What are Mortgage Backed Securities (MBS)?

//What are Mortgage Backed Securities (MBS)?
What are Mortgage Backed Securities (MBS)? 2017-10-06T00:48:02+00:00

Definition: Mortgage-backed securities (MBS), sometimes called mortgage-related securities, are bonds that represent an investment in a group of home loans. These asset-backed securities are formed when lending banks bundle their mortgages into pools and sell them to investment banks or government agencies in the form of a bond. These banks categorize the loans according to credit ratings and sell them to investors.

What does Mortgage Backed Securities Mean?

What is the definition of mortgage backed securities? These tradable asset-backed securities are built around a collection of mortgages and then made available to the public for trade. In essence, it’s a way for individual investors to invest in mortgages without having to actually issue or purchase them.

Typically, MBS are considered to be safe investments because they consist of mortgages that are collateralized with homes. Plus, who doesn’t pay their mortgage? This theory held true until the early 2000s. The sub-prime lending crisis of 2008 was closely related to asset-backed securities where the traded value had reached to unprecedented levels (due to hype) and lost the connection with the actual asset value backing the security itself.

In other words, investors were speculating and trading MBS without actually looking at the underlying assets. The pools of mortgages that were supposedly giving these securities value were filled with high risk loans that were made to people with low or no credit scores. Thus, the MBS should have been worthless, but investors weren’t acting like it and speculating on values anyway. Eventually, the loans defaulted when variable interest rates kicked in and the MBS lost all value.

Let’s take a look at an example.

Example

Bank A specializes in home loans and lends money to home owners who are willing to collateralize their loan with their home. Normally, Bank A would make its money from the loans by charging a small interest rate and waiting out the duration of the loan. This is not only risky, but it is also time consuming, as most mortgages are 30-year loans.

Thus, looking to move some of these mortgages off its books and free up some cash flow, Bank A bundles hundreds of its mortgages and sells them to an investment bank (Bank I). In this way, Bank A gets its principal back up front and earns a small amount of interest. Now, when the borrowers pay their monthly mortgage payments to Bank A, the payments are sent to Bank I because they now own the rights to the income streams of the mortgages. Bank I then splits the mortgages into securities that can be sold to individual investors.

With these multiple layers of intermediaries, the market value expands as the profits at each layer have to be accounted within the market price itself. What essentially reaches the individual investor is a share of risk (magnified in the course of mortgage transfers) with an expectation of higher returns that would reflect with the real estate scenario in an economy.

Summary Definition:

Define Mortgage Backed Securities: MBS means an asset backed securities covered by a mortgage or a group of mortgages.