Define Mortgage-Backed Securities

A mortgage-backed security (MBS), also referred to as a collateralized mortgage obligation (CMO), is another example of financial innovation at work. The MBS product is based upon securitization, which refers to the process of converting any income stream into an investment. In America, Fannie Mae and Freddie Mac are the largest players within the mortgage-backed security market.

A mortgage-backed security represents a claim to an underlying pool of mortgages. A financial institution earns fees from packaging the separate mortgages together and selling off slices of the large pool to individual investors. Investors collect income as homeowners within the pool make mortgage principal and interest payments. Individual mortgage-backed securities are sold through brokerages, or packaged together within sector-specific mutual funds.

Mortgage-Backed Securities: Tranches

Mortgage-backed securities are classified further into tranches. Each tranche offers its own distinct risk versus reward characteristics. For example, Tranche A may represent the first tranche to receive principal and interest payments while Tranche Z is the last in line. Because of this relationship, Tranche A would sell for a higher price because investors are willing to pay up for reduced risk. The high prices associated with Tranche Z limit its profit potential. Meanwhile, Tranche Z would sell for a low price. Tranche Z investors can earn high returns, if all homeowners continue to make timely interest payments. Tranche Z investors are also exposed to large losses, if mortgagees begin to default.

Mortgage-Backed Securities: Performance

MBS perform well and generate regular cash flow amid a stable interest rate environment. When interest rates fall, homeowners are more likely to refinance their existing mortgages. To refinance, people take out new mortgages to pay off old home loan debt. At that point, CMO investors would lose out on the future interest payments associated with the old mortgage. Alternatively, rising interest rates increase chances for loan default as mortgages become less affordable. Further, newly issued fixed income assets would then pay higher interest rates than already-existing MBS. At that point, mortgage-backed securities would lose value.

Mortgage-Backed Securities: Benefits

Mortgage-backed securities increase the amount of capital that is available within the real estate market to make loans. With mortgage-backed securities, banks can effectively raise money from outside investors to offer loans to customers. The increased money supply translates into lower mortgage rates, which allows for improved levels of homeownership.

Mortgage-Backed Securities: Risks

Investopedia highlights mortgage-backed securities as contributing factors behind housing bubbles and their inevitable busts. MBS practices can create a confusing web of banks, investors, hedge funds and homeowners. The increased money supply from the financial institutions may allow for loose lending standards that encourage real estate speculation. The speculation bids home prices up to unsustainable levels that eventually crash due to weak demand. Mortgage-backed securities, securitization, and cheap money have proven to be at the heart of the 2007-2009 housing crisis and its subsequent economic fallout.

Define Mortgage-Backed Securities, Sources:

Investopedia: Collateralized Mortgage Obligation - CMO

Investopedia: Mortgage-Backed Security (MBS)

Fannie Mae: Basics of Fannie Mae MBS