. Since securities are intangible, investors receive paper certificates as proof of their investment. Nowadays investors are more likely to receive electronic certificates as proof of ownership instead of paper.

You can invest in two types of securities:

1. Debt Securities

Debt securities are also known as fixed-income securities. They include CDs and bonds. When you purchase a debt security, the government or corporation that issued it to you is now in debt to you.

2. Equity Securities

Equity securities are more commonly known as stocks. You have a stake in the company you buy a stock in. The performance of the company drives your rate of return.

Both debt and equity securities are liquid, meaning that you can sell them at any time to convert into cash. Most investors hold them until their sale will yield a target return goal.

For Example:

  • Company ABC's stock is selling for $10 per share.
  • You decide to spend $1,000 to buy 100 shares of ABC stock.
  • Your target goal is to make $1,000 off this investment.
  • You sell 100 shares of ABC stock when the price reaches $20 per share.
  • You now have $2,000 from the sale of your shares.
  • Subtracting your initial investment, you have just made $1,000.

There's no guarantee that the stock price will increase enough for you to reach your investment goal. You may even lose money if the stock price drops after you buy and doesn't return to the original purchase price. This is why it is absolutely crucial to conduct research and calculate your risks carefully, or seek advice from an experienced investment consultant.

What Does Backing Securities with Mortgages Mean?

A mortgage-backed security, also known as MBS, is a type of bond representing an investment in a group, or pool, of real estate loans. A bank puts mortgages and real estate loans they lend to borrowers of similar types and credit quality into a pool. There may be hundreds or even thousands of loans in the pool. The bank then sells the pool of loans to a government agency, government sponsored-enterprise (GSE), or private investment firm as a single bond called a mortgage-backed security (MBS). This single bond represents the hundreds or thousands of loans in the pool.

Ginnie Mae is the most common government agency, and Fannie Mae and Freddie Mac are the most common GSE's that purchase mortgage-backed securities. The purchaser of the MBS can then turn around and sell shares of it to other investors.

MBS began as a way for banks to continue making mortgage loans without tying up capital and resources for a lengthy period of time - up to 30 years for a conventional mortgage. By selling the loan's potential principal and interest payments to investors, the bank is able to:

  • Get the liability off its books.
  • Free up the capital used to make the loan.
  • Avoid the risk of the borrower defaulting on the loan.
  • Become only the originator and servicer (payment processor) of the loan.

How Do Mortgage-Backed Securities Work?

Remember our discussion above about securities, specifically debt or fixed-income securities? An MBS is a debt security, but it's unlike a traditional fixed-income bond. Bondholders usually receive semi-annual interest payments for their investment. However, MBS bondholders receive monthly interest payments. Why the difference? Homeowners make monthly principal and interest payments, and these payments make their way to investors.

There's another difference between traditional and MBS bonds. A traditional bond only pays interest with a lump sum payment of the principal when the bond matures, let's say 10 years for a 10 year bond. An MBS bond pays both principal and interest during its lifetime, which is the way mortgages are paid off. In the beginning, MBS pays the investor mostly interest, but over time that changes to mostly principal payments to the investor until the bond matures or mortgage is paid off.

At maturity, the investor doesn't receive a lump sum payout of the principal they have invested in because they have been receiving principal and interest payments all along. The investor's payment also varies from month to month. This is the result of homeowners prepaying the mortgages backing the MBS, which simply means the borrower of the mortgage loan pays the loan off sooner than the investor anticipated.

There are two common types of Mortgage-Backed Securities (MBS):

1. Pass-Through

These are the most basic mortgage-backed securities. Mortgage payments are collected and distributed (passed through) to investors. Most are backed by fixed-rate mortgages, but some may be backed by adjustable-rate mortgages (ARMs). Most have a stated maturity of 30 years, 15 years, or 5 years. However, the average life of a MBS is less than the stated maturity life. That's because the mortgages represented by the bond may be paid down or paid off early by the borrower of the mortgage loan. This is especially true when mortgage rates decrease and many homeowners refinance.

2. Collateralized Mortgage Obligation (CMO)

CMOs are more complex than pass-throughs. CMOs are made up of multiple pools of securities called tranches, or slices. Generally only sophisticated investors invest in CMOs. The CMO investments offer the investor access to cash flows from mortgages without the investor having to directly purchase multiple sets of mortgage investments themselves.

What Does The Mortgage-Backed Securities Market Look Like?

When discussing the size if the MBS market, on must refer to trillions of dollars. The chart below follows the issuance of mortgage-backed securities from 2006 to 2014. This range covers the height of the real estate bubble before the financial crisis, the crash of the housing market, and the recovery into present day. In 2014, issuance of MBS at $1.0 Trillion are only half that of 2006, during the height of the real estate bubble.

MBS Issuance Volume in Trillions of Dollars 2006-2014

Senior portfolio manager Dan Adler of Amundi Smith Breeden says the securities issued before the financial crisis are trading well under par, meaning worse than expected. He adds that these securities offer yields of 2% - 6% when considering defaults.

