A mortgage-backed security (MBS) is a type of

asset-backed security An asset-backed security (ABS) is a Security (finance), security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a group of sma ...

(an " instrument") which is secured by a

mortgage A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners t ...

or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed

residential A residential area is a land used in which houses, housing predominates, as opposed to industrial district, industrial and Commercial Area, commercial areas. Housing may vary significantly between, and through, residential areas. These include ...

; another class is

commercial Commercial may refer to: * (adjective for) commerce, a system of voluntary exchange of products and services ** (adjective for) trade, the trading of something of economic value such as goods, services, information or money * a dose of advertising ...

, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include

collateralized mortgage obligation A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor need ...

s (CMOs, often structured as real estate mortgage investment conduits) and

collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...

s (CDOs). In the U.S. the MBS market has more than $11 trillion in outstanding securities and almost $300 billion in average daily trading volume. A mortgage bond is a

bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Fidelity bond, a type of insurance policy for employers * Chemical bond, t ...

backed by a pool of

mortgages A mortgage loan or simply mortgage (), in civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pur ...

on a real estate asset such as a

house A house is a single-unit residential building. It may range in complexity from a rudimentary hut to a complex structure of wood, masonry, concrete or other material, outfitted with plumbing, electrical, and heating, ventilation, and air c ...

. More generally, bonds which are secured by the pledge of specific assets are called mortgage bonds. Mortgage bonds can pay interest in either monthly, quarterly or semiannual periods. The prevalence of mortgage bonds is commonly credited to Mike Vranos. The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as

tranche In structured finance, a tranche () is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indent ...

s (French for "slices"), each with a different level of priority in the debt repayment stream, giving them different levels of risk and reward. Tranches of an MBS—especially the lower-priority, higher-interest tranches—are/were often further repackaged and resold as collateralized debt obligations. These subprime MBSs issued by investment banks were a major issue in the

subprime mortgage crisis The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis. It led to a severe economic recession, with millions becoming unemployed and many busines ...

of 2006–2008. The total face value of an MBS decreases over time, because like mortgages, and unlike bonds, and most other fixed-income securities, the

principal Principal may refer to: Title or rank * Principal (academia), the chief executive of a university ** Principal (education), the head of a school * Principal (civil service) or principal officer, the senior management level in the UK Civil Ser ...

in an MBS is not paid back as a single payment to the bond holder at maturity but rather is paid along with the interest in each periodic payment (monthly, quarterly, etc.). This decrease in face value is measured by the MBS's "factor", the percentage of the original "face" that remains to be repaid. In the United States, MBSs may be issued by structures set up by

government-sponsored enterprise A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress. Their intended function is to enhance the flow of Credit (finance), credit to targeted sectors of the economy, to make tho ...

s like

Fannie Mae The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a United States government-sponsored enterprise (GSE) and, since 1968, a publicly traded company. Founded in 1938 during the Great Depression as part of the New ...

Securitization

The process of

securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations (or other non-debt assets which generate receivables) and sellin ...

is complex and depends greatly on the

jurisdiction Jurisdiction (from Latin 'law' and 'speech' or 'declaration') is the legal term for the legal authority granted to a legal entity to enact justice. In federations like the United States, the concept of jurisdiction applies at multiple level ...

within which the process is conducted. Among other things, securitization distributes risk and permits investors to choose different levels of investment and risk.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', Chapter 1 (Thomson West, 2013 ed.). The basics are: # Mortgage loans (

mortgage note In the United States, a mortgage note (also known as a ''real estate lien note'', ''borrower's note'') is a promissory note secured by a specified mortgage loan. Mortgage notes are a written promise to repay a specified sum of money plus interest ...

s) are purchased from banks and other lenders, and possibly assigned to a

special purpose vehicle A special-purpose entity (SPE), also called a special-purpose vehicle (SPV) or a financial vehicle corporation (FVC), is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, speci ...

(SPV). # The purchaser or assignee assembles these loans into collections, or "pools". # The purchaser or assignee securitizes the pools by issuing mortgage-backed securities. While a

residential mortgage-backed security Residential mortgage-backed security (RMBS) are a type of mortgage-backed security backed by residential real estate mortgages. Bonds securitizing mortgages are usually treated as a separate class, making reference to the general package of fi ...

