Mortgage Backed Securities (MBS) Explain | by Hamewot Lakiang | Jun, 2024

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A mortgage-backed security (MBS) is a type of investment that is made up of a bundle of home loans bought from the banks that issued them. Essentially, these loans are packaged together and sold as a single security. The payments from the homeowners, including both principal and interest, are collected by a servicing company and then passed through to the investors who own shares in the MBS. This means investors receive regular income payments based on the performance of the underlying mortgages.

let’s look at the following explanation so that we can have a clear understanding of MBS

when banks and other lenders issue mortgages to homeowners. These mortgages are then sold to a financial institution or government sponsored entity (like Fannie Mae or Freddie Mac) that pools them together to create a mortgage backed security. The pooled mortgages are used as collateral to issue securities. This pool might consist of thousands of mortgages with similar characteristics; now Investors can buy shares of these mortgage-backed securities, effectively lending money to the homebuyers in the pool. In return, investors receive portions of the mortgage payments made by the homeowners. The payments from the homeowners are aggregated and distributed to the MBS investors. These payments typically include both the interest and principal amounts from the underlying mortgages.

For example : Imagine a bank, “x Bank,” issues a bunch of home loans to people in your neighbourhood. These loans are for different amounts and have various interest rates, but they all involve homeowners agreeing to make monthly payments to pay off their mortgages.

Now, x Bank doesn’t want to hold onto all these mortgages because they want to free up money to lend to more customers. So, they bundle these mortgages together into a single package. This package is now like a giant loan portfolio, containing pieces of all the individual home loans.

Next, x Bank sells this package to an investment company, “Smart Investments.” Smart Investments takes this bundle of loans and slices it into smaller pieces, called mortgage-backed securities (MBS). They then sell these pieces to individual investors, like you, me, or large institutions.

Here’s where it gets interesting for you, the investor. When you buy an MBS, you’re essentially buying a small portion of all those mortgages. As the homeowners in your neighbourhood make their monthly mortgage payments, these payments get collected and passed through to you and other investors. So, you receive regular payments that are a mix of interest and principal from the mortgages.

To illustrate:

1. x Bank issues 1,000 home loans, each with a different borrower and mortgage terms.

2. These loans are pooled together into a $100 million mortgage package.

3. Smart Investments buys this $100 million package and creates MBS worth $100 million by slicing it into 10,000 units, each worth $10,000.

4. Investors buy these $10,000 MBS units.

5. As homeowners make their monthly mortgage payments, the money is collected by a servicing company.

6. The servicing company distributes these payments to MBS investors based on their share in the pool.

In essence, when you buy an MBS, you’re investing in the real estate market without owning any physical property. Instead, you get a slice of the monthly mortgage payments from hundreds or even thousands of homeowners.

Now let us look the risks involved with MBS

Even though the return on an MBS can be attractive due to the regular income stream, there are risks involved.

These include:

1 Credit Risk: The risk that homeowners will default on their mortgage payments and .

2 Prepayment Risk : The risk that homeowners will pay off their mortgages early, which can happen if interest rates fall and homeowners refinance their loans. This can reduce the expected interest income for investors.

“Now that you’ve understood what MBS are and how they work, let’s end this post by learning about the different types of MBS.”

1 Pass through Securities :

These direct the mortgage payments from the homeowners through to the investors.

2 Collateralized Mortgage Obligations (CMOs):

unlike the pass through securities a Collateralized Mortgage Obligation (CMO) is a complex type of mortgage-backed security that repackages and directs the cash flows from a pool of mortgages into different classes of securities, known as slices or tranches.

Each tranche has its own risk and return profile, which appeals to different types of investors.

These Tranches are

1 Senior Tranches:

These are given the highest priority for receiving principal and interest payments. They typically carry the least risk and offer lower yields.

2 Mezzanine Tranches:

These tranches are subordinate to the senior tranches and receive payments only after the senior tranches have been paid. They carry moderate risk and offer higher yields.

3 Equity or Junior Tranches:

These have the lowest priority and only receive payments after all other tranches have been satisfied. They carry the highest risk and offer the highest yields.

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