Mortgage Backed Securities

Mortgage backed securities are financial instruments collateralized by mortgages. Regarded as a fixed income investment, most mortgage backed securities (MBS) are purchased by financial institutions looking for consistent cash flows. Other buyers of MBS are institutions looking for yield and an indirect exposure to the real estate market. Since most MBSs are divided between commercial and residential issues, buyers of these securities can choose the type of real estate they want an exposure to.

Although some MBS are collateralized by one large real estate mortgage or debt for a large real estate project, most are based on a pool of mortgages that are collected to be securitized. The pool of mortgages not only provides collateral for the securities sold but also provides the cash flows to investors. The interest from the pool is passed on to the investors as an interest payment and principal is passed on as the repayment of the original capital. For this reason MBS securities work like a bond. Investors receive periodic interest and principal payments until the original mortgage loans are repaid.

MBS is created by a process known as securitization. Mortgage originators use securitization as a method for accessing capital to lend. These originators find borrowers and issue mortgages that are then sold to investment banks. The capital that is paid by the investment bank is then used to fund new mortgages. The investment bank then pools the mortgages and sells securities with different risk-return characteristics. By dividing the cash flows from the pool into different levels of return and risk, the investment bank receives more than it paid for the mortgages resulting in a profit for the bank.

The cash flow from the mortgage pool is divided into several "tranches" or slices that are rated by mortgage rating agency as to their level of default risk. Risk is defined as the probability that the cash flows of the securities will be reduced due to default of the underlying mortgages. The investors of the unrated and "B" rated securities take the greatest risk and receive the highest interest rates. Those with the unrated securities are the first to lose their interest and principal when a mortgage defaults. Once all the capital from the unrated bonds is lost due to default, then new defaults will begin to reduce the cash flows of the B bonds and so on until all the tranches or subordination levels are used up. An A rated security is the most secure investment and receives the lowest return. There must be a significant amount of defaults in the pool to use up all the capital in the unrated and B rated bonds before they can affect the A rated tranches. These A rated securities are usually purchased by insurance companies and other financial institutions that prefer these lower risk investments.

All MBS tranches take on the same level of reinvestment risk. Reinvestment risk relates to the amount of cash flows that is reduced due to a borrower prepaying their mortgage. Prepayments result in a return of capital to investors. Each investor receives their percentage ownership of the principal of the mortgage paid back early. The interest that was being paid on the prepaid mortgage is no longer paid and is removed from the cash flow from all the mortgage tranches. It is called reinvestment risk because the investors must reinvest the prepaid capital to receive a return. It is a risk because there is no guarantee that the investor can reinvest the prepaid capital at the same rate that was being paid on that particular investment.

Securitization and Mortgage Backed Securities helped finance the housing and mortgage boom. Since the credit crisis and the high default rates associated with it, mortgage securitization has declined rapidly.

Financial Terms by BetterTrades