(RMBS) is secured by single-family, one- to four-unit real estate, a

commercial mortgage-backed security Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgage, commercial and multifamily mortgages rather than residential real estate. CMBS tend to be more complex and volatile than Residen ...

(CMBS) is secured by commercial and multi-family properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties, and other commercial sites. A CMBS is usually structured as a different type of

security Security is protection from, or resilience against, potential harm (or other unwanted coercion). Beneficiaries (technically referents) of security may be persons and social groups, objects and institutions, ecosystems, or any other entity or ...

than an RMBS. These securitization trusts may be structured by government-sponsored enterprises as well as by private entities that may offer

credit enhancement Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction in struct ...

features to mitigate the risk of prepayment and default associated with these mortgages. Since residential mortgage holders in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety usually without financial penalty ( prepayment), the monthly cash flow of an MBS is not known in advance, and an MBS therefore presents a risk to investors. In the United States, the most common securitization trusts are sponsored by

and

Freddie Mac The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is an American publicly traded, government-sponsored enterprise (GSE), headquartered in Tysons, Virginia.Ginnie Mae The Government National Mortgage Association (GNMA), or Ginnie Mae, is a government-owned corporation of the United States Federal Government within the Department of Housing and Urban Development (HUD). It was founded in 1968 and works to exp ...

, a US government-sponsored enterprise backed by the full faith and credit of the US government, guarantees that its investors receive timely payments but buys limited numbers of mortgage notes. Some private institutions also securitize mortgages, known as "private-label" mortgage securities. Issuances of private-label mortgage-backed securities increased dramatically from 2001 to 2007 and then ended abruptly in 2008, when real estate markets began to falter. An example of a private-label issuer is the

real estate mortgage investment conduit A real estate mortgage investment conduit (REMIC) is "an entity that holds a fixed pool of mortgages and issues multiple classes of interests in itself to investors" under U.S. Federal income tax law and is "treated like a partnership for Federal i ...

(REMIC), a tax-structure entity usually used for CMOs; among other things, a REMIC structure avoids so-called double taxation.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', Chapter 4 (Thomson West, 2013 ed.).

Advantages and disadvantages

The securitization of mortgages in the 1970s had the advantage of providing more capital for housing at a time when the demographic bulge of baby boomers created a housing shortage and inflation was undermining a traditional source of housing funding, the

savings and loan association A savings and loan association (S&L), or thrift institution, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans. While the terms "S&L" and "thrift" are mainly used in the United States, ...

s (or thrifts), which were limited to providing uncompetitive 5.75% interest rates on savings accounts and consequently losing savers' money to

money market fund A money market fund (also called a money market mutual fund) is an open-end mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a hig ...

s. Unlike the traditional localized, inefficient mortgage market where there might be a shortage or surplus of funds at any one time, MBSs were national and international in scope and regionally diversified. Mortgage-backed securities helped move interest rates out of the banking sector and facilitated greater specialization among financial institutions. However, mortgage-backed securities may have "led inexorably to the rise of the subprime industry" and "created hidden, systemic risks". They also "undid the connection between borrowers and lenders". Historically, "less than 2% of people lost their homes to foreclosure", but with securitization, "once a lender sold a mortgage, it no longer had a stake in whether the borrower could make his or her payments."

History

Among the early examples of mortgage-backed securities in the United States were the

slave mortgage A slave mortgage was a financial instrument used by financiers wherein money was lent on the basis of the value of enslaved people. There are records of slave mortgages in the United States (Louisiana, South Carolina, and Virginia) and in South A ...

bonds of the early 18th century and the farm railroad mortgage bonds of the mid-19th century which may have contributed to the panic of 1857. There was also an extensive commercial MBS market in the 1920s.

US government

In June 1933, the Glass–Steagall Act was signed into law by President Franklin D. Roosevelt. This legislative initiative separated

commercial banking A commercial bank is a financial institution that accepts deposits from the public and gives loans for the purposes of consumption and investment to make a profit. It can also refer to a bank or a division of a larger bank that deals with whol ...

from

investment banking Investment banking is an advisory-based financial service for institutional investors, corporations, governments, and similar clients. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by und ...

