What are mortgage backed securities?

Mortgage backed securities (MBS) are pools of mortgages that are sold as bond-like financial instruments to investors in the open market, also known as the “secondary market”.  Although many banks and lenders participate in the sale of mortgage backed securites, there are two companies that control a combined total of 90% of this market in the U.S.-The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).  Mortgage backed securities offered for sale by these institutions are also known as ”agency bonds”.  They purchase mortgages from banks and mortgage lenders, pool them into mortgage backed securities, and offer them for sale to investors from all over the world.  Without this market, the banks would literally not have enough money to keep up with the demand for mortgages in the U.S.  This market allows banks to sell this debt into the open market, thus replinishing their supply of money to loan to new borrowers.

The majority of investors that purchase mortgage backed securities are foreign.  They may include various institutions, governments, and sometimes individuals.  Mortgage backed securities are rated according to a variety of risk factors, which affect the price.  

The two main components are price and yield, which are inversely related.  When one rises, the other automatically falls.   

Fannie Mae was established by FDR as part of the New Deal in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.  As a result of the housing collapse caused by the Great Depression, banks were unwilling to loan money for home financing.  They initially provided money to banks for the purpose of providing home financing toperate as government sponsored entities (GSEs).  Although they are privately held corporations with shareholders, they also enjoy the backing of the federal government.  Their main purpose is to serve as the chief market makers for pools of mortgage backed securities.  They purchase pools of mortgages from banks and then turn around and sell them on the secondary market to investors from around the world.  Their portfolio of securities is an astonishing 6.2 Trillion dollars.  That’s 46% larger than the largest bank   Although most people have never heard of this term, today almost every mortgage made in the United States is pooled into and sold as one of these securities.  Without the ability to raise capital by selling these loans, banks would literally not have enough money to lend to new homebuyers.  

A home buyer used to have no choice but to pay a large down payment (usually at least 20 percent) and would borrow the rest of the money needed to buy the home from a bank.  The bank loaned them money they had taken in from the general public-money that was deposited into savings accounts, CD’s, and so forth.  The bank’s profit was in the spread (difference) between the amount of interest they paid to their depositors versus the amount of interest they would charge to the home buyer.    One of the main problems of this “old fashioned” way of making mortgage loans is that banks simply do not have enough money to lend to enough homeowners to keep up with consumers demand for housing. 

In 1938 as part of the “New Deal”, the Federal National Mortgage Association (Fannie Mae) was created for the purpose of raising money from foreign investors to loan as mortgages.  Since Fannie Mae was a government sponsored entity, it allowed them to borrow money from investors at very low rates of interest and loan sing and a government goal to increase home ownership meant that a system had to be created to raise the capital needed to finance this expansion.   The investment bankers on Wall Street saw an opportunity to create an investment vehicle that would serve two purposes.  First, it would free up much needed capital for the banks to loan for new mortgages and second, it would harness the vast sums of investment capital from around the world and draw them into the U.S. housing market.  This was the birth of the mortgage-backed security.

If this concept sounds vaguely familiar, that’s because it’s very similar to how the government raises money to operate through the sale of U.S. Treasury Bonds.   While T-Bonds are backed by the full faith and credit of the U.S. government, mortgage-backed securities are backed by the collateral of the real estate by which they are secured.  Additionally, some are also backed by either private mortgage insurance companies (PMI) or the Federal Housing Administration (FHA loans) or the Veterans Administration (VA loans).  Generally, home buyers who have less than 20% down must either pay monthly PMI, a lump-sum PMI payment (also known as lender paid PMI) or they must take out a second mortgage to avoid having to pay PMI.  PMI is basically insurance that protects the MBS investor in case the homeowner defaults on the mortgage.  Without this insurance, investors would demand a higher rate of return and thus the rates for mortgages would be much higher. 

Today, with the exception of a very few banks that keep specialty loan programs called portfolio loans on their books, almost all mortgages are pooled and sold as mortgage-backed securities.   The recent economic crisis triggered by sub prime loans has not changed this fundamental fact.  Even though many people still make their payments to a bank, that bank quite often doesn’t own the actual mortgage debt itself, they just own the servicing rights to the loan.   The homeowner may never have a clue who actually owns their debt because the investor usually has no interest in servicing the loan, they are just looking for an investment vehicle.  The mortgage servicer  handles all the servicing aspects of a mortgage loan, including:

* Maintaining a customer service call center where homeowners can call when they have questions about their loan.

* Managing the escrow account on a mortgage, including paying taxes and insurance owed by the homeowner but collected as part of their monthly mortgage payment, as well as adjusting the payment if the cost of taxes or insurance changes.

* Providing payoff statements to title companies, lenders and homeowners when they want to refinance or pay off their loan.

* Collecting the monthly payments and forwarding that money to the investor (a.k.a. the owner of the mortgage backed security)

* Providing the homeowner with monthly payment statements or automatic draft of their payment from their checking account.

Once a homeowner pays off their mortgage, this money is credited back to the balance of the MBS.  This is one major difference between a mortgage backed security and a traditional bond, such as a T-Bond or a municipal bond.  Bonds have a specific maturity date (a specific date at which the principal balance will be repaid to the bondholder) whereas the date that homeowners will pay off their mortgage is uncertain.  Only a very small percentage of homeowners who take out a 30 year mortgage will actually wait 30 years to pay off the loan.  Most will either sell their home, refinance their existing mortgage, or pay off their loan early.  For example, an investor who purchases a mortgage backed security will likely not own that security in 30 years.  An investor who purchases a T-Bond at inception may very well hold their investment until maturity.  Most mortgage backed securities consisting of 30 year term mortgages will payoff in 10 years or less.  So investors tend to treat these much the same as a 10 year bond, regardless of the fact that their maturity date is 30 years.