Mortgage-Backed Securities (MBS) involve the process of securitization of a pool of mortgage loans, which are sold to investors in the form of notes and bonds. When an individual takes a mortgage loan from a bank to buy a house, the bank may not hold onto the loan for its entire term but instead, it pools the loan with many other loans and sells notes and bonds to investors. This allows the bank to recycle its capital and make more mortgage loans to its customers.
Usually, the securitization process is done by the headquarters office of the bank or a company with the capability to do so, such as an investment bank. Mortgage-backed securities are backed by a specific pool of mortgage loans and the interest paid on these loans is passed on to the investors holding the notes and bonds. Similarly, when the principal is repaid on the loans, it is passed on to the investors holding the notes and bonds as principal repayment.
Mortgage-backed securities can include residential mortgage-backed securities, which are secured by home mortgage loans, and commercial mortgage-backed securities, which are collateralized by commercial loans on properties like office buildings and retail stores. Each pool of mortgages collateralizes a series of notes and bonds with varying maturities to suit the needs of different investor groups.
Risk
Mortgage-backed securities (MBS) carry certain risks that can result in losses for investors. Here are some key risks associated with MBS:
- Credit Risk: This risk stems from the underlying mortgages that make up the MBS. If borrowers default on their mortgage payments, it can lead to a loss of principal and interest for MBS investors. Economic conditions, such as a recession or a housing market downturn, can increase the likelihood of borrower defaults and impact the credit quality of MBS.
- Prepayment Risk: MBS are structured as pools of mortgage loans, and borrowers have the option to prepay their mortgages. When interest rates decline, borrowers may refinance their mortgages at lower rates, resulting in early repayment of the underlying loans. This can disrupt the expected cash flows for MBS investors, as they may receive principal payments earlier than anticipated. Additionally, if prepayments occur when interest rates are low, investors may have to reinvest the returned principal at lower interest rates, potentially leading to lower overall returns.
- Interest Rate Risk: MBS prices are sensitive to changes in interest rates. When interest rates rise, the value of MBS can decline. This is because higher rates make existing fixed-rate mortgages less attractive to potential homebuyers, reducing demand for MBS. Consequently, MBS investors may experience a loss in the market value of their securities if they need to sell them before maturity.
- Liquidity Risk: MBS can sometimes suffer from reduced liquidity, especially during times of market stress. If market participants are unwilling to buy or sell MBS, it can be challenging to execute trades at desired prices. This lack of liquidity can make it difficult for investors to exit their positions or adjust their portfolios, potentially resulting in losses.
- Structural Risk: The structure of MBS, including tranches and credit enhancements, can introduce additional risks. For example, certain MBS may have different priority levels of payment, and losses may first affect lower tranches, while higher tranches are relatively protected. Additionally, credit enhancements such as mortgage insurance or guarantees may not fully mitigate losses in all situations.
It is important for investors to carefully assess and understand these risks associated with mortgage-backed securities before investing in them. Diversification, thorough analysis of credit quality, monitoring economic and interest rate conditions, and understanding the specific characteristics of the MBS being considered can help manage and mitigate potential losses.