, providing safeguards against possible corruption with many types of investment securities (like the MBS). Even though the

fixed-rate mortgage A fixed-rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment amounts and the duration of ...

did not yet exist at this time, the law deemed it illegal for a banking institution to both sponsor debts and design investment vehicles or market-making tools as the selfsame entity. In other words, the Mortgage-Backed Security could probably not have existed at this time (without a little tweaking of the laws). As part of the

New Deal The New Deal was a series of wide-reaching economic, social, and political reforms enacted by President Franklin D. Roosevelt in the United States between 1933 and 1938, in response to the Great Depression in the United States, Great Depressi ...

following the

Great Depression The Great Depression was a severe global economic downturn from 1929 to 1939. The period was characterized by high rates of unemployment and poverty, drastic reductions in industrial production and international trade, and widespread bank and ...

, the US federal government created the

Federal Housing Administration The Federal Housing Administration (FHA), also known as the Office of Housing within the Department of Housing and Urban Development (HUD), is a Independent agencies of the United States government, United States government agency founded by Pr ...

(FHA) with the

National Housing Act of 1934 The National Act of 1934, , , also called the Better Housing Program, was part of the New Deal passed during the Great Depression in order to make housing and home mortgages more affordable. It created the Federal Housing Administration (FHA ...

to assist in the construction, acquisition, and rehabilitation of residential properties. The FHA helped develop and standardize the

as an alternative to the

balloon payment mortgage A balloon payment mortgage is a mortgage loan, mortgage that does not fully amortization (business), amortize over the term of the mortgage note, note, thus leaving a balance due at Maturity (finance), maturity.Wiedemer, John P, ''Real Estate Fin ...

by insuring them, and helped the mortgage design garner usage. In 1938, the government also created the government-sponsored corporation

to create a liquid secondary market in these mortgages and thereby free up the loan originators to originate more loans, primarily by buying FHA-insured mortgages. As part of the

Housing and Urban Development Act of 1968 Housing refers to a property containing one or more shelter as a living space. Housing spaces are inhabited either by individuals or a collective group of people. Housing is also referred to as a human need and human right, playing a cr ...

, Fannie Mae was split into the current Fannie Mae and

Ginnie Mae The Government National Mortgage Association (GNMA), or Ginnie Mae, is a government-owned corporation of the United States Federal Government within the Department of Housing and Urban Development (HUD). It was founded in 1968 and works to exp ...

to support the FHA-insured mortgages, as well as

Veterans Administration The United States Department of Veterans Affairs (VA) is a Cabinet-level executive branch department of the federal government charged with providing lifelong healthcare services to eligible military veterans at the 170 VA medical centers an ...

(VA) and

Farmers Home Administration The Farmers Home Administration (FmHA) was a U.S. government agency established in August 1946 to replace the Farm Security Administration. It superseded the Resettlement Administration during the Great Depression and operated until 2006. FmHA mi ...

(FmHA) insured mortgages, with the full faith and credit of the US government. In 1970, the federal government authorized Fannie Mae to purchase conventional mortgages—that is, those not insured by the FHA, VA, or FmHA, and created

Freddie Mac The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is an American publicly traded, government-sponsored enterprise (GSE), headquartered in Tysons, Virginia.collateralized mortgage obligation A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor need ...

. In 1960 the government enacted the Real Estate Investment Trust Act to allow the creation of the

real estate investment trust A real estate investment trust (REIT, pronounced "reet") is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of real estate, including office and apartment buildings, studios, warehouses, hos ...

