How Mortgage-Backed Securities Work

Mortgage-backed securities are kind of like stock market units, but for mortgage brokers. Essentially, a mortgage-backed security (MBS) is a type of asset-backed security. It’s secured by a mortgage or collection of mortgages. The mortgages are placed in groups, called MBSs and sold to a group of individuals (normally an investment bank). These banks then securitize the loans by bundling them together into a security that investors can buy.

How the MBS Came About

Originally, when someone wanted a mortgage, they would head directly to their local bank. However, things began to change around the 1930s, when the Great Depression began. Falling real estate prices made it clear to local banks that they would lose money. This was because, at the time, there was no secondary market for trading mortgage loans. Instead, banks had to wait the entire life of the loan to be repaid in full—a difficult thing to do during an economic crisis.

This in turn, gave birth to the first generation of mortgage bankers and mortgagors. The first mortgages were adjustable rate mortgages, and they lasted anywhere from three to five years, using farmland as collateral. With the collapse of real estate prices due to the Great Depression of the 1930s, these mortgage bankers and mortgagors largely disappeared as a source of funds for real estate markets.

So what happened then? In 1933, the Federal Housing Administration (FHA) mortgage insurance program was created. Then, in 1944 the Veterans Administration (VA) mortgage guarantee program was initiated. Now that these administrations had been put into place, adjustable rate loans were no longer the norm, and instead, long-term mortgages with fixed rates took over.

There’s way more to talk about than we could possibly cover in terms of the history of MBSs and how they came about—but we’re here to talk about how they work.

Mortgage-backed Securities and Market Liquidity

So let’s get down to it. How exactly are Mortgage-backed securities created? First, you have someone who needs a loan for a home. They go to their local bank and the bank issues them a loan. However, when in possession of the bank, these mortgages aren’t tradable and they can’t be bought and sold easily because every mortgage for every home has a different loan amount and interest rate. However, being able to create a basic unit of measurement for mortgages, makes it possible to trade and sell mortgages like shares of stock. The process of changing a bundle of mortgages into tradable units of mortgage stock is called securitization. Again, these are secure shares of mortgage-specific stocks that are a safer investment precisely because they won’t drastically change in price.

This in turn creates market liquidity. This is when an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset’s price. This is essential to the stability of markets. Because MBSs are almost identical to trading stocks, mortgage brokers do need to follow the economy closely and how it’ll impact the housing market. They also need to make sure that when they trade stock that their assets are not losing value every time a bundle of mortgages (MBSs) changes hands. In this way, the US economy and the housing market are directly linked through a parallel association.

Securitizing Loans

However, local banks can’t securitize mortgages into MBSs on their own. To do this, they’ll need the help of a larger investment bank. This investment bank will then help assemble a sort of shell-corporation that can securitize mortgages into MBSs and sell them as shares of stock to investors. Investors, (such as Rate Leaf), then buy up these mortgages.

Naturally, there are different subsets of mortgage-backed-securities that you can invest in, which are known as tranches. Tranches are used as categories to determine an investor’s ROI. There are three: equity, mezzanine, and senior. These three categories all come with different levels of risks and yields. But we’ll get more into that later. The point is that once investors buy these mortgage-backed securities, they’ve essentially bought up mortgages that they’re now waiting for other people to buy from them.

Why do banks even go through the trouble of doing this? The answer is fees. Throughout the home buying process, brokers must deal with a complex network of real estate and finance professionals. Each of them make fees off of the home buying process. These fees give banks the liquidity to continue buying up more loans and recreating the cycle of MBS securitization.