Mortgage-Backed Securities

What are mortgage-backed securities?

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.

Mortgage-backed securities exhibit a variety of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk. An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive. (Source: SEC)

A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgages. Payments are typically made monthly over the lifetime of the underlying loans.

Since residential mortgagors in the United States have the option to pay more than the required monthly payment, with the additional payment reducing the remaining loan principal, the monthly cash flows are not known in advance. This advance payment of principal is known as prepayment and is an additional risk for MBS investors.

Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities

1. transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.

(Source: Wikipedia)