(REIT) to encourage real estate investment, and in 1977

Bank of America The Bank of America Corporation (Bank of America) (often abbreviated BofA or BoA) is an American multinational investment banking, investment bank and financial services holding company headquartered at the Bank of America Corporate Center in ...

issued the first private label pass-through. In 1983 the

Federal Reserve Board The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve Board, is the main governing body of the Federal Reserve System. It is charged with overseeing the Federal Reserve Banks and with helping implement the mo ...

amended

Regulation T Federal Reserve Board Regulation T (also referred to as Reg T) is 12 CFR §220 – Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 (Credit by Brokers and Dealers). Regulation T governs the extension of credit by securit ...

to allow

broker-dealer In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and ...

s to use pass-throughs as

margin Margin may refer to: Physical or graphical edges *Margin (typography), the white space that surrounds the content of a page * Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust *Leaf ...

collateral, equivalent to

over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...

non-

convertible bond In finance, a convertible bond, convertible note, or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in ...

s. In 1984 the government passed the

Secondary Mortgage Market Enhancement Act The Secondary Mortgage Market Enhancement Act of 1984 (SMMEA) was an Act of Congress intended to improve the marketability of private label mortgage-backed security passthroughs. It is mentioned as a significant contributing factor in the subprime ...

to improve the marketability of private label pass-throughs, which declared

nationally recognized statistical rating organization A nationally recognized statistical rating organization (NRSRO) is a credit rating agency (CRA) approved by the U.S. Securities and Exchange Commission (SEC) to provide information that financial firms must rely on for certain regulatory purpo ...

AA- rated mortgage-backed securities to be legal investments equivalent to Treasury securities and other federal

government bond A government bond or sovereign bond is a form of Bond (finance), bond issued by a government to support government spending, public spending. It generally includes a commitment to pay periodic interest, called Coupon (finance), coupon payments' ...

s for federally chartered banks (such as

federal savings bank Federal savings associations (also called "federal thrifts" or "federal Savings Banks"), in the United States, are institutions chartered by the Office of Thrift Supervision which is now administered by Office of the Comptroller of the Currency a ...

s and federal savings associations), state-chartered financial institutions (such as

depository bank A depository bank (U.S. usage) or depositary bank (predominantly EU usage) is a specialist financial entity which, depending on jurisdiction, facilitates investment in securities markets. Depository banks in the United States In the United St ...

s and

insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to protect ...

companies) unless overridden by state law before October 1991 (which 21 states did), and

Department of Labor A ministry of labour (''British English, UK''), or labor (''American English, US''), also known as a department of labour, or labor, is a government department responsible for setting labour standards, labour dispute mechanisms, employment, workfor ...

–regulated

pension fund A pension fund, also known as a superannuation fund in some countries, is any program, fund, or scheme which provides pension, retirement income. The U.S. Government's Social Security Trust Fund, which oversees $2.57 trillion in assets, is the ...

s. The

Tax Reform Act of 1986 The Tax Reform Act of 1986 (TRA) was passed by the 99th United States Congress and signed into law by President Ronald Reagan on October 22, 1986. The Tax Reform Act of 1986 was the top domestic priority of President Reagan's second term. The ...

allowed the creation of the tax-exempt

(REMIC)

for the express purpose of issuing pass-throughs. The Tax Reform Act may have contributed to the

savings and loan crisis The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of approximately a third of the savings and loan associations (S&Ls or thrifts) in the United States between 1986 and 1995. These thrifts were b ...

of the 1980s and 1990s that resulted in the

Financial Institutions Reform, Recovery and Enforcement Act of 1989 The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), is a United States federal law enacted in the wake of the savings and loan crisis of the 1980s. It established the Resolution Trust Corporation to close hundreds ...

, which dramatically changed the savings and loan industry and its federal regulation, encouraging loan origination. Nevertheless, probably the most influential action that encouraged the

of 2008 (other than the neglectful actions of banking institutions) was the Financial Services Moderation Act (also called the

Gramm–Leach–Bliley Act The Gramm–Leach–Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999, () is an act of the 106th United States Congress (1999–2001). It repealed part of the Glass–Steagall Act of 1933, removing barriers in ...

). It was signed into law in 1999 by

President Clinton William Jefferson Clinton ( né Blythe III; born August 19, 1946) is an American politician and lawyer who was the 42nd president of the United States from 1993 to 2001. A member of the Democratic Party, he previously served as the att ...

