What Are Mortgage Backed Securities?

Mortgage-backed securities are securities whose values are backed using mortgage loans. Those mortgage loans are bought from banks and lending institutions and linked together into pools to increase value and reduce risk. Those securities are sold to investors as bonds, which can be bought and sold any way investors want. So long as the mortgages in the pool are paid off on time, the bonds will have value. Mortgage-backed securities were popular during the housing bubble. They have lost some of that popularity since the housing market collapsed. While investors can still buy mortgage-backed securities, they are not as sound--or as profitable--as they used to be.

Understanding Mortgage-Backed Securities

Today, most mortgage-backed securities are issued by government-sponsored enterprises, companies that were established by the US Congress. Two of the best-known government-sponsored enterprises, Fannie Mae and Freddie Mac, are owned by the US government, while others are controlled by private entities and backed by the US government. These were created in order to increase home ownership among Americans. During the housing market boom, private lending institutions such as brokerage firms, banks and home building companies also issued mortgage-backed securities.

The purpose of mortgage-backed securities is twofold. By selling mortgage obligations to investors, government-sponsored enterprises and private companies can take those mortgages off their balance sheets. This allows lending institutions to loosen their mortgage loan requirements and offer mortgage loans to borrowers who would not otherwise be able to qualify. For government-sponsored companies, the looser requirements serve to facilitate their mission, while private companies get an opportunity to earn more profit by increasing the number of lenders that can take out their loans.

For investors, the mortgage-backed securities represent investments that are more profitable than stocks. With stocks, investors profit by buying them and selling them at higher prices. Yet with bonds, the investors can also profit by holding on to them. Every time the borrowers make monthly payments on their mortgages, the investors get the portion of the profit. The profits might decline if one of the borrowers defaults, but the sheer number of mortgages that make up the pool ensures the investors will earn at least some profit.

Types of Mortgage-Backed Securities

There are several different types of mortgage-backed securities, including these:

  • Pass-through mortgage-backed security--This is the most common and the simplest security. Its pools are made up of mortgages on either residential or commercial buildings. To ensure diversity, they may include several different types of properties.
  • Collateralized mortgage obligation security--In this security, mortgages that make up the pools are sorted into tranches. Tranches are groups of mortgages that share certain common characteristics, such as the repayment time and the size of the properties.
  • Stripped mortgage-backed security--In this security, the bonds are divided into two types. One generates income using the borrowers' interest payments, while the other generates income using the borrowers' principal payments.

Mortgage-Backed Securities and Risk

Mortgage-backed securities are also grouped based on the creditworthiness of the borrowers that took out the underlying mortgages. This, in turn, is determined based on how strict the mortgage application requirements are. They include the following:

  • Prime mortgages--mortgages for which borrowers have to submit full documentation and have strong credit scores
  • Alt-A mortgages--mortgages with somewhat weaker requirements. Borrowers can submit partial documentation, credit score requirements are lower and so on.
  • Subprime mortgages--mortgages for which borrowers don't have to submit any documents and credit requirements are weak

During the housing bubble, a significant portion of mortgage-backed securities were made up of Alt-A and subprime mortgages. Now that the housing bubble has collapsed, they have become much rarer. So, while mortgage-backed securities earn more profit that they have in the past, they are not as widely available as they used to be.

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