Mortgage-Backed Securities Improve Liquidity and Reduce Risk for Banks
A mortgage-backed security is an investment solution that is backed by a mortgage. It is similar to other instruments such as mutual funds, bonds, and stocks. The value of the MBS is linked to the underlying asset.
How It Works
Financial institutions such as mortgage companies and banks extend financing. The loan is then sold to Ginnie Mae, Freddie Mac, or Fannie Mae or an investment bank. The agency or bank pools together multiple loans that carry similar interest rates. They offer securities on the secondary market which come with the same payment as the pool of loans. They are offered to individual, corporate, and institutional investors.
Types of Securities
There are different types, including inverse floating rate, floating rate, principal only, interest only, accrual, and support or companion classes. Other types include target amortization, planned amortization, and sequential pay securities. Planned amortization classes transfer payments to support or companion classes with the aim of generating a steady cash flow. The window and payment schedule are pre-specified. With target amortization products, the schedule is set in such a way that prepayment occurs at a constant speed. Then there are accrual classes whereby the interest earned is added to the principal and not paid on a monthly basis.
Residential mortgage-backed securities are another variety. The cash flow is derived from a subprime mortgage, home equity loan, or another form of residential debt. The holders are entitled to interest and principal payments. Commercial mortgage-backed securities are different in that they are linked to commercial debt. The risk for investors is lower than with RMBSs because of the set term.
In general, this type of investment is complicated. While there are simple solutions such as pass-through participation certificates, others are more complex, for example, mortgage derivatives. They are organized in tranches. This is a way to divide the pool of loans into similar-risk categories. The second 5 – 7 years of payments is more risky, and investors receive higher returns. The problem with this type of investment is that the borrower may default. Refinancing is another issue because people opt for refinancing when interest rates go down.
Benefits for Investors
Investors usually buy mortgage-backed securities because they offer an attractive rate of return. Other advantages include transfer of risk, efficiency, and liquidity. Quasi-government agencies and investment banks that buy loans offer cash to financial institutions. The money is used to offer loans to individual borrowers and businesses and make profits. This makes the MBS a liquid product. Then the profits from the sale of securities are used by agencies to offer subsidized loans to low-income families. Second, MBSs are efficient in that it is cheaper to hold securities than lines of credit and home loans. Investors are offered interest rate payments in return. This is also a safer investment instrument than non-secured bonds. When it comes to risk transfer, financial institutions that sell home loans to investment banks transfer the risk of a borrower’s default. This is a way to ensure that the bank has a low risk profile. Loan securitization is also beneficial because it regulates interest rates. It stops financial institutions from over- and undercharging for loans. Low interest rates are not attractive to investment banks and agencies. High interest rates signal to investment banks that loans are offered to borrowers with blemished credit. Thus the risk for default is also higher.
Downsides
Mortgage-backed securities have changed the banking and housing industry, making it easier to buy real estate. Before the global financial crisis, many financial institutions offered zero down payment to borrowers who proved unable to meet their monthly payments. Lenders sold risky loans to pooling agencies, thus contributing to the subprime mortgage crisis. Everyone was affected because many financial entities, pension funds, and investors held MBSs. While selling home loans is a way to gain access to funds and offer new loans, banks did not pay the consequences for offering bad loans. They extended loans to borrowers with poor credit and low or no down payment. Finally, mortgage-back securities were not regulated which contributed to the asset bubble.
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