, and allowed sole, in-house creation (by solitary banking institutions) of Mortgage-Backed Securities as investment and derivatives instruments. This legislative decision did not just tweak or finesse the preexisting law, it effectively repealed the Glass-Steagall Act of 1933, the only remaining statutory safeguard poised against the ensuing disaster.

Subprime mortgage crisis

Low-quality mortgage-backed securities backed by

subprime mortgages In finance, subprime lending (also referred to as near-prime, subpar, non-prime, and second-chance lending) is the provision of loans to people in the United States who may have difficulty maintaining the repayment schedule. Historically, subpr ...

in the United States caused a

crisis A crisis (: crises; : critical) is any event or period that will lead to an unstable and dangerous situation affecting an individual, group, or all of society. Crises are negative changes in the human or environmental affairs, especially when ...

that played a major role in the

2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...

. By 2012 the market for high-quality mortgage-backed securities had recovered and was a profit center for US banks.

Types

Most bonds backed by mortgages are classified as an MBS. This can be confusing because a security derived from an MBS is also called an MBS. To distinguish the basic MBS bond from other mortgage-backed instruments, the qualifier ''pass-through'' is used, in the same way that "vanilla" designates an option with no special features. Subtypes of mortgage-backed security include: ''Pass-through securities'' are issued by a trust and allocate the cash flows from the underlying pool to the securities holders on a pro rata basis. A trust that issues pass-through certificates is taxed under the grantor trust rules of the Internal Revenue Code. Under these rules, the holder of a pass-through certificate is taxed as a direct owner of the portion of the trust allocatable to the certificate. In order for the issuer to be recognized as a trust for tax purposes, there can be no significant power under the trust agreement to change the composition of the asset pool or otherwise to reinvest payments received, and the trust must have, with limited exceptions, only a single class of ownership interests. ** A ''

'' (RMBS) is a pass-through MBS backed by mortgages on

property. ** A ''

'' (CMBS) is a pass-through MBS backed by mortgages on

property. In addition to single-family residential mortgages, Fannie Mae and Freddie Mac also issue multi-family securities, expanding the diversity and reach of their securitization activities. A ''

'', or "pay-through bond", is a debt obligation of a legal entity that is collateralized by the assets it owns. Pay-through bonds are typically divided into classes that have different maturities and different priorities for the receipt of principal and in some cases of interest. They often contain a sequential pay security structure, with at least two classes of mortgage-backed securities issued, with one class receiving scheduled principal payments and prepayments before any other class. Pay-through securities are classified as debt for income tax purposes. A ''stripped mortgage-backed security'' (SMBS) where each mortgage payment is partly used to pay down the loan's

and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes: ** An ''interest-only stripped mortgage-backed security'' (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments. *** A ''net interest margin security'' (NIMS) is re-securitized residual interest of a mortgage-backed security ** A ''principal-only stripped mortgage-backed security'' (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments. There are a variety of underlying mortgage classifications in the pool: ''Prime'' mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong

credit score A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report, information typically sourced from credit bu ...

s, etc. ''

Alt-A An Alt-A mortgage, short for Alternative A-paper, is a type of U.S. Mortgage loan, mortgage that, for various reasons, is considered riskier than A-paper, or "prime", and less risky than "subprime lending, subprime," the riskiest category. For thes ...

'' mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) Alt-A mortgages tend to be larger in

Uses

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities: # transform relatively

illiquid In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...

, individual financial assets into liquid and tradable capital market instruments # allow mortgage originators to replenish their funds, which can then be used for additional origination activities # can be used by

Wall Street Wall Street is a street in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It runs eight city blocks between Broadway (Manhattan), Broadway in the west and South Street (Manhattan), South Str ...

banks to monetize the

credit spread Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt), ...

between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically a public market transaction) # are often a more efficient and lower-cost source of financing in comparison with other bank and capital markets financing alternatives. # allow issuers to diversify their financing sources by offering alternatives to more traditional forms of debt and equity financing # allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently, and achieve compliance with risk-based capital standards The high

liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...

of most mortgage-backed securities means that an investor wishing to take a

position Position often refers to: * Position (geometry), the spatial location (rather than orientation) of an entity * Position, a job or occupation Position may also refer to: Games and recreation * Position (poker), location relative to the dealer * ...

need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread. Reasons (other than investment or

speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable in a brief amount of time. It can also refer to short sales in which the speculator hope ...

) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing).

Market size and liquidity

As of the second quarter of 2011, there was about $13.7 trillion in total outstanding US mortgage debt. There were about $8.5 trillion in total US mortgage-related securities, with about $7 trillion of that securitized or guaranteed by government-sponsored enterprises or government agencies, and the remaining $1.5 trillion being pooled by private mortgage conduits. As of 2021, the volume of mortgage-backed securities (MBS) outstanding in the United States has surpassed 12 trillion U.S. dollars, marking a significant growth in the market size. This expansion reflects the increasing role of MBS in the financing of residential real estate, demonstrating the importance of these securities in the overall financial system and housing market. According to the Bond Market Association, gross US issuance of agency MBS was: 2005: USD 0.967 trillion 2004: USD 1.019 trillion 2003: USD 2.131 trillion 2002: USD 1.444 trillion 2001: USD 1.093 trillion This data underscores the fluctuating nature of the MBS market over time, influenced by varying economic conditions, interest rates, and housing market dynamics.

Pricing

Valuation

The weighted-average maturity (WAM) and weighted average coupon (WAC) are used for valuation of a pass-through MBS, and they form the basis for computing cash flows from that mortgage pass-through. Just as this article describes a bond as a 30-year bond with 6%

coupon rate In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product. Customarily, coupons are issued by manufacturers of consumer packaged goods or by retailers, to be used in ...

, this article describes a pass-through MBS as a $3 billion pass-through with 6% pass-through rate, a 6.5% WAC, and 340-month WAM. The pass-through rate is different from the WAC; it is the rate that the investor would receive if he/she held this pass-through MBS, and the pass-through rate is almost always less than the WAC. The difference goes to servicing costs (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors). To illustrate these concepts, consider a mortgage pool with just three mortgage loans that have the following outstanding mortgage balances, mortgage rates, and months remaining to maturity:

Weighted-average maturity

The ''weighted-average maturity'' (WAM) of a pass-through MBS is the average of the maturities of the mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an average across mortgages, as distinct from concepts such as

weighted-average life In finance, the weighted-average life (WAL) of an amortizing loan or amortizing bond, also called average life, is the weighted average of the times of the ''principal repayments'': it's the average time until a dollar of principal is repaid. In a ...

and duration, which are averages across payments of a single loan. The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance or initiation of the MBS. The WAM for the above example is computed as follows: Another measure often used is the Weighted-average loan age.

Weighted-average coupon

The ''weighted-average coupon'' (WAC) of a pass-through MBS is the average of the coupons of the mortgages in the pool, weighted by their original balances at the issuance of the MBS. For the above example this is:

Theoretical pricing

Pricing a "vanilla" corporate bond is based on two sources of uncertainty: default risk (credit risk) and

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...

(IR) exposure. The MBS adds a third risk: early redemption ( prepayment). The number of homeowners in residential MBS securitizations who prepay increases when interest rates decrease. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection. Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in

finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...

. The level of difficulty rises with the complexity of the IR model and the sophistication of the prepayment IR dependence, to the point that no closed-form solution (i.e., one that could be written down) is widely known. In models of this type,

numerical methods Numerical analysis is the study of algorithms that use numerical approximation (as opposed to symbolic manipulations) for the problems of mathematical analysis (as distinguished from discrete mathematics). It is the study of numerical methods t ...

provide approximate theoretical prices. These are also required in most models that specify the

credit risk Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...

as a

stochastic Stochastic (; ) is the property of being well-described by a random probability distribution. ''Stochasticity'' and ''randomness'' are technically distinct concepts: the former refers to a modeling approach, while the latter describes phenomena; i ...

function with an IR

correlation In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics ...

. Practitioners typically use specialised Monte Carlo methods or modified Binomial Tree numerical solutions.

