What it means
When a bank makes a mortgage, its money is tied up for many years. To free that money, banks bundle thousands of similar mortgages together and sell slices of the bundle to investors as securities.
The investors receive the interest and principal that borrowers pay each month, less a fee for the people who collect the payments. Mortgage-backed securities matter to the wider economy because they connect mortgage lending to the bond market.
By turning loans into tradeable investments, they bring in money from pension funds, insurers and banks, and that money keeps mortgages available to households. They also spread the risk of borrowers defaulting among many holders.
The most common structure is the pass-through, where the monthly payments flow straight through to investors in proportion to their share. More complex versions divide the pool into slices called tranches, each with a different priority for payment and a different level of risk.
The safest tranche is paid first and the riskiest is paid last, which means it absorbs the first losses. The key risk specific to these securities is prepayment.
If interest rates fall, homeowners refinance, and investors get their money back early and must reinvest it at lower rates. If rates rise, repayments slow down and investors are stuck with a lower rate for longer.
Credit risk depends on who stands behind the pool. Some securities carry a government or government-backed guarantee, which protects investors against borrower defaults, whereas private-label ones do not.
The 2007-2009 financial crisis showed how badly things can go wrong when weak loans are bundled and rated too generously. Investors judge these securities by yield, but the quoted yield assumes a particular pace of prepayment.
Analysts therefore show a range of outcomes under faster and slower scenarios, and a buyer should look at the worst of them before committing. A security that looks generous in one scenario can look ordinary in another.
In practice
Real-world examples.
Example
A regional bank has made $500,000,000 of mortgages and wants to make more loans. It sells the mortgages into a pool backing a mortgage-backed security. The cash from investors lets the bank lend again, while the investors collect the monthly payments.
Example
A pension fund needs steady income to pay retired members. It buys a guaranteed pass-through security that pays monthly and has a higher yield than a government bond of similar length. The finance team monitors prepayment because it changes the timing of the cash it receives.
Example
A treasury manager at an insurer notices that interest rates have dropped sharply. She expects homeowners to refinance quickly, which would return principal early, so she reduces the insurer's holding of these securities. She wants to avoid reinvesting a large cash sum at lower rates.
Formula
Calculation
Monthly pass-through interest = Pool balance x Pass-through rate / 12
Pass-through rate = Average mortgage rate - Servicing and guarantee fees
Suppose a pool holds $240,000,000 of mortgages with an average rate of 6.0%, and fees of 0.5% are deducted, so the pass-through rate is 6.0% - 0.5% = 5.5%. Monthly interest to investors is 240,000,000 x 0.055 / 12 = 13,200,000 / 12 = $1,100,000. If borrowers also repay $400,000 of scheduled principal that month, investors receive 1,100,000 + 400,000 = $1,500,000 in total, before any prepayments.Case study
Seen in the real world.
Riverbend Mortgage Co is an illustrative, fictional lender that originates about $60,000,000 of home loans a month. Holding them all would use up its capital within a year, so it sells batches into a pool of mortgage-backed securities.
In one quarter, $180,000,000 of loans were pooled and sold to investors. Riverbend kept a servicing fee of 0.25% a year for collecting the payments, which on that pool came to $450,000 annually.
When rates fell later in the year, many borrowers refinanced and the pool shrank faster than investors had forecast. The illustrative lesson is that the buyers of the security, not the lender, bear the prepayment risk, and they price it into what they are willing to pay.
Watch out
Common mistakes.
- Treating a mortgage-backed security as risk-free because it is backed by houses, when borrowers can default and house prices can fall.
- Ignoring prepayment risk, which can shorten or lengthen the life of the investment depending on interest rate moves.
- Assuming all these securities carry the same guarantee, when government-backed and private-label ones differ greatly in credit protection.
Questions
People also ask.
Who receives the mortgage payments?
The payments go to the investors who hold the security, after a servicing fee is taken by the company that collects them.
What is a tranche?
A tranche is a slice of the pool with its own priority for payment, so senior slices are paid first and junior slices take losses first.
Why did mortgage-backed securities cause problems in 2008?
Many pools contained weak loans that were rated too highly, so when borrowers defaulted the losses spread through the financial system.
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