Understanding a Mortgage-Backed Security’s Meaning
There exist several different financial assets in the market today that can be used as investments. However, since there exist so many different financial assets, it is important to examine them carefully in order to ensure that their time horizons align with yours along and are appropriate for you keeping in mind your threshold for risk and your broader financial goals. This article seeks to explore one particular financial asset i.e., mortgage-backed security (or MBS).
AN MBS is an investment that is much like a bond that is composed of a ton of home loans bought via the banks that issued them. Those who invest in MBS’s are the recipients of periodic payments. These operate in a manner akin to that of bond coupon payments that are provided to those who invest in bonds.
Examining Mortgage-Backed Securities with a Fine-Toothed Comb
A mortgage-backed security can be understood to be a variation of an asset-backed security that is formed by bringing together mortgages exclusively. An investor who invests in a mortgage-backed security essentially lends his money to those seeking to buy a home. It is possible for an MBS to be bought and sold via a broker. Different issuers have different requirements that stipulate the minimum investment needed for such a security.
The financial crisis of 2007-2008 was majorly impacted by the subprime mortgage meltdown of the time. This crisis made clear that the security and worth tethered to a mortgage-backed security was only as good as the mortgages that backed it up.
Other terms used to refer to an MBS include mortgage pass-through and mortgage-related security.
In order to understand the working of a mortgage-backed security, understand that it functions by turning the bank into an intermediary that engages with home buyers along with those operating in the investment industry. A bank is capable of granting mortgages to its customers and then selling them at a discount such that they are included under an MBS. The bank then goes on to list the sale as a plus on its balance sheet and does not lose out on any money in the event that a homebuyer defaults in the future.
This process is amenable to all involved as everyone carries on as they are supposed to. This means that the bank in question places reasonable requirements needed to be fulfilled in order to grant mortgages, homeowners make it a point to pay their dues on time and credit rating agencies involved partake in due diligence with regards to reviewing the MBS.
If an individual seeks to sell their MBS in the market today, it must be issued by a government-sponsored enterprise. Else, an authorised financial institution ought to have issued it. The basic idea that follows is that the origins of the mortgages must stem from an authorised financial institution that is regulated. Further, the MBS under consideration must be the recipient of one of the top two ratings that are handed out by a credit rating agency that is accredited.
Examining the Two Popular Forms of Mortgage-Backed Securities
There exist two popular variants of mortgage-backed securities that have been examined below.
Pass-Throughs
These MBS’s are designed to function as trusts within which mortgage payments are collected and then directed towards investors. The maturities that apply to these mortgage-backed securities are ordinarily 5, 15 or 30 years. It is possible for the life span of a pass-through to fall below its stated maturity. This depends on the principal payments applicable to the mortgages that constitute the pass-through.
Collateralised Mortgage Obligations (or CMOs)
Such mortgage-backed securities are made up of several groups of securities that are known as tranches or segments. These tranches are each assigned credit ratings that determine the rates at which they are returned to investors.
Taking a Look at Mortgage-Backed Securities Today
Mortgage-backed securities continue to be bought and sold in today’s day and age. They continue to exist and operate within the markets as people still tend to pay off their mortgages provided, they can. However, the American Federal Reserve System happens to own a large portion of MBS’s today. That being said, they have begun to slowly sell off their holdings.
Collateralised debt organisations have also begun to gain prominence once again despite having lost their original appeal following the 2007-2008 crisis. This is based on the assumption that Wall Street has learned its lesson and will be more prudent with regard to purchasing MBSs. At the moment though, it is too soon to come to any conclusions regarding their future prospects.
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