What are mortgage-backed securities?

Mortgage-backed securities

Mortgage-backed securities (MBSs) are bonds that are tied to mortgage loans. Essentially, lenders pool together a large number of mortgage loans to sell to a governmental agency or a financial firm that uses the collection of loans as collateral for MBSs. MBSs are bought and sold on the bond market by investors.

These are different from traditional bond investments — MBSs offer investors monthly payments instead of coupon payments every six months to a year.

The majority of MBSs are issued by Ginnie Mae, an agency within the U.S. government, or Fannie Mae and Freddie Mac, which are government-sponsored enterprises (GSEs). Private firms like investment banks and other financial institutions may also issue MBSs.

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How mortgage-backed securities work

MBSs are investment vehicles for individuals, and they can also be profitable for lenders. When you take out a mortgage loan at your bank, the bank handles the application process and the initial servicing of the loan. It could continue to collect your principal and interest payments, or it may sell your loan (along with many others) to investors.

Today, MBSs are considered fairly safe investments, due in part to the regulations put in place after the 2008 financial crisis.”

Selling loans packaged as MBSs places cash back into the lender’s hands to use on other loan opportunities. The bank still makes money by collecting loan origination fees and interest payments. It also lowers the bank’s overall risk profile by selling off loans with 15- and 30-year terms.

Today, MBSs are considered fairly safe investments, due in part to the regulations put in place after the 2008 financial crisis. Prior to this, to stay competitive, many lenders lowered their lending standards. Banks and financial institutions were regulated, but MBSs weren’t.

Many of these loans were sold off by the lenders, even though these borrowers had a greater risk of default. Now, the mortgage industry is more heavily regulated to protect borrowers and investors.

Mortgage-backed securities for buyers

If your mortgage is sold as an MBS, your loan terms won’t change and you’ll continue to make monthly mortgage payments (often to a new servicer, however). Your financial institution is required to alert you of any changes to your loan status by sending a transfer notice. If your loan has been sold, you’ll want to pay close attention to any payment instructions within that document.

Look for a lender that services its own loans if you want to work with the same company through the life of your mortgage.

Some lenders don’t sell their mortgage loans; credit unions and small community banks are more likely to continue to service your loan until the term ends.

If working with the same lender is important to you, be sure to ask potential lenders if they resell their mortgage loans before you enter into a loan agreement.

» MORE: 9 mortgage questions to ask your lender

Mortgage-backed securities for investors

Savvy investors may choose to purchase MBSs for their potential to earn higher yields than other bond investments (such as treasury bonds) offer. MBSs are considered a relatively safe investment compared to stocks because they’re typically tied to fixed-rate mortgages. These loans are also vetted and backed by GSEs.

With any loan, however, there’s always a risk of default. If a large number of loans within an MBS are in default, the investor won’t make money from a borrower’s interest and principal payments. On the flip side, the investor could lose the opportunity to earn interest payments if the borrower pays off the mortgage loan earlier than expected or decides to refinance with another lender.

Types of mortgage-backed securities

There are three different types of mortgage-backed securities: pass-throughs, stripped MBSs and collateralized mortgage obligations. These differ in how the loans are packaged and sold as MBSs.

Pass-throughs

With pass-throughs, the MBS issuer collects monthly mortgage payments from borrowers and then distributes a portion of that cash (both principal and interest payments) to the bondholders. Most of the mortgages pooled are fixed-rate loans, although some could have adjustable rates.

The maturity dates can vary — usually between five, 15 and 30 years. For the most part, mortgages in pass-throughs are similar in nature, so the income is more predictable.

Stripped mortgage-backed securities

Stripped mortgage-backed securities (SMBSs) split the borrower’s monthly payments into interest and principal groups. If an investor isn’t interested in a pass-through because of the upfront investment required, an SMBS may be more appealing. They can choose to invest in either the interest or the principal payments of the loan.

Collateralized mortgage obligations

Collateralized mortgage obligations (CMOs) are made up of mortgages with varying loan terms. Similar mortgages within a CMO are grouped together and called a “tranche”; each CMO may be comprised of many tranches. These tranches also have different rules regarding principal and interest payments, so the income from CMOs can be less reliable than that of pass-throughs.

Bottom line

Mortgage-backed securities are investment vehicles secured by mortgage loans. It’s common for a lender to sell a group of home loans to free up cash and reduce its overall risk. Investors purchase MBSs to collect portions of the principal and interest payments borrowers make each month.

MBSs are sophisticated investments and may not be the right fit for every individual, so make sure to discuss the potential benefits and risks with your trusted financial advisor.

If you’re a homeowner and your mortgage loan is sold to another lender, there’s no need to panic. Your loan terms won’t change with a new loan servicer. However, if you aren’t comfortable with the possibility of working with a different servicer throughout the course of your mortgage, do your research and seek out lenders that don’t transfer their loans.