Mortgage-Backed Securities

Definition

Mortgage-backed securities (MBS) are financial instruments created by pooling together a collection of mortgages and selling shares of that pool to investors. These securities allow investors to earn income from the mortgage payments made by borrowers, while also providing liquidity to the housing market by allowing lenders to free up capital for new loans. MBS are an important part of the real estate finance landscape as they facilitate the flow of funds into mortgage lending and affect interest rates and availability of credit.

5 Must Know Facts For Your Next Test

1. Mortgage-backed securities can be classified into different types, including agency MBS, which are issued or backed by government entities, and non-agency MBS, which are not government-backed and can carry higher risks.
2. The cash flows from mortgage-backed securities depend on the timely payment of principal and interest by the underlying mortgage borrowers, making their performance sensitive to economic conditions.
3. MBS played a significant role in the 2008 financial crisis due to poor underwriting standards and the subsequent wave of mortgage defaults, leading to substantial losses for investors.
4. Investors in mortgage-backed securities receive monthly payments based on the mortgage payments made by homeowners, providing a steady stream of income.
5. Mortgage-backed securities contribute to the overall stability of the housing market by providing lenders with funds to issue new mortgages, thus promoting homeownership.

Review Questions

• How do mortgage-backed securities provide liquidity to the housing market?
  • Mortgage-backed securities enhance liquidity in the housing market by allowing lenders to bundle their mortgage loans into a single security that can be sold to investors. This process frees up capital for lenders, enabling them to issue new mortgages rather than having their capital tied up in existing loans. As a result, more money is available for new home loans, which can stimulate housing market activity and support homeownership.
• Discuss the impact of government-sponsored enterprises on the mortgage-backed securities market.
  • Government-sponsored enterprises like Fannie Mae and Freddie Mac play a crucial role in the mortgage-backed securities market by purchasing mortgages from lenders and packaging them into MBS. By providing a guarantee on these securities, they help reduce risk for investors, thereby increasing demand for MBS. This backing stabilizes the housing market and encourages more lending, as lenders feel more secure in selling their loans.
• Evaluate the risks associated with investing in non-agency mortgage-backed securities compared to agency MBS.
  • Non-agency mortgage-backed securities tend to carry higher risks compared to agency MBS because they are not backed by government guarantees. Investors in non-agency MBS face potential losses if borrowers default on their mortgages or if property values decline. In contrast, agency MBS benefit from implicit or explicit government backing, which mitigates credit risk and offers a greater level of security. Understanding these differences is essential for investors when making decisions about asset allocation in their portfolios.

Related terms

Collateralized Mortgage Obligation: A type of mortgage-backed security that includes multiple classes of bonds with different risk levels and maturities, designed to meet the varying investment needs of investors.

Government-Sponsored Enterprises: Organizations like Fannie Mae and Freddie Mac that support the mortgage market by purchasing mortgages and issuing mortgage-backed securities, helping to enhance liquidity.

Securitization:

The financial process of transforming illiquid assets, like mortgages, into liquid securities that can be sold in the capital markets.