Interest rate risk and prepayment risk

Theoretical pricing models must take into account the link between interest rates and loan prepayment speed. Mortgage prepayments are usually made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a ''risk'' for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). In other words, the proceeds received would need to be reinvested at a lower interest rate. Hence the term ''prepayment risk''. Professional investors generally use arbitrage-pricing models to value MBS. These models deploy

scenarios consistent with the current

yield curve In finance, the yield curve is a graph which depicts how the Yield to maturity, yields on debt instruments – such as bonds – vary as a function of their years remaining to Maturity (finance), maturity. Typically, the graph's horizontal ...

as drivers of the

econometric Econometrics is an application of statistical methods to economic data in order to give empirical content to economic relationships. M. Hashem Pesaran (1987). "Econometrics", '' The New Palgrave: A Dictionary of Economics'', v. 2, p. 8 p. 8� ...

prepayment models that models homeowner behavior as a function of projected mortgage rates. Given the market price, the model produces an

option-adjusted spread Option-adjusted spread (OAS) is the yield spread which has to be added to a benchmark yield curve to discount a security's payments to match its market price, using a dynamic pricing model that accounts for embedded options. OAS is hence mode ...

, a valuation metric that takes into account the risks inherent in these complex securities. There are other drivers of the prepayment function (or prepayment risk), independent of the

, such as: * economic growth, which is correlated with increased turnover in the housing market * home prices

inflation In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

* unemployment * regulatory risk (if borrowing requirements or

tax law Tax law or revenue law is an area of legal study in which public or sanctioned authorities, such as federal, state and municipal governments (as in the case of the US) use a body of rules and procedures (laws) to assess and collect taxes in a ...

s in a country change this can change the market profoundly) *

demographic Demography () is the statistics, statistical study of human populations: their size, composition (e.g., ethnic group, age), and how they change through the interplay of fertility (births), mortality (deaths), and migration. Demographic analy ...

trends, and a shifting

risk aversion In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more c ...

profile, which can make fixed rate mortgages relatively more or less attractive

Credit risk

The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The

credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government). It is the practice of predicting or forecasting the ability of a supposed debtor to pay back the debt or default. The ...

of MBS is fairly high because: # Most

originations include research on the mortgage borrower's ability to repay, and will try to lend only to the creditworthy. An important exception to this is "no-doc" or "low-doc" loans. # Some MBS issuers, such as

, guarantee against homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the full faith and credit of the US federal government. This is not the case with Fannie Mae and Freddie Mac, but these two entities have lines of credit with the US federal government; however, these lines of credit are extremely small compared to the average amount of money circulated through these entities in one day's business. Additionally, Fannie Mae and Freddie Mac generally require private mortgage insurance on loans in which the borrower provides a

down payment In accounting, a down payment (also called a deposit in British English) is an initial up-front partial payment for the purchase of expensive goods or services such as a car or a house. It is usually paid in cash or equivalent at the time of fin ...

that is less than 20% of the property value. # Pooling many mortgages with uncorrelated default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments (see Copula). Although the

risk neutral In economics and finance, risk neutral preferences are preference (economics), preferences that are neither risk aversion, risk averse nor risk seeking. A risk neutral party's decisions are not affected by the degree of uncertainty in a set of out ...

is theoretically identical between a mortgage ensemble and the average mortgage within it, the chance of catastrophic loss is reduced. # If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default. If the MBS was not underwritten by the original real estate and the issuer's guarantee, the rating of the bonds would be much lower. Part of the reason is the expected

adverse selection In economics, insurance, and risk management, adverse selection is a market situation where Information asymmetry, asymmetric information results in a party taking advantage of undisclosed information to benefit more from a contract or trade. In ...

against borrowers with improving credit (from MBSs pooled by initial credit quality) who would have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).

