Mortgage-backed securities (MBS) are based on mortgage loans. Each security is a group of loans made to homebuyers; the loans are backed by real estate as collateral. The underlying loans on which MBS are based are made by lenders such as mortgage banks, commercial banks, savings and loan associations and similar financial institutions.
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MBS themselves are then issued to investors by organizations such as:
- Federal National Mortgage Association (FNMA), known as “Fannie Mae”
- Federal Home Loan Mortgage Corporation (FHLMC), nicknamed “Freddie Mac”
- Government National Mortgage Association (GNMA), also referred to as “Ginnie Mae”.
GNMA (Ginnie Mae) is a government-owned corporation, guaranteed by the U.S. Government. Its aim is to make mortgage funds available throughout the U.S. FHLMC (“Freddie Mac”) and FNMA (“Fannie Mae”) on the other hand are publicly owned and government sponsored, but not explicitly guaranteed by the Government. They make investments possible in increments of $1,000, compared to GNMA’s minimum new issue of $25,000.
All Mortgage Backed Securities, even in the case of Ginnie Mae, are subject to local, state and federal taxes.
Mortgage-backed securities (MBS for short) are therefore debt-backed securities, as are bonds in general. However, there are differences:
Principal and interest are paid throughout, instead of the typical bond remuneration of interest during the term and the par value of the bond at the end
Payments are made monthly, not semi-annually.
The term of an MBS is not certain, because prepayments, defaults or extensions can shorten or lengthen the term.
The differences listed above apply to “pass-through” MBS: principal, interest and any prepaid principal are paid to the investor by the issuer who has collected principal and interest from a pool of mortgages.
The potential advantage to investors of MBS is that they typically offer greater yields than those of government bonds, while maintaining a credit risk considered to be minimal when the underlying mortgages are backed by one of the three institutions above, with federal agency or government sponsored status. However, other institutions may also issue MBS.
The potential risks include:
- Credit risk, meaning the risk that the issuer of the MBS fails.
- Default risk, if homebuyers fail to keep up payments on their mortgages
- Liquidity, where the characteristics of an MBS may make it more difficult to resell
- Prepayment risk, if homebuyers pay off their mortgages earlier than expected, especially when interest rates are low. This has the follow-on effect of making it more difficult for investors to find high-yield investments to reinvest the principal returned from their MBS
- Extension risks, often when interest rates are rising. Homebuyers reduce their mortgage payments, interest payments to investors fall and the term of the MBS becomes longer.