Mortgage lending institutions, such as banks and privatized mortgage lenders are responsible for granting mortgage loans to qualified individuals.
The services rendered by mortgage lending institutions are meant to produce profit and revenue through the applied mortgage interest rates and any imposed fees for providing mortgage loans to individuals. However, because mortgage loans will have a quite a long life term, the revenue that is to be generated will not be an immediate result.
In order for financial institutions to receive profits and be able to continue providing their services, many times they will be sold off to third party investors in order to generate immediate profits. The mortgage loans sold to third parties are known as mortgage backed securities.
How do Mortgage Backed Securities Work?
Mortgage backed securities will prove to be a highly complicated procedure and is contingent upon existing jurisdictional laws. However, the process can be simplified in the following manner:
1. Banks, mortgage companies, and mortgage loan originators sell mortgage loans to third party investors.
2. The purchased loans are then assembled into “pools,” usually by a governmental agency.
3. The governmental agency will issue claims that are based on the principal and interest amounts that are made by borrowers in reference to the loans contained within the pool.
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).
These governmental agencies will essentially provide for guarantees to investors that the payments on the purchased mortgage backed securities will be made in a timely fashion.
Purpose of Mortgage Backed Securities
The overall goal behind mortgage backed securities to reduce and diversify risk to lending institutions. In having mortgage backed securities grouped into pools, the risks of non-payment will be compensated by the remaining mortgage backed securities within that pool.
Furthermore, in selling the mortgage loans off to a third party, the loan amount will have already been provided for, minimizing the risk most effectively of dealing with defaulting on mortgage loans.
The main advantage behind mortgage backed securities is that if allows for mortgage lenders to keep generating and offering loans. Because profits are not contingent upon the actual life term of the loans, they will have the capital necessary to keep providing subsequent loans and keep the credit market afloat.
Disadvantages of Mortgage Backed Securities
Even though there are positive applications of mortgage backed securities in the fact that it allows mortgage companies to continue providing loans and also offer for a type of investment opportunities, there have been drawbacks associated with mortgage backed securities.
One of the main issues at hand is that it may create a situation where mortgage companies will be more lax in their qualifications for prospective lenders. In knowing the loan may be turned into a mortgage backed security, the risk of providing a loan to an unqualified applicant may not be apparent.
However, this can create a situation where mortgage backed securities included into pools are now comprised of bad loans, with more being susceptible to default, and thus, negating the purpose and use of mortgage backed securities.