Mortgage-backed securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by pooling together a collection of mortgage loans, which are then sold as investment products to investors. They are typically backed by the cash flows generated from the mortgage payments made by homeowners, offering investors a way to earn income based on these payments. MBS are closely tied to interest rates and can be affected by benchmark rates like LIBOR, impacting their pricing and yield.

5 Must Know Facts For Your Next Test

1. MBS can be issued by government-sponsored entities like Fannie Mae and Freddie Mac, or by private financial institutions, impacting their risk profiles.
2. The performance of mortgage-backed securities is influenced by economic factors such as unemployment rates and housing market trends, which affect borrowers' ability to make payments.
3. Investors in MBS typically receive monthly payments based on the underlying mortgage payments, which can vary depending on the structure of the security.
4. MBS played a significant role in the 2008 financial crisis, as defaults on subprime mortgages led to widespread losses in the market.
5. The yield on MBS is often compared to other fixed-income investments, and changes in benchmark rates like LIBOR can directly impact their attractiveness to investors.

Review Questions

• How do mortgage-backed securities operate within the financial system, and what role do they play in providing liquidity?
  • Mortgage-backed securities operate by pooling together multiple mortgage loans and allowing investors to purchase shares in this pool. This process of securitization provides liquidity to lenders, enabling them to free up capital to issue more loans. Investors benefit from a stream of income generated from the mortgage payments made by homeowners, making MBS an essential component of the broader financial system.
• Discuss the impact of changes in LIBOR on mortgage-backed securities and how it affects investor decisions.
  • Changes in LIBOR can significantly influence the pricing and yield of mortgage-backed securities since they are often tied to interest rates. When LIBOR rises, borrowing costs increase for homeowners, potentially leading to higher default rates or slower prepayment speeds. Investors closely monitor these changes as they can alter cash flow expectations and affect the overall risk-return profile of MBS investments.
• Evaluate the risks associated with investing in mortgage-backed securities, particularly in relation to economic downturns and housing market fluctuations.
  • Investing in mortgage-backed securities carries inherent risks, especially during economic downturns when job losses may lead to increased mortgage defaults. Additionally, fluctuations in the housing market can impact property values and borrower equity, further influencing repayment behavior. Understanding these risks is crucial for investors as they navigate potential volatility in cash flows and overall returns from MBS investments.

Related terms

Collateralized Mortgage Obligation (CMO): A type of mortgage-backed security that divides the pool of mortgages into different tranches, each with varying levels of risk and return.

Prepayment Risk: The risk that homeowners will pay off their mortgages early, which can affect the cash flows and yields of mortgage-backed securities.

Securitization: The process of converting financial assets, like mortgage loans, into marketable securities, allowing for better liquidity and investment opportunities.