Unraveling the Mysteries of Mortgage Backed Securities: What You Need to Know
In the world of finance, few terms are as shrouded in mystery as Mortgage Backed Securities (MBS). These complex financial instruments have been at the center of several high-profile crises, including the 2008 global financial meltdown. Despite their importance, many individuals remain unaware of what MBS are and how they work. In this article, we’ll delve into the world of MBS, exploring their history, structure, and impact on the global economy.
What are Mortgage Backed Securities?
Mortgage Backed Securities (MBS) are a type of asset-backed security that represents an interest in a pool of mortgage loans. These loans are typically residential mortgages, issued by banks and other financial institutions to borrowers. The mortgages are then packaged together and sold to investors as a single security, known as an MBS.
The process begins when a borrower takes out a mortgage to purchase a home. The lender, such as a bank or mortgage company, issues a mortgage note to the borrower. The note represents the borrower’s promise to repay the loan with interest over a set period, usually 15 or 30 years.
Once the loan is issued, the lender sells it to a mortgage-backed securities issuer, such as Fannie Mae or Freddie Mac. The issuer pools the loan with other mortgages from different lenders and creates an MBS. This pool of mortgages is then divided into smaller units, called tranches, which are sold to investors.
Types of Mortgage Backed Securities
There are several types of MBS, each with its own characteristics and risks:
1. Pass-Through Mortgages: These securities allow investors to receive payments based on the interest and principal payments made by borrowers.
2. Collateralized Mortgage Obligations (CMOs): CMOs are created by dividing a pool of mortgages into multiple tranches, each with a different level of credit risk.
3. Collateralized Bond Obligations (CBOs): CBOs are similar to CMOs but focus on bonds rather than mortgages.
4. Commercial Mortgage-Backed Securities (CMBS): These securities represent commercial property loans rather than residential mortgages.
How Do Mortgage Backed Securities Work?
Here’s an example of how an MBS works:
1. Pool Creation: A lender issues 100 mortgages with an average value of $200,000 each.
2. Pooling: The mortgages are pooled together and divided into three tranches: Aaa-rated ( safest), BBB-rated (medium-risk), and CCC-rated (riskiest).
3. Tranche Creation: Each tranche is assigned a specific level of credit risk and interest rate.
4. Issuance: The pooled mortgages are sold to investors as three separate securities.
5. Servicing: The lender responsible for collecting monthly payments from borrowers and distributing them to investors.
Risks Associated with Mortgage Backed Securities
While MBS can provide attractive returns for investors, they also come with significant risks:
1. Credit Risk: Borrowers may default on their loans, reducing the value of the MBS.
2. Interest Rate Risk: Changes in interest rates can affect the value of the MBS.
3. Prepayment Risk: Borrowers may pay off their loans early, reducing the life of the MBS.
4. Liquidity Risk: Investors may struggle to sell their MBS at a favorable price due to market conditions.
The Impact of Mortgage Backed Securities on the Global Economy
Mortgage Backed Securities have played a significant role in shaping the global economy:
1. Globalization: MBS have enabled cross-border investments and increased global financial integration.
2. Housing Market Boom: The widespread use of MBS fueled housing market growth in many countries, leading to rapid price appreciation and increased homeownership rates.
3. Financial Crisis: The collapse of the subprime mortgage market in 2007-2008 led to a global financial crisis, causing widespread job losses and economic instability.
Conclusion
Mortgage Backed Securities are complex financial instruments that have both benefits and risks. While they provide investors with attractive returns, they also expose them to credit risk, interest rate risk, prepayment risk, and liquidity risk. Understanding how MBS work is crucial for individuals seeking to navigate the world of finance effectively.
In conclusion, Mortgage Backed Securities are an integral part of the global financial system, influencing housing markets and economic growth worldwide. As investors seek higher returns in a low-yield environment, it’s essential to understand the intricacies of MBS and their associated risks. By doing so, we can better appreciate the complexities of finance and make informed decisions about our investments.
How do Mortgage Backed Securities Work?
This process is known as securitization. In the United States, the securitization process is done by governmental agencies, such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).