Mortgage-Backed Securities Explained

Mortgage-backed securities, or MBS, are popular income investments for individuals, mutual funds and financial institutions. Misrepresentation of MBS quality was a cause of the financial crisis of 2007 and 2008, but they are still a popular investment class.

Function

Mortgage-backed securities are debt investments in pools of mortgages. Holders of MBS are entitled to payment of interest and principal as the payments on the mortgages held in the pool are made.

Identification

The majority of MBS are issued by the Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, known as Ginnie Mae, Fannie Mae and Freddie Mac, respectively.

Considerations

Ginnie Mae is a U.S. government agency; its securities are backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are government-sponsored enterprises whose securities have certain guarantees but not full U.S. government backing.

Types

Regular pass-through MBS securities entitle holders to their proportionate share of principal and interest as payments are made. Exotic mortgage securities such as CMOs (collateralized mortgage obligations) and mortgage derivatives have different claims on various pieces of mortgage pools.

Potential

Regular pass-through agency mortgage-backed securities are safe, marketable investments for investors or mutual funds. Derivative mortgage securities can be dangerous and hard to value.

Warning

Most regular MBS make payments monthly to investors that are a combination of interest and principal, just like mortgages. If interest rates fall, the pool of mortgages will be paid off faster and investors will receive their principal back sooner than planned. Rising interest rates will stretch out the time it takes an MBS to pay off the principal.

References

• Securities and Exchange Commission: Mortgage-Backed Securities