Decoding Mortgage Backed Securities- Understanding the Inner Workings of the Housing Market’s Cornerstone
What is Mortgage Backed Securities?
Mortgage backed securities (MBS) are financial instruments that are created by pooling together a group of mortgages and then selling shares of these mortgages to investors. These securities are backed by the cash flows generated from the mortgages, making them a popular investment choice for many investors. The concept of MBS was introduced in the 1970s to help homeowners obtain affordable mortgages and to provide a new source of investment for financial institutions.
In this article, we will explore the basics of mortgage backed securities, their benefits, risks, and how they have evolved over the years.
Understanding Mortgage Backed Securities
Mortgage backed securities are essentially a collection of mortgages that have been packaged and sold as a single security. These mortgages can be for residential, commercial, or even government-backed loans. The primary characteristic of MBS is that they are backed by the cash flows from the underlying mortgages, which include the principal and interest payments made by homeowners.
When a mortgage is originated, it is typically held by a lender, such as a bank or mortgage company. However, to free up capital for new loans, the lender may sell the mortgage to an investment bank or a government-sponsored entity (GSE) like Fannie Mae or Freddie Mac. These institutions then bundle the mortgages together and issue MBS, which are then sold to investors.
Benefits of Mortgage Backed Securities
There are several benefits to investing in mortgage-backed securities:
1. Diversification: MBS provide investors with exposure to a diversified portfolio of mortgages, which can reduce the risk associated with investing in a single mortgage.
2. Income: MBS generate regular interest payments, which can provide a steady stream of income for investors.
3. Liquidity: MBS are highly liquid, meaning they can be bought and sold relatively easily in the secondary market.
4. Low correlation with stocks: MBS tend to have a low correlation with the stock market, making them a good hedge against market volatility.
Risks of Mortgage Backed Securities
Despite their benefits, there are also risks associated with investing in mortgage-backed securities:
1. Credit risk: The risk that homeowners will default on their mortgages, leading to a loss of principal for investors.
2. Interest rate risk: The risk that changes in interest rates will affect the value of the MBS, as investors may be less willing to pay a premium for securities with lower yields.
3. Prepayment risk: The risk that homeowners will pay off their mortgages early, which can reduce the cash flows generated by the MBS.
Evolution of Mortgage Backed Securities
Over the years, the mortgage-backed securities market has evolved significantly. The early days of MBS were dominated by GSEs like Fannie Mae and Freddie Mac, which were created to provide liquidity to the mortgage market. However, the market expanded in the 1990s and 2000s, with the rise of private-label MBS, which were backed by mortgages originated by banks and other financial institutions.
The financial crisis of 2008 highlighted the risks associated with mortgage-backed securities, particularly those that were backed by subprime mortgages. As a result, the market has become more regulated, with stricter underwriting standards and increased transparency.
In conclusion, mortgage-backed securities are a complex financial instrument that can offer various benefits to investors. However, it is crucial to understand the risks and to conduct thorough due diligence before investing in these securities.
