The term ‘Mortgage-backed Securities’ can be explained in a simple manner. People take loans when buying property. An organization buys these loans which are mostly on residential property and then ‘securitizes’ these loans. This means that it would issue securities which represent claims on the principal amount of the loans bought as well as interest paid by borrowers. In a nutshell, mortgage-backed securities are debt obligations which represent claims to cash flows from mortgage loan pools.
Freddie Mac, Fannie Mae, Ginnie Mae –do these names sound familiar? Well, these are not names of people but of organizations in the U.S. which issue mortgage-backed securities. Freddie Mac is actually Federal Home Loan Mortgage Corporation, Fannie Mae is Federal National Mortgage Association and Ginnie Mae stands for Government National Mortgage Association.
All these organizations are sponsored by the U.S. government. Ginnie Mae has the full backing of the U.S. Government; it provides a guarantee to investors who have bought mortgage-backed securities that they would receive payments on time.
Fannie Mae and Freddie Mac on the other hand, have been given only some special powers. They are allowed to borrow from the U.S. Treasury. Apart from these government-linked institutions some private organizations like banks, home construction companies as well as brokerages issue mortgage-backed securities which are called private label mortgage-backed securities (MBS).
These are typical mortgage-backed securities wherein the money collected in the mortgage pool is paid or passed on to the investors in the proportion of their investments in the securities.
Procedure of payment:
Every month the investor pays the interest on the principal due for that month and a part of the principal as per the terms of the loan. This payment is passed on to the investors of mortgage-backed securities. As the principal reduces over time, the interest payment component in the monthly installment keeps on increasing.
Investors were not satisfied with the plain vanilla mortgage-backed securities. There was a demand for more exotic products resulting in the creation of instruments called Collaterized Mortgage Obligations (CMOs) where the investors are paid in tranches. So, different investors would be a paid at different times and at different rates according to the terms set.
Mortgages are usually taken for a period of about 30 years. When interest rates fall, homeowners may find attractive refinance options and may decide to prepay their existing home loans. When the investors are given back the principal amount, they would find it difficult to find good avenues for investment and would have to settle for investments with low returns.
While mortgage-backed securities issued by government- backed agencies are safe, the introduction of private label mortgage-backed securities in 2000, have brought high degrees of risk to these securities. Home loans may be given to financially unsound parties who will be unable to repay the loans-the much discussed ‘subprime loans’. The investors get tempted by the high returns promised and buy them. When there are loan defaults, the entire investment gets wiped out as seen in the subprime crisis of 2008.
Though mortgage-backed securities and their derivative counterparts look like attractive investment options, we have seen the dangers involved and their cascading effect on the economy as a whole.