Mortgage Backed Securities & its Importance

Mortgage-Backed Securities: A Comprehensive Overview

Mortgage backed securities (MBS) are a big deal in the world of finance and accounting. They have played a major role in the global financial markets, from individual mortgage rates to the overall stability of the financial system. This article will break down MBS, including their structure, types, benefits, risks and their impact on the financial world.

Mortgage Backed Securities

What are Mortgage Backed Securities?

Mortgage backed securities are investment products that represent claims on the cash flows from pools of mortgage loans. In other words, they are created when multiple mortgage loans are packaged together and sold to investors. The cash flow from homeowners paying off their mortgage loans is passed through to investors in the form of monthly payments.

History and Evolution

MBS were first introduced in the US in the late 1960s by the Government National Mortgage Association (Ginnie Mae) to provide liquidity to the mortgage market. Over the years, the MBS market has grown exponentially with various government sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac playing a major role.

Mortgage Backed Securities Structure

Components of MBS

1. Mortgage Pool: The base of an MBS is a pool of mortgage loans. These loans are usually similar in terms of interest rate, maturity and credit quality.
2. Issuers: Issuers can be GSEs, private financial institutions or other entities that package and securitize mortgages.
3. Investors: Investors in MBS are pension funds, insurance companies, mutual funds and individual investors looking for stable income.

Types of MBS

1. Pass-Through Securities: The most basic form of MBS where the principal and interest payments from the mortgage pool are passed through to investors.
2. Collateralized Mortgage Obligations (CMOs): More complex MBS that are divided into tranches with different risk levels, maturities and interest rates. CMOs offer customized cash flow structures to meet investor needs.
3. Residential Mortgage Backed Securities (RMBS): These are backed by residential mortgages and are usually issued by GSEs or private entities.
4. Commercial Mortgage Backed Securities (CMBS): These are backed by commercial real estate loans such as office buildings, hotels and shopping centers.

Benefits of Mortgage Backed Securities

Liquidity and Capital Availability

MBS provide liquidity to the mortgage market. By converting illiquid mortgage loans into liquid securities, lenders can free up capital to issue more loans and support home ownership and economic growth.

Diversification and Risk Management

For investors, MBS offer diversification. By investing in a pool of mortgages, investors can spread their risk across multiple loans and reduce the impact of any one borrower defaulting.

Yield Enhancement

MBS usually offer higher yields than other fixed income securities with similar credit ratings. This yield premium is attractive to investors looking for better returns on their investment.

Risks Associated with Mortgage-Backed Securities

Interest Rate Risk

MBS are interest rate sensitive. When rates go up, existing MBS values go down because new securities offer higher rates. When rates go down, prepayment rates go up and homeowners refi their mortgages, reducing the return on MBS.

Prepayment Risk

Prepayment risk is a big deal for MBS investors. When rates go down, homeowners refi their mortgages and pay off the loans in the MBS pool early. Investors get their principal back sooner than expected, often at a time when reinvestment options may have lower returns.

Credit Risk

While many MBS are backed by GSEs and have minimal credit risk, private-label MBS (those issued by non-GSE entities) have significant credit risk. During the 2007-2008 financial crisis, many private-label MBS had big defaults and big losses for investors.

Accounting for Mortgage-Backed Securities

Initial Recognition and Measurement

MBS are classified as available-for-sale (AFS) or held-to-maturity (HTM) on the balance sheet. At initial recognition, MBS are measured at fair value, which is usually the purchase price.

Subsequent Measurement

• Available-for-Sale (AFS) Securities: Measured at fair value, with unrealized gains or losses in other comprehensive income (OCI). When the security is sold or matures, the OCI is reclassified to profit or loss.
• Held-to-Maturity (HTM) Securities: Measured at amortized cost using the effective interest method. HTM securities are held to maturity so they don’t fluctuate in value in the income statement.

Impairment and Derecognition

If there’s evidence of impairment (e.g. significant decline in fair value or credit deterioration), the carrying amount of the MBS is written down and an impairment loss is recognized in profit or loss. Derecognition occurs when the rights to the cash flows from the MBS expire or the security is sold.

The Role of MBS in the Financial Crisis

The 2007-2008 financial crisis showed the risks of MBS, especially private-label MBS. Many of those securities were backed by subprime mortgages which had high default rates as housing prices fell. The resulting losses caused the value of MBS to collapse and contributed to the broader financial crisis. This crisis demonstrated the need for proper risk assessment, transparency and regulation in the MBS market.

Summary

Mortgage-backed securities are the foundation of the modern financial system, providing liquidity, diversification and yield enhancement. But they also have big risks: interest rate, prepayment and credit. Investors, financial professionals and regulators need to understand the MBS structure, benefits and risks. As the market changes, we must stay vigilant and manage prudently to keep the financial system stable.