If you've ever bought a home, you probably had to take out a mortgage to finance it. But have you ever wondered what happens to your mortgage after you sign on the dotted line? The answer is that your mortgage, along with thousands of others, may be bundled together and sold to investors as a type of security called a mortgage-backed security (MBS).
Mortgage-backed securities are created when a financial institution (such as a bank) pools together a large number of individual mortgages and packages them into a single security. This security is then sold to investors, who receive regular payments based on the interest and principal payments made by the individual homeowners whose mortgages are included in the security. This process is known as securitization.
The structure of mortgage-backed securities can vary depending on the type of mortgages included in the security. For example, a mortgage-backed security may consist of only prime mortgages (i.e., mortgages issued to borrowers with excellent credit) or subprime mortgages (i.e., mortgages issued to borrowers with poor credit). Additionally, the structure of the security may include different levels of risk, with some investors receiving higher returns but also facing a greater risk of default.
One advantage of mortgage-backed securities is that they allow investors to diversify their portfolio and potentially earn a higher rate of return than they would from other types of investments. However, there are also several disadvantages and risks associated with investing in MBS.
One of the most significant risks associated with mortgage-backed securities is the potential for default. If a large number of homeowners whose mortgages are included in the security are unable to make their mortgage payments, the value of the security can plummet, leaving investors with significant losses. This was a major factor in the 2008 financial crisis, which was triggered in part by the collapse of the subprime mortgage market.
Another risk associated with mortgage-backed securities is the potential for prepayment. If homeowners are able to pay off their mortgages early, investors in the MBS may not receive the expected returns, as the principal payments will be returned earlier than expected.
To mitigate these risks, investors can take several steps, including carefully analyzing the underlying mortgages included in the security and diversifying their portfolio. Additionally, government regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 have introduced new rules and requirements aimed at increasing transparency and reducing the potential for excessive risk-taking in the mortgage-backed securities market.
Despite the risks associated with mortgage-backed securities, they continue to be a popular investment option for many investors. According to data from the Securities Industry and Financial Markets Association, the total outstanding balance of mortgage-backed securities in the U.S. was approximately $8.8 trillion as of the end of 2021.
In conclusion, mortgage-backed securities can be a complex and potentially risky investment, but they also offer the potential for higher returns and diversification. As with any investment, it's important to carefully evaluate the risks and potential rewards before deciding whether to invest in MBS.