What is a Mortgage Backed Security

Posted By Paul

I was recently asked about Mortgage Backed Securities (which I'd never heard of before), so I've been doing some research into them which I thought might be of interest to the group. Here's what I've found so far:

A Mortgage Backed Security (MBS) is a way to invest in the mortgage market by buying a share in a conglomerate of mortgages. I'm going to talk about something called a pass-through MBS which is the simplest type.

Let's start with how you get one. You contact a bank or broker and put some minimum investment into an MBS (I read that the minimum is usually at least $1000).

So just as an example, let's say that you take $10000 and put it into an MBS. What exactly did you do?

Well you took your 10 grand and put it into a fund that is a conglomeration of a bunch of mortgages. It's almost like you loaned someone a $10,000 mortgage.

In fact, a lot of the interesting facets of an MBS can be understood by imagining that you took your $10,000 and loaned it to someone. So I'm going to illustrate what I've learned about MBS by comparing it to loaning the money to someone (we'll call this fictional person Joe Borrower) as a mortgage.

So first off, to invest in an MBS you need to go to your bank or broker and buy a share of an MBS. You give them your $10,000 and in return you get a bond for that amount with a specific maturity and a specific interest rate.

Using our metaphor, buying the bond is very much like making a fixed rate mortgage loan to Joe B. his mortgage will have a term (let's say 30 years) and a specific interest rate (let's say 5%).

So in the mortgage world Joe B gets a monthly bill for his payment. His payment starts off as being mostly interest with some principal going to the $10,000 he borrowed from you. As the years go by more and more of each payment will go towards the principal.

An MBS works the same way. Every month you'll get a check for a certain amount. At the beginning the amount will mostly be interest, but some amount of it will also be part of the $10,000 that you invested in the first place. As time goes by the interest will decline and the principal will increase.

Now lets say that Joe B always pays his mortgage the standard amount. Then for 30 years he will get a bill for the exact same amount and will pay that exact amount. At the end of the 30 years he will have paid off the $10,000 (along with a lot of interest).

It's the same for an MBS. In an ideal case you will get the same amount every month. At the beginning it will be mostly interest, and will gradually transition. At the end of the 30 years you will have your $10,000 back plus the interest that you received over the years.

It's a lot like YOU are the mortgage lender. Sounds pretty cool right? Well here are a couple of small wrinkles. You'll notice above that I said that your payment in an ideal case remains the same. What do I mean by that?

One problem is what if Joe B can't pay his mortgage? Well you have the house as collateral so that helps, and of course in a real MBS you are just one small part of a large conglomeration of mortgages so the risk of any one person defaulting on their loan is diluted.

Another concern with an MBS is what does it mean to you if a lot of the holders of the mortgages in your MBS start to pay off their mortgage early? Well it means exactly the same thing as if Joe B decided to put extra money towards his mortgage payment every month. The total payment you get would get bigger (because he's putting the extra money towards it) but in the long run you're not making as much interest as you would have if he had stuck to the standard payments. So if Joe B keeps paying his mortgage down early then you will end up getting your $10,000 back sooner, but you won't get as much interest.

Other problems relate to interest rates. Let's say that after a year interest rates have gone from 5% down to 2.5%. What is Joe B likely to do? He'll refinance of course to take advantage of the better rate. What does this mean to you? Well it essentially means that he pays off his entire loan early (the refinance pays off the old loan and creates a new one, but you don't own a piece of the new one). If a lot of people in your MBS conglomeration start refinancing then instead of getting your money back slowly over 30 years with a specific amount of interest you could get a bunch of your money back right at the start and then be done in a much shorter time with less interest paid to you.

Another scenario, let's say that a year after making your loan to Joe B at 5% interest rates have shot up to 15%. What's Joe B going to do? He's going to hold onto that mortgage for dear life because he wants to keep his awesomely low interest rate. What's the problem here? Well if interest rates have shot up to 15% you might be able to get a much better return on your $10,000 with a CD or a plain old savings account, but you don't have the $10,000 because it's been lent out to Joe B. You'll get it all back eventually (with interest) but you may be hating that you're making a mere 5% on your money when you could be making more in some other low risk investment.

So can you get out of the MBS early? Apparently yes by selling your bond, but using our metaphor again let's say you want to sell your mortgage to Joe B to someone else. They pay you some amount and they take over the loan. Well how excited do you think people will be to take over Joe B's 5% mortgage when they could take over a new mortgage paying 15% instead? In this case you may have to sell your mortgage at a discounted rate if you really want to unload it.

So I paint a somewhat gloomy picture of the MBS, but look at it from a different standpoint. If people in your MBS pay off early then the worst thing that will happen is that you'll get your $10,000 back sooner and you won't make as much interest as you'd hoped. If interest rates shoot up and you do nothing then the worst that will happen is that you'll end up with your $10,000 back plus some interest, just maybe not as much as you could have made elsewhere.

Compare this to stocks where if you invest $10,000 then you could easily lose all or part of your initial investment. This is why MBS investments are considered to be quite conservative.

This is a pretty rough description of what an MBS is, and this is just from my own research into it. I read that often the minimums to get into an MBS are high (in the range of $10,000-$25,000), but that it's considered a very safe investment.

Also, you may be thinking that there are administrative costs related to keeping track of all of these mortgages and sending out payments, and wondering how those expenses are paid. You're correct to think that and the answer is that some small percentage of your interest goes to administrative costs to maintain the MBS.

I'm curious enough about mortgage backed securities that I'm going to keep doing some research into them. If nothing else it's interesting to think about how a mortgage is viewed from the lender's side (and a mortgage lender is more or less what you become when you put money into an MBS).

If anyone out there has invested in Mortgage Backed Securities I would be very interested in hearing from them to get a first hand account of the process. Also if anyone sees any mistakes in what I've written here please let me know. Since I'm so new to MBS investment vehicles I might have misinterpreted something I read at some point.