What are Mortgage-Backed Securities and How Do They Affect Rates?
Mortgage backed-securities, or MBSs, are bonds secured by a mortgage or pools of mortgages. A portion of each payment you make each month is passed on to MBS investors, who also receive payments from hundreds of other loans pooled together in that mortgage-backed security. MBS trading is critical to the health of the mortgage-lending market, and is a major factor in how high or low your rate is.
How mortgage-backed securities work
Every mortgage-backed security starts with a mortgage. You close on your mortgage, the lender deposits the funds into an escrow account to pay the seller, and you start making monthly payments of principal and interest to the lender.
The bank can decide to keep your mortgage, or create a mortgage-backed security following these steps:
- The bank pools your loans with other home loans that have similar interest rates and terms.
- The bundle of loans becomes a mortgage-backed security (MBS).
- The bank can keep the MBS to earn monthly payments of principal of interest on all of the loans in the security.
- The bank can sell the MBS, freeing up funds to lend to other homebuyers or homeowners.
Homebuying and refinancing keeps MBS money flowing. When loans are paid off through home sales or refinancing, money is freed up for new mortgages to be made. This “liquid” market for mortgage funds keeps money flowing.
Are mortgage-backed securities still legal?
Yes. Although MBS were a factor in the 2008 financial crisis, it was primarily because lenders offered mortgages to high-risk borrowers without regard for whether they could repay the loans. When home values dropped, MBS investors were left with pools of loans secured by homes that were “upside-down,” which means the homes were worth less than the mortgage balance owed. When the homeowners were unable make their payments, the loans defaulted causing a massive financial crisis.
The Consumer Financial Protection Bureau (CFPB) has since set strict “ability to repay” rules that reduce the odds that MBS investors will be stuck with large pools of bad loans.
How MBSs affect mortgage rates
Lenders set interest rates based on the amount of risk they take that you might not repay the loan. When someone defaults on a loan, banks lose more than the principal and interest they stop receiving on the loan. They incur the legal costs of foreclosing and the ongoing expenses of holding and maintaining the property.
Even a handful of foreclosures could result in large losses for mortgage lenders. An MBS allows the banks to “diversify their investment:” If a handful of loans default in a pool of hundreds of loans that are paying on time, the risk is spread out so lenders can offer more financing at better interest rates.
MBS are also affected by the same economic and market factors as bonds with one major exception: The investors are always trying to guess when you might pay off your current mortgage.
How do mortgage-backed securities drive rates up?
MBS investors don’t want to be have a lot of low-interest rate loans if rates are on the rise. Historically, mortgage rates are higher when the economy is doing well or inflation is spiking. Mortgage lenders will start to raise their rates knowing MBS investors will be looking for higher returns, which means you’ll pay a higher rate if you need a mortgage during this time.
How do MBSs drive rates down?
If you look at a mortgage rates trend graph over the past several decades, when the economy starts to falter or inflation falls, mortgage rates often follow a downward path. MBS investors holding higher interest rate loans have to replace the loans that are paid off as people refinance to lower rates. Remember: They make their income on both the principal and interest, so each loan that is paid off is lost revenue for them. That means they start buying MBSs with lower rate mortgages to generate new income. The more MBSs that investors buy, the lower the rates drop.
Different types of mortgage-backed securities
When you take out a conventional or government-backed home loan, in most cases a mortgage-backed security will be involved.
Conventional loans. If you have a conventional loan, there’s a good chance it’s part of an MBS created or held by Fannie Mae and Freddie Mac in the secondary market. These government-sponsored enterprises keep a steady flow of affordable funds flowing throughout the U.S. housing market.
Government loans. Ginnie Mae (GNMA) guarantees MBSs for loans backed by the government. These include loans insured by the Federal Housing Administration (FHA); loan guaranteed by the U.S. Department of Veterans Affairs (VA); and loans backed by the U.S. Department of Agriculture (USDA).
Pass-throughs. With this type of MBS, your mortgage payments are collected and “passed through” to investors. Most pass-through mortgage-backed securities are backed by fixed-rate mortgages, but adjustable-rate mortgages (ARMs) and other loan types may be mixed in to create the security.
Collateralized mortgage obligations. Also known as CMOs for short, these mortgage-backed securities are made up of many pools of different securities divided into slices or “tranches.” They are a complex type of pass-through security traded by sophisticated investors.