Mortgage-backed securities are traded with little liquidity risk, meaning the risk of not being able to quickly sell them after buying is low. They're considered a safe investment with the same creditworthiness as treasuries. Their return is typically 1% to 2% higher than treasuries. This is because of the prepayment risk described above. As with any investment, the higher the risk the higher the rate of return to offset that risk. J.P. Morgan's Mortgage-Backed Securities Fund has averaged a ten-year return (ticker symbol: OMBAX) at net asset value (NAV) of 5.07%.

Let's take a closer look at the J.P. Morgan Mortgage-Backed Securities Fund (ticker symbol: OMBAX). The chart below follows the 1 year rate of returns from December 31, 2005 to December 31, 2014. The year 2009 had the highest returns of over 14% (same year the housing market was said to bottom out), whereas 2013 had the lowest at a negative return of -0.90%.

Mortgage-Backed Securities Fund Rate of Return 2005-2014

Let's take a look at another chart below, following what a $10,000 investment at the beginning of 2005 would look like during the same ten year time frame using the same 1 year rate of returns as the J.P. Morgan Mortgage-Backed Securities Fund (ticker symbol: OMBAX).

Growth in Value of a $10,000 Investment Over 10 Years

As you can see from the chart above, a $10,000 initial investment into this fund grew $6,574 to a total value of $16,574 by the end of 2014, which is approximately a 65% cumulative return on your investment over the course of 10 years.

Mortgage-Backed Securities (MBS) are ideal for investors who:

  • Are conservative but looking for a higher yield than treasuries.
  • Do not need to rely on a fixed stream of investment income on which to live.

Most mortgage-backed securities (MBS) require a minimum investment of $25,000; however, some Collateralized Mortgage Obligations (CMO) only require $5,000. CMOs are only recommended for sophisticated investors because of their complexity.

What Role Did Mortgage-Backed Securities Play in the Recent Recession?

Before the 21st century, U.S. banks conducted due diligence when making mortgage loans. They asked for and verified a borrower's income, debt, and credit rating before lending money for a home purchase or refinance. Essentially, lenders used to limit their risk as much as possible before lending money. Mortgage-backed securities allowed banks to pass the risk of real estate loans to the agencies and investors who purchased shares in them, so the need for strict underwriting to reduce risk was relaxed as time went on.

When the highly qualified mortgage loan applicants started drying up, banks turned to subprime borrowers. They had lower credit ratings and posed a higher credit risk. Banks charged a higher interest rate to offset these risks. At first, mortgage-backed securities for subprime loans performed well because the first subprime borrowers were more likely to make their mortgage payments - at a higher interest rate - than later subprime borrowers closer to the 2008 global financial crisis.

The chart below outlines the subprime mortgage market as a share of the entire mortgage origination market from 1996 to 2008. During the year 2003, the subprime mortgage market sky rocketed from 8.3% market share to nearly 21% only one year later. The peak was reached in 2006 at nearly 24% of the entire mortgage market. This year also coincides with the peak of the housing bubble, just before the market crash.

Subprime Share of Mortgage Market 1996-2008

By August 2008, one out of every 416 U.S. households had a foreclosure filed against it. As more and more subprime borrowers defaulted on their loans, mortgage-backed securities started performing poorly for the investors. The ones that consisted primarily of subprime mortgages eventually became worthless, causing huge losses and write downs to the investors.

At the same time, new home construction was far greater than the demand for it, creating excess inventory. Housing prices dropped. Many homeowners learned their homes were worth less than their loans and walked away from them increasing the number of foreclosures further. Huge investment banks with portfolios full of these underperforming subprime MBS found their net worth's sinking. Bear Stearns was bought by J.P. Morgan for $2 per share. Just one week before its stock price was $70 per share. Lehman Brothers also went under.

Fannie Mae and Freddie Mac, which owned $3 trillion in mortgage investments at that time, asked for and received help from the federal government. The mortgage crisis was in full swing. Fannie Mae and Freddie Mac were unable to lend money or purchase loans from lenders. As a result, direct lenders like banks and mortgage companies stopped lending their money to consumers due to the instability of the market as a whole.

With limited loans, consumers stopped buying goods and services and the markets further crashed. The companies making and providing those goods and services started laying off employees making the situation even worse. The economy went into a tail spin resulting in the worst recession since the Great Depression.

Final Thoughts

As a real estate investor, the responsibility of the outcome ultimately comes down to you. Whether you are an expert, fairly knowledgeable, or a novice, you should always tread lightly when approaching your nest eggs to use for investment purposes. Be sure your risks are well calculated.

All investment decisions are essentially speculations. When you are speculating, it's very important to conduct your own research, review analysis by others, and take time to digest the information. If you find yourself not completely understanding a particular investment tool after thoroughly researching, then it may be best to not proceed and look for investment tools that you fully comprehend, there is certainly no lack of them out there.

Investing in mortgage-backed securities are relatively complicated, which is why this article has been written to help you understand the basics of this investment tool in order to learn how they work, what impact they can have on the economy and whether or not you would want to use them as one of your investment tools.

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