Mortgage-Backed Security

Mortgage-Backed Security

A derivative whose value is derived from unpaid mortgages. This entitles the owner to a claim on the principal and interest payments on the particular mortgages backing the security. MBSs pay an interest rate that is usually related to the interest rates the homeowners are paying on their mortgages. The equivalent of the coupon on a mortgage-backed security is a percentage of the interest and principal paid on the mortgages backing the security. An obvious risk to an MBS is the possibility that interest rates may decline, causing homeowners to refinance their mortgages. This provides capital to MBS holders, but it comes at a time when purchasing more MBSs would yield less due to the decline in interest rates. More complicated versions of MBSs include the collateralized mortgage obligation and the mortgage derivative. These attempt to reduce the risk associated with declines in interest rates.

Another risk associated with mortgage-backed securities is the possibility that a substantial number of mortgages will default. A main proximate cause of the credit crunch, which began in 2006-2007, was the fact that many mortgage-backed securities backed by subprime mortgages began to default. See also: Credit risk, Liquidity risk, Credit crunch.

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Mortgage-backed security. Mortgage-backed securities are created when the sponsor buys up mortgages from lenders, pools them, and packages them for sale to the public, a process known as securitization.

The securities are available through publicly held corporations such as Fannie Mae and Freddie Mac or other financial institutions. Some of the securities are guaranteed by the Government National Mortgage Association, or Ginnie Mae.

The money raised by selling the bonds is used to buy additional mortgages, making more money available to lend.

The most common mortgage-backed securities, also known as pass-through securities, are self-amortizing, and pay interest and repay principal over the term of the security.

Mortgage-backed securities known as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (REMICs) are structured differently. While a CMO or REMIC pays interest on a regular basis, the principal payments are structured in what are known as tranches and mature in sequence.

The principal is repaid to bondholders in the order in which the tranches are stacked, so the holders of the shortest-term tranche are paid principal first, the next shortest second, and so on.

You can buy individual mortgage-backed securities or select mutual funds, such as Ginnie Mae funds, that invest in mortgage-backed securities.