Mortgage-Backed Securities (MBS): What is it & how it works

For centuries, businesses have continuously increased the revenue of investors by generating means and opportunities for revenue generation. Investors are aimed to increase profit margins and gains through the spread of risks across varying investment opportunity that allows the investor to leverage on the ever-growing nature of business ideas. 

With over 7 billion people across the world, there exists the place and time to gain the best there is to offer in an industry with varying opportunities. This article offers all there is to know on mortgage-backed securities and how it improves finances for investors globally.

What are mortgage-backed securities?

Mortgage-backed securities are financial products made up of a collection of mortgages issued by a bank to individuals over a while, packed and then sold to an investor. The mortgage itself acts as security to the transaction with the investors aiming to make gains from the debt payments of the mortgagees. 

The bank acts as a trustee or as an intermediary between the mortgagee and the investor while overseeing and ensuring the payment of the mortgage loan by the mortgagee. The mortgages of various mortgages are joined together to form a single grouped mortgage-backed securities. 

How mortgage-backed securities work

Mortgage-bank securities work similarly to their asset-backed counterparts with the determining difference being the underlying asset from which the cash is generated for the investor. Unlike asset-backed securities, the underlying asset used as collateralized debt is the property which was mortgaged for the loan. 

The mortgage-backed securities are concerned mainly with drawing mortgages from varying periods and offering them to the investor to buy up collectively. The investor invariably inputs money into the mortgages, thereby, taking the position of the bank as the mortgagor while investing in the home market. 

For instance, TFY bank granted mortgages to over 1000 clients at various times from January 2000 to December 2002. TFY bank gathers all their existing mortgages, totalling 1000 into packaged mortgage-backed securities (MBS) and offers the MBS for sale, usually at a discount, to the investor. 

From the example above, the investor automatically takes the position of the mortgagor from the bank. The bank, nonetheless, remains in the transaction as an intermediary to the investor and the mortgagees ensuring compliance with the original agreement among the parties. The bank also records the mortgage as a profit gained irrespective of the failure or otherwise of the mortgage transaction. 

Parties to mortgage-backed securities transaction 

There are essentially five major parties to the mortgage-backed securities transaction, these are the bank, the Investor, the Mortgagee, the credit-rating agencies, and the investment banks or houses.

1. The bank: The bank is the mother and initiator of the MBS transaction which brings all varying parties together. The bank gathers the mortgages into groups, classifies all the mortgages and sells these MBS to the investor. 

Aside from banks, there exist other financial institutions offering mortgage-related loans to homeowners that can also issue mortgage-backed securities to investors. These financial institutions also qualify under this category.

2. The investment banks: Also investment non-banking institutions, are institutions that play significant roles in the MBS process. The banks after gathering the mortgages into a single MBS offer the MBS to the investment house to sell to the investor. 

The banks can either sell to the investors directly or through investment houses. In practice, it is usually difficult for banks to get investors willing to take up such responsibility and risks, the investment houses are equipped to better find investors for the banks at a commission. These investment houses can be brokers who trade the MBS on the capital market.

3. Mortgagees: these are the homeowners who sought loans from the banks. The mortgagee is vital to the MBS transaction because their compliance with the terms of the mortgage contract can largely influence the success or failure of the MBS. 

4. Investors: Investors are the high net-worth individuals or institutions, which have opted to acquire the MBS through the investment made to the bank. All gains made from each mortgage are delivered right to them.

5. Credit-rating agencies: credit-rating agencies are responsible for rating the success or otherwise of the transaction. They play the role of due diligence and the possibility of each mortgagee paying up their debt. In Nigeria, there are only three credit-rating agencies, these are DataPro Limited, Agusto and Co, and Global Credit Rating. 

Pros and Cons of mortgage-backed securities

Pros of mortgage-backed securities

  1. It reduces the bank’s balance sheet: the balance sheet of the bank is highly reduced following an eventual MBS transaction allocating the bank’s mortgagees to the investor. The over 100 mortgages would no longer appear on the balance sheet of the bank, allowing for simplicity and ease.
  2. Offers the investor with opportunity: The mortgage-backed securities offer the investor an already existing investment that is most likely to offer large returns to the investor in the long run. Investors holding the MBS banks on the assurance of due diligence by the bank before granting the mortgage to the homeowner and the credit-rating agency who are professionals in identifying the likelihood of success in the transaction.

Cons of mortgage-backed securities

  1. Complexity: mortgage-backed securities are highly complex transactions that are difficult to generally comply with. The procedures, documentations, due diligence and other factors provide a series of professionals working round the clock to ensure that hundreds or thousands of mortgagees are coupled into single mortgage-backed securities.
  2. It is a high risk: The likelihood of the transaction failing is very high, this is because the grouping of various mortgages into one mortgage-backed security can make windows for various risks. One such risk is the possibility of one or more of the mortgagees not paying up the loan; once this occurs, the loss is borne by the investor who has made payment for the loan.

Conclusion

Mortgage-backed securities are very complex financial products offered to investors through discounts backed by mortgages.

The transaction has continued to grow in popularity among investors and the business world in general.

Frequently Asked Questions (FAQs)

Are mortgage-backed securities examples of collateralized debt obligations?

Yes, mortgages stand as examples of collateralized debt obligations.

Does the mortgagee know the existence of the investor in an MBS transaction?

No, the mortgagee doesn’t ordinarily know and the possibility of letting each mortgagee know might be impossible following the number of mortgagees involved.

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Richard Okoroafor

Richard Okoroafor

Richard is a brilliant legal content writer who doubles as a finance lawyer. He brings his wealth of legal knowledge in corporate commercial transactions to bear, offering the best value that exceeds expectations.

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