Mortgage-backed security
A mortgage-backed security (MBS) is a type of asset-backed security (an "instrument") which is secured by a mortgage 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;[1] another class is commercial, 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 obligations (CMOs, often structured as real estate mortgage investment conduits) and collateralized debt obligations (CDOs).[2]
A mortgage bond is a bond backed by a pool of mortgages on a real estate asset such as a house. 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 tranches (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.[3] These subprime MBSs issued by investment banks were a major issue in the subprime mortgage crisis 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 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 enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks.
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.[32]
A collateralized mortgage obligation, 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.[33] 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.[34] Pay-through securities are classified as debt for income tax purposes.[35]
A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal 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:
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 scores, etc.
Alt-A 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.)[37] Alt-A mortgages tend to be larger in
Market size and liquidity[edit]
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[edit]
Valuation[edit]
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, 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:
Recording and Mortgage Electronic Registration Systems[edit]
One critical component of the securitization system in the US market is the Mortgage Electronic Registration Systems (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 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.[43][44] 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.