Real-world pricing

Because of the diversity in MBS types, there is a wide variety of pricing sources. In general, the more uniform or liquid the MBS, the greater the transparency or availability of prices.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', Chapter 5 (Thomson West, 2013 ed.). Most traders and money managers use

Bloomberg Bloomberg may refer to: People * Daniel J. Bloomberg (1905–1984), audio engineer * Georgina Bloomberg (born 1983), professional equestrian * Michael Bloomberg (born 1942), American businessman and founder of Bloomberg L.P.; politician a ...

and Intex to analyze MBS pools and more esoteric products such as CDOs, although tools such as Citi's The Yield Book, Barclays POINT, and BlackRock's AnSer are also prevalent across Wall Street, especially for multi–asset class managers. Some institutions have also developed their own proprietary software. Complex structured products tend to trade less frequently and involve more negotiation. Prices for these more complicated MBSs, as well as for CMOs and CDOs, tend to be more subjective, often available only from dealers. The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or

PSA PSA, PsA, Psa, or psa may refer to: Biology and medicine * Posterior spinal artery * Primary systemic amyloidosis, a disease caused by the accumulation of abnormal proteins * Prostate-specific antigen, an enzyme used as a blood tracer for pro ...

. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases. If an investor has acquired a pool at a premium (>100), as is common for higher coupons, then they ''are'' at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar prepaid, which may significantly decrease the yield. This is likely to happen as holders of higher-coupon mortgages can have a larger incentive to refinance. Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS pool was bought at a discount (<100). This is due to the fact that when the borrower pays back the mortgage, he or she does so at "par". If an investor purchases a bond at 95 cents on the dollar, as the borrower prepays the investor gets the full dollar back, increasing their yield. However, this is less likely to occur, as borrowers with low-coupon mortgages have lower, or no, incentives to refinance. The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high-premium (high-coupon) MBSs backed by mortgages with an original loan balance no larger than $85,000 command the largest pay-ups. Even though the borrower is paying an above market yield, he or she is dissuaded from refinancing a small loan balance due to the high fixed cost involved. Low Loan Balance: < $85,000
Mid Loan Balance: $85,000–$110,000
High Loan Balance: $110,000–$150,000
Super High Loan Balance: $150,000–$175,000
New Loan Balance Buckets: $175,000–$200,000
$200,000–$225,000
$225,000–$250,000
$250,000–$275,000
TBA: > $275,000 The plurality of factors makes it difficult to calculate the value of an MBS security. Often market participants do not concur, resulting in large differences in quoted prices for the same instrument. Practitioners constantly try to improve prepayment models and hope to measure values for input variables implied by the market. Varying

liquidity premium In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity. It is a segment of a three-part theory that works to explain the beha ...

s for related instruments and changing liquidity over time make this a difficult task. One factor used to express the price of an MBS security is the pool factor.

Recording and Mortgage Electronic Registration Systems

One critical component of the securitization system in the US market is the

Mortgage Electronic Registration Systems Mortgage Electronic Registration Systems, Inc. (MERS) is an American privately held corporation. MERS is a separate and distinct corporation that serves as a nominee on mortgages after the turn of the century and is owned by holding company MERSC ...

(MERS) created in the 1990s, which created a private system wherein underlying mortgages were assigned and reassigned outside of the traditional county-level recording process. The legitimacy and overall accuracy of this alternative recording system have faced serious challenges with the onset of the mortgage crisis: as the US courts flood with

foreclosure Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has Default (finance), stopped making payments to the lender by forcing the sale of the asset used as the Collateral (finance), coll ...

cases, the inadequacies of the MERS model are being exposed, and both local and federal governments have begun to take action through suits of their own and the refusal (in some jurisdictions) of the courts to recognize the legal authority of MERS assignments. The assignment of mortgage (deed of trust) and note (obligation to pay the debt) paperwork outside of the traditional US county courts (and without recordation fee payment) is subject to legal challenge. Legal inconsistencies in MERS originally appeared trivial, but they may reflect dysfunctionality in the entire US mortgage securitization industry.

References

Bibliography

* * *

External links

Vink, Dennis and Thibeault, André (2008). "ABS, MBS and CDO Compared: An Empirical Analysis" ''The Journal of Structured Finance''

MBS Basics
by Mortgage News Daily, ''MBS Commentary''

by Chris Wilson, in Slate Magazine
TBA Trading and Liquidity in the Agency MBS Market, ''by the Federal Reserve Bank of New York''
{{DEFAULTSORT:Mortgage-Backed Security Structured finance Financial capital United States housing bubble